Fall 2010 - Makeup

savannahstate.edu/misc/dowlingw/3155/Quizes%20-%20Fall%202010/makeup_fall_2010_-_html.htm

1.

Savelots Stores' current financial statements are shown below:

Inventories

$ 500

Accounts payable

$ 100

Other current assets

400

Short-term notes payable

370

Fixed assets

370

Total assets

$1,270

Sales

$2,000

Operating costs

1,843

EBIT

157

Less: Interest
EBT

Common equity
Total liab. and equity

800
$1,270

37
120

Less: Taxes (40%)

Net income

48
72

A recently released report indicates that Savelots' current ratio of 1.9 is in line with the industry average.
However, its accounts payable, which have no interest cost and which are due entirely to purchases of
inventories, amount to only 20% of inventory versus an industry average of 60%. Suppose Savelots took
actions to increase its accounts payable to inventories ratio to the 60% industry average, but it (1) kept all
of its assets at their present levels (that is, the asset side of the balance sheet remains constant) and (2)
also held its current ratio constant at 1.9. Assume that Savelots' tax rate is 40%, that its cost of short-term
debt is 10%, and that the change in payments will not affect operations. In addition, common equity would
not change. With the changes, what would be Savelots' new ROE?
a.

10.5%

b.

7.8%

c.

9.0%

d.

13.2%

e.

12.0%

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ANSWER:

A
The firm is not using its "free" trade credit (that is, accounts payable (A/P)) to the same
extent as other companies. Since it is financing part of its assets with 10% notes
payable, its interest expense is higher than necessary.
Calculate the increase in payables:
Current (A/P)/Inventories ratio = 100/500 = 0.20.
Target A/P = 0.60(Inventories) = 0.60(500) = 300.
Increase in A/P = 300 - 100 = 200.
Because the current ratio and total assets remain constant, total liabilities and equity
must be unchanged. The increase in accounts payable must be matched by an equal
decrease in interest bearing notes payable. Notes payable decline by 200. Interest
expense decreases by 200 0.10 = 20.
Construct comparative Income Statements:

Sales

Old

New

$2,000

$2,000

1,843

1,843

Operating costs
EBIT

157

157

Less: Interest

37

17

EBT

120

140

Less: Taxes
Net income (NI)

48
$

72

56
$

84

ROE = NI/Equity = $72/$800 = 9%. $84/$800 = 10.5%.

New ROE = 10.5%.
POINTS:

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2/27

2.

Large, well-known public companies can reduce the time required to register and issue securities by using
a(n)
a.

Shelf registration.

b.

Subchapter S registration.

c.

Underwriting syndicate.

d.

Secondary market registration.

e.

"Red herring" registration.

ANSWER:

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3.

An agreement for the sale of securities in which the investment bank guarantees the sale by purchasing the
securities from the issuer and then sells the securities in the primary is a(n) ____.
a.

best efforts arrangement

b.

guaranteed issue arrangement

c.

underwritten arrangement

d.

private placement

e.

None of the above

ANSWER:

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4.

What is the effective annual return (EAR) for an investment that pays 10 percent compounded annually?
a.

equal to 10 percent

b.

greater than 10 percent

c.

less than 10 percent

d.

This question cannot be answered without knowing the dollar amount of the investment.

e.

None of the above is correct.

ANSWER:

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5.

Suppose someone offered you your choice of two equally risky annuities, each paying $5,000 per year for
5 years. One is an annuity due, while the other is a regular (or deferred) annuity. If you are a rational
wealth-maximizing investor which annuity would you choose?
a.

The annuity due.

b.

The deferred annuity.

c.

Either one, because as the problem is set up, they have the same present value.

d.

Without information about the appropriate interest rate, we cannot find the values of the two
annuities, hence we cannot tell which is better.

e.

The annuity due; however, if the payments on both were doubled to $10,000, the deferred annuity
would be preferred.

ANSWER:

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4/27

6.

A $10,000 loan is to be amortized over 5 years, with annual end-of-year payments. Given these facts,
which of these statements is correct?
a.

The annual payments would be larger if the interest rate were lower.

b.

If the loan were amortized over 10 years rather than 5 years, and if the interest rate were the same
in either case, the first payment would include more dollars of interest under the 5-year
amortization plan.

c.

The last payment would have a higher proportion of interest than the first payment.

d.

The proportion of interest versus principal repayment would be the same for each of the 5
payments.

e.

The proportion of each payment that represents interest as opposed to repayment of principal
would be higher if the interest rate were higher.

