1) Freedman Flowers’ stock has a 50% chance of producing a 25% return, a 30%
chance of producing a 10% return, and a 20% chance of producing a -28% return. What
is the firm’s expected rate of return?
a.9.41%
b.9.65%
c.9.90%
d.10.15%
e.10.40%
2) Which of the following events is likely to encourage a company to raise its target
debt ratio, other things held constant?
a.An increase in the personal tax rate
b.An increase in the company’s operating leverage
c.The Federal Reserve tightens interest rates in an effort to fight inflation
d.The company’s stock price hits a new high
e.An increase in the corporate tax rate
3) Porter Plumbing’s stock had a required return of 11.75% last year, when the risk-free
rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor
risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the
firm’s beta remain unchanged. What is the company’s new required rate of return?
(Hint: First calculate the beta, then find the required return.)
a.14.38%
b.14.74%
c.15.11%
d.15.49%
e.15.87%
4) The preemptive right is important to shareholders because it
a.will result in higher dividends per share
b.is included in every corporate charter
c.protects the current shareholders against a dilution of their ownership interests
d.protects bondholders, and thus enables the firm to issue debt with a relatively low
interest rate
e.allows managers to buy additional shares below the current market price
5) Firms HD and LD are identical except for their level of debt and the interest rates
they pay on debtHD has more debt and pays a higher interest rate on that debt. Based
on the data given below, what is the difference between the two firms’ ROEs?
Applicable to Both FirmsFirm HD’s DataFirm LD’s Data
Assets$200Debt ratio50%Debt ratio30%
EBIT$40Interest rate12%Interest rate10%
Tax rate35%
a.2.18%
b.2.29%
c.2.41%
d.2.54%
e.2.66%
6) Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 is invested in
Stock X and the remainder is invested in Stock Y. X’s beta is 1.50 and Y’s beta is 0.70.
What is the portfolio’s beta?
a.0.65
b.0.72
c.0.80
d.0.89
e.0.98
7) Which of the following procedures does the text say is used most frequently by
businesses when they do capital budgeting analyses?
a.Differential project risk cannot be accounted for by using “risk-adjusted discount
rates” because it is highly subjective and difficult to justify. It is better to not risk adjust
at all
b.Other things held constant, if returns on a project are thought to be positively
correlated with the returns on other firms in the economy, then the project’s NPV will be
found using a lower discount rate than would be appropriate if the project’s returns were
negatively correlated
c.Monte Carlo simulation uses a computer to generate random sets of inputs, those
inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged
to find the project’s expected NPV. Sensitivity and scenario analyses, on the other hand,
require much more information regarding the input variables, including probability
distributions and correlations among those variables. This makes it easier to implement
a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the
most frequently used procedure
d.DCF techniques were originally developed to value passive investments (stocks and
bonds). However, capital budgeting projects are not passive investmentsmanagers can
often take positive actions after the investment has been made that alter the cash flow
stream. Opportunities for such actions are called real options. Real options are valuable,
but this value is not captured by conventional NPV analysis. Therefore, a project’s real
options must be considered separately
e.The firm’s corporate, or overall, WACC is used to discount all project cash flows to
find the projects’ NPVs. Then, depending on how risky different projects are judged to
be, the calculated NPVs are scaled up or down to adjust for differential risk
8) Suppose a firm relies exclusively on the payback method when making capital
budgeting decisions, and it sets a 4-year payback regardless of economic conditions.
Other things held constant, which of the following statements is most likely to be true?
a.It will accept too many long-term projects and reject too many short-term projects (as
judged by the NPV)
b.The firm will accept too many projects in all economic states because a 4-year
payback is too low.
c.The firm will accept too few projects in all economic states because a 4-year payback
is too high
d.If the 4-year payback results in accepting just the right set of projects under average
economic conditions, then this payback will result in too few long-term projects when
the economy is weak
e.It will accept too many short-term projects and reject too many long-term projects (as
judged by the NPV)
9) Downie Foods recently completed a 4-for-1 stock split. Prior to the split, its stock
sold for $120 per share. If the firm’s total market value increased by 5% as a result of
increased liquidity caused by the split, what was the stock price following the split?
a. $28.43
b. $29.93
c. $31.50
d. $33.08
e. $34.73
10) A venture capital investment group received a proposal from Wireless Solutions to
produce a new smart phone. The variable cost per unit is estimated at $250, the sales
price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and the
investors will put up the funds if the project is likely to have an operating income of
$500,000 or more. What sales volume would be required in order to meet this profit
goal?
a.4,513
b.4,750
c.5,000
d.5,250
e.5,513
11) Barette Consulting currently has no debt in its capital structure, has $500 million of
total assets, and its basic earning power is 15%. The CFO is contemplating a
recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy
back shares of the company’s common stock, paying book value. If the company
proceeds with the recapitalization, its operating income, total assets, and tax rate will
remain unchanged. Which of the following is most likely to occur as a result of the
recapitalization?
a.The ROA would remain unchanged
b.The basic earning power ratio would decline
c.The basic earning power ratio would increase
d.The ROE would increase
e.The ROA would increase
12) Which of the following statements is CORRECT?
a.A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5%
coupon bond (assuming all else equal)
b.The total return on a bond during a given year is the sum of the coupon interest
payments received during the year and the change in the value of the bond from the
beginning to the end of the year
c.The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the
price of a 5-year, 10% bond
d.A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is
not expected to default would sell at a discount if interest rates were below 9% and at a
premium if interest rates were greater than 11%
e.10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10%
coupon bonds
13) You recently sold 200 shares of Apple stock to your brother. The transfer was made
through a broker, and the trade occurred on the NYSE. This is an example of:
a. A futures market transaction
b. A primary market transaction
c. A secondary market transaction
d. A money market transaction
e. An over-the-counter market transaction
14) An analyst wants to use the Black-Scholes model to value call options on the stock
of Heath Corporation based on the following data:
The price of the stock is $40.
The strike price of the option is $40.
The option matures in 3 months (t = 0.25).
The standard deviation of the stock’s returns is 0.40, and the variance is 0.16.
The risk-free rate is 6%.
Given this information, the analyst then calculated the following necessary components
of the Black-Scholes model:
d1 = 0.175
d2 = -0.025
N(d1) = 0.56946
N(d2) = 0.49003
N(d1) and N(d2) represent areas under a standard normal distribution function. Using
the Black-Scholes model, what is the value of the call option?
a.$2.81
b.$3.12
c.$3.47
d.$3.82
e.$4.20
15) Which of the following would increase the likelihood that a company would
increase its debt ratio, other things held constant?
a.An increase in the corporate tax rate
b.An increase in the personal tax rate
c.The Federal Reserve tightens interest rates in an effort to fight inflation
d.The company’s stock price hits a new low
e.An increase in costs incurred when filing for bankruptcy
16) An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has
$2,000,000 of EBIT, which is expected to remain constant in the future. The company
pays out all of its earnings, so earnings per share (EPS) equal dividends per shares
(DPS). Its tax rate is 40%.
The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds
to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and
the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the
recapitalization occurs.
Assuming that the shares can be repurchased at the price that existed prior to the
recapitalization, what would the price be following the recapitalization?
a.$65.77
b.$69.23
c.$72.69
d.$76.33
e.$80.14
17) Joel Foster is the portfolio manager of the SF Fund, a $3 million hedge fund that
contains the following stocks. The required rate of return on the market is 11.00% and
the risk-free rate is 5.00%. What rate of return should investors expect (and require) on
this fund?