ANSWER:

E
If the interest rate were higher, the payments would all be higher, and all of the
increase would be attributable to interest. So, the proportion of each payment that
represents interest would be higher.
Note that statement b is false because interest during Year 1 would be the interest
rate times the beginning balance, which is $10,000. With the same interest rate and
the same beginning balance, the Year 1 interest charge will be the same, regardless
of whether the loan is amortized over 5 or 10 years.

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5/27

7.

Assume that you will receive $2,000 a year in Years 1 through 5, $3,000 a year in Years 6 through 8, and
$4,000 in Year 9, with all cash flows to be received at the end of the year. If you require a 14 percent rate of
return, what is the present value of these cash flows?
a.

$9,851

b.

$13,250

c.

$11,714

d.

$15,129

e.

$17,353

ANSWER:

C
Cash flow time line:
Tabular solution:
PV

= $2,000 (PVIFA 14%, 5) + $3,000 (PVIFA 14%, 5) (PVIF14%, 9)

= $2,000 (3.4331) + $3,000 (2.3216) (0.5194) + $4,000 (0.3075)
= $6,866.20 + $3,617.52 + $1,230.00 = $11,713.72 $11,714.

Financial calculator solution:

Using cash flows
Inputs: CF0 = 0; CF 1 = 2,000; N j = 5; CF 2 = 3,000; N j = 3; CF 3 = 4,000; I = 14.
Output: NPV = $11,713.54 $11,714.
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6/27

8.

The Desai Company just borrowed $1,000,000 for 3 years at a quoted rate of 8 percent, quarterly
compounding. The loan is to be amortized in end-of-quarter payments over its 3-year life. How much
interest (in dollars) will your company have to pay during the second quarter?
a.

$15,675.19

b.

$18,508.81

c.

$21,205.33

d.

$24,678.89

e.

$28,111.66

ANSWER:

Compute the quarterly payment:

Beg Bal

PMT

INT

Principal

End Bal

$1,000,000.00

$94,559.60

$20,000.00

$74,559.60

$925,440.40

925,440.40

94,559.60

18,508.81

76,050.79

849,389.61

Interest in the second quarter (payment) is $18,508.81.

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9.

Here are the expected returns on two stocks:

Returns
Probability

0.1

-20%

10%

Portfolio

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0.8

20

15

0.1

40

20

If you form a 50-50 portfolio of the two stocks, what is the portfolio's standard deviation?
a.

8.1%

b.

10.5%

c.

13.4%

d.

16.5%

e.

20.0%

ANSWER:

A
Fill in the columns for "XY" and "product," and then use the formula to calculate the
standard deviation. We did each P calculation with a calculator, stored the value, did
the next calculation and added it to the first one, and so forth. When all three
calculations had been done, we recalled the stored memory value, took its square
root, and had .
Probability

Portfolio X Y

Product

0.1

-5.0%

0.8

17.5

14.0

0.1

30.0

3.0

-0.5%

= 16.5%

Covariance:
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8/27

10.

Allen Corporation can (1) build a new plant which should generate a before-tax return of 11 percent, or (2)
invest the same funds in the preferred stock of FPL, which should provide Allen with a before-tax return of
9%, all in the form of dividends. Assume that Allen's marginal tax rate is 25 percent, and that 70 percent of
dividends received are excluded from taxable income. If the plant project is divisible into small increments,
and if the two investments are equally risky, what combination of these two possibilities will maximize
Allen's effective return on the money invested?
a.

All in the plant project.

b.

All in FPL preferred stock.

c.

60% in the project; 40% in FPL.

d.

60% in FPL; 40% in the project.

e.

50% in each.

ANSWER:

B
After-tax return on the new project:
0.11(1 - T) = 0.11(0.75) = 0.0825 = 8.25%.
After-tax return on the preferred stock:
0.09[1 - 0.25(0.3)] = 0.08325 = 8.325%.
Therefore, invest 100 percent in the FPL preferred stock.

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9/27

11.

Which of the following statements is most correct?

a.

If a bond's yield to maturity exceeds its coupon rate, the bond's current yield must also exceed its
coupon rate.

b.

If a bond's yield to maturity exceeds its coupon rate, the bond's price must be less than its maturity
value.

c.

If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the
bonds should sell for the same price regardless of the bond's coupon rate.

d.

Answers b and c are both correct.

e.

None of the above answers are correct.

ANSWER:

B
Statement b is correct. If a bond's YTM exceeds its coupon rate, the n, by definition,
the bond sells at a discount. Thus, the bond's price is less than its maturity value.
Statement a is false. Consider zero-coupon bonds. A zero-coupon bond's YTM
exceeds its coupon rate (which is equal to zero); however, its current yield is equal to
zero which is equal to its coupon rate. Statement c is false; a bond's value is
determined by its cash flows: coupon payments plus principal. If the 2 bonds have
different coupon payments, their prices would have to be different in order for them to
have the same YTM.