StockAmountBeta
A$1,075,0001.20
B 675,0000.50
C 750,0001.40
D 500,0000.75
$3,000,000
a.10.56%
b.10.83%
c.11.11%
d.11.38%
e.11.67%
18) Which of the following statements is CORRECT?
a.An indenture is a bond that is less risky than a mortgage bond
b.The expected return on a corporate bond will generally exceed the bond’s yield to
maturity
c.If a bond’s coupon rate exceeds its yield to maturity, then its expected return to
investors exceeds the yield to maturity
d.Under our bankruptcy laws, any firm that is in financial distress will be forced to
declare bankruptcy and then be liquidated
e.All else equal, senior debt generally has a lower yield to maturity than subordinated
debt
19) Hinkle Corporation buys on terms of 2/15, net 60 days. It does not take discounts,
and it typically pays on time, 60 days after the invoice date. Net purchases amount to
$550,000 per year. On average, what is the dollar amount of total trade credit (costly +
free) the firm receives during the year, i.e., what are its average accounts payable?
(Assume a 365-day year, and note that purchases are net of discounts.)
a.$90,411
b.$94,932
c.$99,678
d.$104,662
e.$109,895
20) Which of the following statements is CORRECT?
a.The preemptive right gives stockholders the right to approve or disapprove of a
merger between their company and some other company
b.The preemptive right is a provision in the corporate charter that gives common
stockholders the right to purchase (on a pro rata basis) new issues of the firm’s common
stock
c.The stock valuation model, P0 = D1/(rs – g), cannot be used for firms that have
negative growth rates
d.The stock valuation model, P0 = D1/(rs – g), can be used only for firms whose growth
rates exceed their required returns
e.If a company has two classes of common stock, Class A and Class B, the stocks may
pay different dividends, but under all state charters the two classes must have the same
voting rights
21) Which of the following statements is CORRECT?
a.Sunk costs must be considered if the IRR method is used but not if the firm relies on
the NPV method
b.A good example of a sunk cost is a situation where a bank opens a new office, and
that new office leads to a decline in deposits of the bank’s other offices
c.A good example of a sunk cost is money that a banking corporation spent last year to
investigate the site for a new office, then expensed that cost for tax purposes, and now
is deciding whether to go forward with the project
d.If sunk costs are considered and reflected in a project’s cash flows, then the project’s
calculated NPV will be higher than it otherwise would be
e.An example of a sunk cost is the cost associated with restoring the site of a strip mine
once the ore has been depleted
22) You were recently hired by Garrett Design, Inc. to estimate its cost of common
equity. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00%
(constant); and F = 5.00%. What is the cost of equity raised by selling new common
stock?
a.10.77%
b.11.33%
c.11.90%
d.12.50%
e.13.12%
23) You have been asked to forecast the additional funds needed (AFN) for Houston,
Hargrove, & Worthington (HHW), which is planning its operation for the coming year.
The firm is operating at full capacity. Data for use in the forecast are shown below.
However, the CEO is concerned about the impact of a change in the payout ratio from
the 10% that was used in the past to 50%, which the firm’s investment bankers have
recommended. Based on the AFN equation, by how much would the AFN for the
coming year change if HHW increased the payout from 10% to the new and higher
level? All dollars are in millions.
Last year’s sales = S0$300.0Last year’s accounts payable$50.0
Sales growth rate = g40%Last year’s notes payable$15.0
Last year’s total assets = A0*$500.0Last year’s accruals$20.0
Last year’s profit margin = PM20.0%Initial payout ratio10.0%
a.$31.9
b.$33.6
c.$35.3
d.$37.0
e.$38.9
24) Which of the following statements is CORRECT?
a.Since debt financing is cheaper than equity financing, raising a company’s debt ratio
will always reduce its WACC
b.Increasing a company’s debt ratio will typically reduce the marginal cost of both debt
and equity financing. However, this action still may raise the company’s WACC
c.Increasing a company’s debt ratio will typically increase the marginal cost of both
debt and equity financing. However, this action still may lower the company’s WACC
d.Since a firm’s beta coefficient it not affected by its use of financial leverage, leverage
does not affect the cost of equity
e.Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio
will always increase its WACC
25) Which of the following statements best describes the optimal capital structure? The
optimal capital structure is the mix of debt, equity, and preferred stock that maximizes
the company’s ____.