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10/27

12.

Devine Divots issued a bond a few years ago that has a face value equal to $1,000 and pays investors $30
interest every six months. The bond has eight years remaining until maturity. If you require a 7 percent rate
of return to invest in this bond, what is the maximum price you should be willing to pay to purchase the
bond?
a.

$761.15

b.

$939.53

c.

$940.29

d.

$965.63

e.

$1,062.81

ANSWER:

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13.

In international markets, excluding stocks sold in the United States, what is any stock that is traded in a
country other than the issuing company's home country called?
a.

ADRs

b.

Yankee stock

c.

Euro stock

d.

Class A stock

e.

Preferred stock

ANSWER:

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11/27

14.

Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund a new
project. The increase in shares will bring to 25 million the number of shares outstanding. Nahanni's longterm growth rate is 6 percent, and its current required rate of return is 12.6 percent. The firm just paid a
$1.00 dividend and the stock sells for $16.06 in the market. On the announcement of the new equity issue,
the firm's stock price dropped. Nahanni estimates that the company's growth rate will increase to 6.5
percent with the new project, but since the project is riskier than average, the firm's cost of capital will
increase to 13.5 percent. Using the DDM constant growth model, what is the change in the equilibrium
stock price?
a.

-$1.77

b.

-$1.06

c.

-$0.85

d.

-$0.66

e.

-$0.08

ANSWER:

C
Calculate new equilibrium price and determine change:
Change in price = $16.06 - $15.21 = $0.85

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12/27

15.

Which of the following statements is correct?

a.

The constant growth DDM model can be used to value a stock only if the stock's dividends are
expected to grow forever at a constant rate which is less than the required rate of return on the
stock.

b.

If the growth rate is negative, the constant growth DDM model cannot be used.

c.

The constant growth DDM model may be written as r 0 = D 0/P0 + g.

d.

The constant growth DDM model may be written as P 0 = D 0/(r + g).

e.

The constant growth DDM model may be written as P 0 = D 0/(r - g).

ANSWER:

A
Statement a is the condition necessary for the constant growth model. All the other
statements are false.

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13/27

16.

Philadelphia Corporation's stock recently paid a dividend of $2.00 per share (D 0 = $2), and the stock is in
equilibrium. The company has a constant growth rate of 5 percent and a beta equal to 1.5. The required
rate of return on the market is 15 percent, and the risk-free rate is 7 percent. Philadelphia is considering a
change in policy which will increase its beta coefficient to 1.75. If market conditions remain unchanged,
what new constant growth rate will cause the common stock price of Philadelphia to remain unchanged?
a.

8.85%

b.

18.53%

c.

6.77%

d.

5.88%

e.

13.52%

ANSWER:

C
Calculate the initial required return and equilibrium price
rs = 0.07 + (0.08)1.5 = 0.19 = 19%.
Calculate the new required return and equilibrium growth rate
New rs = 0.07 + (0.08)1.75 = 0.21.
New rs = 0.21 = ; P 0 = $15 (Unchanged)

POINTS:

3.15 2.0

= 2g + 15g (Multiply both sides by 15, combine like terms.)

1.15

= 17g

= 0.06765 6.77%

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14/27

17.

Which of the following statements is most correct?

a.

If investors become more risk averse, but r RF remains constant, the required rate of return on high
beta stocks will rise, the required return on low beta stocks will decline, but the required return on
an average risk stock will not change.

b.

If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual
Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would have
betas of 1.0 and thus would be equally risky from an investor's standpoint.

c.

An investor who holds just one stock will be exposed to more risk than an investor who holds a
portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock
portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to
compensate for the greater risk.

d.

Assume that the required rate of return on the market , r M, is given and fixed. If the yield curve
were upward-sloping, then the Security Market Line (SML) would have a steeper slope if 1-year
Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for
rRF .

e.

Statements a, b, c, and d are all false.

ANSWER:

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15/27

18.

HR Corporation has a beta of 2.0, while LR Corporation's beta is 0.5. The risk-free rate is 10%, and the
required rate of return on an average stock is 15%. Now the expected rate of inflation built into r RF falls by
3 percentage points, the real risk-free rate remains constant, the required return on the market falls to 11%,
and the betas remain constant. When all of these changes are made, what will be the difference in required
returns on HR's and LR's stocks?
a.

1.0%

b.

2.5%

c.

4.5%

d.

5.4%

e.

6.0%

ANSWER:

E
bHR = 2.0; bLR = 0.5. No changes occur.
rRF = 10%. Decreases by 3% to 7%.
rM = 15%. Falls to 11%.
Now SML: ri = r RF + (r M - rRF )bI
rHR = 7% + (11% - 7%)2 = 7% + 4%(2)

15%

rLR = 7% + (11% - 7%)0.5 = 7% + 4%(0.5)

Difference

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6%

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16/27

19.

An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100 per year at
the end of each year of the 20 years. Find the internal rate of return to the nearest whole percentage point.
a.

9%

b.

7%

c.

5%

d.

3%

e.

11%

ANSWER:

C
Cash flow time line:
Financial calculator solution:
Inputs: = 0; = -100; Nj = 19; = 3,210
Output: IRR = 5.0%
Alternate method annuity calculation
Inputs: N = 20; PMT = -100; FV = 3,310
Output: I = 5.0%

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17/27

20.

Which of the following is most correct? The modified IRR (MIRR) method:
a.

Always leads to the same ranking decision as NPV for independent projects.

b.

Overcomes the problem of multiple rates of return.

c.

Compounds cash flows at the required rate of return.

d.

Overcomes the problem of cash flow timing and the problem of project size that leads to criticism
of the regular IRR method.

e.

Answers b and c are both correct.

ANSWER:

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21.

Which of the following statements is correct?

a.

There can never be a conflict between NPV and IRR decisions if the decision is related to a
normal, independent project, i.e., NPV will never indicate acceptance if IRR indicates rejection.

b.

To find the MIRR, we first compound CFs at the regular IRR to find the TV, and then we discount
the TV at the required rate of return to find the PV.

c.

The NPV and IRR methods both assume that cash flows are reinvested at the required rate of
return. However, the MIRR method assumes reinvestment at the MIRR itself.

d.

If you are choosing between two projects which have the same cost, and if their NPV profiles
cross, then the project with the higher IRR probably has more of its cash flows coming in the later
years.

e.

A change in the required rate of return would normally change both a project's NPV and its IRR.

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ANSWER:

A
Statement a is true. To see this, sketch out a NPV profile for a normal, independent
project, which means that only one NPV profile will appear on the graph. If r < IRR,
then IRR says accept. But in that case, NPV > 0, so NPV will also say accept.
Statement d is false. Here is the reasoning:
1.

For the NPV profiles to cross, one project must have a higher NPV at r = 0
than the other project, i.e., their vertical axis intercepts will be different.

2.

A second condition for NPV profiles to cross is that one have a higher IRR
than the other.

3.

The third condition necessary for profiles to cross is that the project with the
higher NPV at r = 0 have the lower IRR. One can sketch out two NPV profiles
on a graph to see that these three conditions are indeed required.

4.

The project with the higher NPV at r = 0 must have more cash inflows,
because it has the higher NPV when cash flows are not discounted, which is
the situation if r = 0.

5.

If the project with more total cash inflows also had its cash flows come in
earlier, it would dominate the other projectits NPV would be higher at all
discount rates, and its IRR would also be higher, so the profiles would not
cross. The only way the profiles can cross is for the project with more total
cash inflows to get a relatively high percentage of those inflows in distant
years, so that their PVs are low when discounted at high rates.

Most students either grasp this intuitively or else just guess at the question!

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19/27

22.

Capitol City Transfer Company is considering building a new terminal in Salt Lake City. If the company
goes ahead with the project, it must spend $1 million immediately (at t = 0) and another $1 million at the
end of Year 1 (t = 1). It will then receive net cash flows of $0.5 million at the end of Years 2-5, and it expects
to sell the property and net $1 million at the end of Year 6. All cash inflows and outflows are after taxes.
The company's required rate of return is 12 percent, and it uses the modified IRR criterion for capital
budgeting decisions. What is the project's modified IRR (MIRR)?
a.

11.9%

b.

12.0%

c.

11.4%

d.

11.5%

e.

11.7%

ANSWER:

E
Financial calculator solution:
Calculate TV (Terminal value)
Inputs: = 0; = 500,000; Nj = 4; = 1,000,000; I = 12.
Output: NFV = $3,676,424.
Calculate MIRR
Inputs: N = 6; PV = -1,892,857; FV = 3,676,424.
Output: I = 11.6995% 11.70%.

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20/27

23.

Which of the following statements is correct?

a.

An asset that is sold for less than book value at the end of a project's life will generate a loss for the
firm and will cause an actual cash outflow attributable to the project.

b.

Only incremental cash flows are relevant in project analysis and the proper incremental cash flows
are the reported accounting profits because they form the true basis for investor and managerial
decisions.

c.