a.stock price
b.cost of equity
c.cost of debt
d.cost of preferred stock
e.earnings per share (EPS)
26) If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock’s
expected capital gains yield for the coming year?
a.6.50%
b.6.83%
c.7.17%
d.7.52%
e.7.90%
27) Which of the following actions should Reece Windows take if it wants to reduce its
cash conversion cycle?
a.Take steps to reduce the DSO
b.Start paying its bills sooner, which would reduce the average accounts payable but not
affect sales
c.Sell common stock to retire long-term bonds
d.Sell an issue of long-term bonds and use the proceeds to buy back some of its
common stock
e.Increase average inventory without increasing sales
28) Which of the following statements is CORRECT?
a.Two firms with the same expected dividend and growth rates must also have the same
stock price
b.It is appropriate to use the constant growth model to estimate a stock’s value even if
its growth rate is never expected to become constant
c.If a stock has a required rate of return rs = 12%, and if its dividend is expected to
grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%
d.The price of a stock is the present value of all expected future dividends, discounted
at the dividend growth rate
e.The constant growth model takes into consideration the capital gains investors expect
to earn on a stock
29) One year ago Lerner and Luckmann Co. issued 15-year, noncallable, 7.5% annual
coupon bonds at their par value of $1,000. Today, the market interest rate on these
bonds is 5.5%. What is the current price of the bonds, given that they now have 14
years to maturity?
a.$1,077.01
b.$1,104.62
c.$1,132.95
d.$1,162.00
e.$1,191.79
30) Taylor Textbooks Inc. buys on terms of 2/15, net 50 days. It does not take discounts,
and it typically pays on time, 50 days after the invoice date. Net purchases amount to
$450,000 per year. On average, what is the dollar amount of costly trade credit (total
credit – free credit) the firm receives during the year? (Assume a 365-day year, and note
that purchases are net of discounts.)
a.$43,151
b.$45,308
c.$47,574
d.$49,952
e.$52,450
31) In 1985, a given Japanese imported automobile sold for 1,476,000 yen, or $8,200. If
the car still sold for the same amount of yen today but the current exchange rate is 144
yen per dollar, what would the car be selling for today in U.S. dollars?
a.$5.964
b.$8,200
c.$10,250
d.$12,628
e.$13,525
32) Two operationally similar companies, HD and LD, have the same total assets,
operating income (EBIT), tax rate, and business risk. Company HD, however, has a
much higher debt ratio than LD. Also HD’s basic earning power (BEP) exceeds its cost
of debt (rd). Which of the following statements is CORRECT?
a.HD should have a higher times interest earned (TIE) ratio than LD
b.HD should have a higher return on equity (ROE) than LD, but its risk, as measured by
the standard deviation of ROE, should also be higher than LD’s
c.Given that BEP > rd, HD’s stock price must exceed that of LD
d.Given that BEP > rd, LD’s stock price must exceed that of HD
e.HD should have a higher return on assets (ROA) than LD
33) The fact that long-term debt and common stock are raised infrequently and in large
amounts lessens the need for the firm to forecast those accounts on a continual basis.
34) A stock’s beta is more relevant as a measure of risk to an investor who holds only
one stock than to an investor who holds a well-diversified portfolio.
35) A firm’s AFN must come from external sources. Typical sources include short-term
bank loans, long-term bonds, preferred stock, and common stock.
36) One problem with ratio analysis is that relationships can be manipulated. For
example, if our current ratio is greater than 1.5, then borrowing on a short-term basis
and using the funds to build up our cash account would cause the current ratio to
increase.
37) Diversification will normally reduce the riskiness of a portfolio of stocks.
38) If a dollar will buy fewer units of a foreign currency in the forward market than in
the spot market, then the forward currency is said to be selling at a premium to the spot
rate.
39) Although it is extremely difficult to make accurate forecasts of the revenues that a
project will generate, projects’ initial outlays and subsequent costs can be forecasted
with great accuracy. This is especially true for large product development projects.