It is unrealistic to expect that increases in net working capital that are required at the start of an
expansion project are simply recovered at the project's completion. Thus, these cash flows are
included only at the start of a project.

d.

Equipment sold for more than its book value at the end of a project's life will increase income and,
despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book
value.

e.

All of the above are false.

ANSWER:

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21/27

24.

Sun State Mining Inc., an all-equity firm, is considering the formation of a new division which will increase
the assets of the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U.S.
Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If Sun State wants to reduce its
required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?
a.

2.2

b.

1.0

c.

1.8

d.

1.6

e.

2.0

ANSWER:

B
Old assets = 1.0.

New assets = 0.5.

Total assets = 1.5.

Old required rate:

18% = 7% + (5%) b
beta = 2.2.
New required rate:
16% = 7% + (5%) b
beta = 1.8.
New b must not be greater than 1.8, therefore
0.3333(b) = 0.3333
b = 1.0.
Therefore, beta of the new division cannot exceed 1.0.
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J. Ross and Sons Inc.

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred
stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell
as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a
dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred
stock. Ross expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells
for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm
recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow
indefinitely at a constant rate of 10 percent per year.

22/27

25.

Refer to J. Ross and Sons Inc . What is the firm's cost of newly issued preferred stock?
a.

10.0%

b.

12.5%

c.

15.5%

d.

16.5%

e.

18.0%

ANSWER:

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26.

Refer to J. Ross and Sons Inc . What will be the WACC above this break point?
a.

12.5%

b.

8.3%

c.

10.6%

d.

11.9%

e.

14.1%

ANSWER:

D
WACC = 6%(0.40) + 12.5%(0.10) + 16.5%(0.50) = 11.90%.

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23/27

27.

Which of the following are practical difficulties associated with capital structure and degree of leverage
analyses?
a.

It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates (r s values)
are affected by different degrees of financial leverage.

b.

Managers' attitudes toward risk differ and some managers may set a target capital structure other
than the one that would maximize stock price.

c.

Managers often have a responsibility to provide continuous service; they must preserve the longrun viability of the enterprise. Thus, the goal of employing leverage to maximize short-run stock
price and minimize capital cost may conflict with long-run viability.

d.

All of the above.

e.

None of the above represent a serious impediment to the practical application of leverage analysis
to capital structure determination.

ANSWER:

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24/27

28.

Which of the following statements is correct?

a.

There have been no significant observed differences in the capital structures of U.S. corporations
in comparison to their German and Japanese counterparts.

b.

Different countries use essentially the same international accounting conventions with respect to
reporting assets on a historical versus replacement cost basis.

c.

An analysis of both bankruptcy and equity reporting costs leads to the conclusion that U.S. firms
should have more equity and less debt than firms in Japan and Germany.

d.

Equity monitoring costs are higher in the United States than in Japan and Germany.

e.

Debt monitoring costs are probably lower in the United States than in Japan and Germany.

ANSWER:

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25/27

29.

Which of the following is correct?

a.

Generally, debt to total assets ratios do not vary much among different industries although they do
vary for firms within a particular industry.

b.

Utilities generally have very high common equity ratios due to their need for vast amounts of equity
supported capital.

c.

The drug industry has a high debt to common equity ratio because their earnings are very stable
and thus, can support the large interest costs associated with higher debt levels.

d.

Wide variations in capital structures exist between industries and also between individual firms
within industries and are influenced by unique firm factors including managerial attitudes.

e.

Since most stocks sell at or around their book values, using accounting values provides an
accurate picture of a firm's capital structure.

ANSWER:

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30.

Assume that a firm has a DFL of 1.25. If sales increase by 20 percent, the firm will experience a 60 percent
increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not
increase?
a.

$113,412

b.

$100,000

c.

$84,375

d.

$67,568

e.

$42,115

ANSWER:

D
DTL = DEPS/DSales = 60%/20% = 3.0.
DOL = DTL/DFL = 3.0/1.25 = 2.40.
Old EBIT = $100,000/ [1 + (0.20)(2.40)] = $100,000/1.48 = $67,568.
Alternate solution:
Use DFL expression to calculate change in EBIT and previous EBIT:
DFL

= 1.25 = % DEPS/ % DEBIT

= 0.60/ [ DEBIT/($100,000 - DEBIT)]
= [0.60($100,000) - 0.60(DEBIT)]/DEBIT

1.25DEBIT

= $60,000 - 0.60(DEBIT)

1.85DEBIT

= $60,000

DEBIT

= $32,432.

Old EBIT = $100,000 - $32,432 = $67,568.

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