Pretest - Chapters 2,3,5,6 & 7

savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/summer_2011_-_2,3,5,6,7_pretest.htm

1.

Depreciation, as shown on the income statement, is regarded as a use of cash because it is an expense.

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2.

When a firm pays off a loan using cash, the source of funds is the decrease in the asset account, cash,
while the use of funds involves a decrease in a liability account, debt.

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3.

Non-cash assets are expected to produce cash over time but the amount of cash they eventually produce
could be higher or lower than the values at which the assets are carried on the books.

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4.

Taxes, payment patterns, and reporting considerations, as well as credit sales and non-cash costs, are
reasons why operating cash flows can differ from accounting profits.

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5.

A decline in the inventory turnover ratio suggests that the firm's liquidity position is improving.

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6.

Profitability ratios show the combined effects of liquidity, asset management, and debt management on
operations.

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7.

The information contained in the annual report is used by investors to form expectations about future
earnings and dividends.

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8.

On the balance sheet, total assets must equal total liabilities plus stockholders equity.

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9.

A firm's net income reported on its income statement must equal the operating cash flows on the
statement of cash flows.

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10.

A statement reporting the impact of a firm's operating, investing, and financing activities on cash flows
over an accounting is the statement of cash flows.

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11.

A liquid asset is an asset that can be easily converted into cash without a significant loss of its original
value.

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12.

Retained earnings is the cash that has been generated by the firm through its operations which has not
been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts
and thus, these cash accounts, when added together, will always be equal to the total retained earnings
of the firm.

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13.

The financial position of companies whose business is seasonal can be dramatically different depending
upon the time of year chosen to construct financial statements. This time sensitivity is especially true with
respect to the firm's balance sheet.

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14.

Current cash flow from existing assets is highly relevant to the investor. However, the value of the firm
depends primarily upon its growth opportunities. As a result, profit projections from those opportunities
are the only relevant future flows with which investors are concerned.

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15.

The inventory turnover and current ratios are related. The combination of a high current ratio and a low
inventory turnover ratio relative to the industry norm might indicate that the firm is maintaining too high an
inventory level or that part of the inventory is obsolete or damaged.

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16.

We can use the fixed asset turnover ratio to legitimately compare firms in different industries as long as all
the firms being compared are using the same proportion of fixed assets to total assets.

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17.

If an individual investor buys and sells existing stocks through a broker, these are primary market
transactions.

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18.

Financial asset markets deal with stocks, bonds, mortgages, and other claims on real assets with respect
to the distribution of future cash flows.

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19.

American depository receipts are foreign stocks that sell in American stock exchanges and are
denominated in dollar prices.

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20.

The OTC market is a physical exchange, much like the New York Stock Exchange, where securities
dealers provide trading in unlisted securities.

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21.

The debt markets are segmented based on the maturity of the debt instruments, the type of debt
instruments, and the participants in the market.

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22.

During or near peaks of business activity, yield curves that are flat or downward sloping (possibly with
humps) often are prevalent.

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23.

The fact that a percentage of the interest income received by one corporation is excluded from taxable
income has encouraged firms to use more debt financing relative to equity financing.

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24.

The liquidity preference theory states that each borrower and lender has a preferred maturity and that the
slope of the yield curve depends on supply and demand for funds in the long-term market relative to the
short-term market.

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25.

If you have information that a recession is ending, and the economy is about to enter a boom, and your
firm needs to borrow money, it should probably issue long-term rather than short-term debt.

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26.

The two reasons most experts give for the existence of a positive maturity risk premium are (1) because
investors are assumed to be risk averse, and (2) because investors prefer to lend long while firms prefer
to borrow short.

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27.

The existence of an upward sloping yield curve proves that the liquidity preference theory is correct,
because an upward sloping curve necessarily implies that firms must offer a maturity risk premium in
order to induce investors to lend for longer periods.

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28.

Suppose financial institutions, such as savings and loans, were required by law to make long-term, fixed
interest rate mortgages, but, at the same time, were largely restricted, in terms of their capital sources, to
deposits that could be withdrawn on demand. Under these conditions, these financial institutions should
prefer a "normal" yield curve to an inverted curve.

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29.

Investors with a higher time preference for consumption will demand a lower rate of return to forego
current consumption and save than investors with a lower time preference for consumption.

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30.

Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so
they tend to attract it away from less efficient firms or from those whose products are not in demand.

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31.

Typically, debentures have higher interest rates than mortgage bonds primarily because the mortgage
bonds are backed by assets while debentures are unsecured.

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32.

A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls
are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount
back and reinvest it elsewhere at higher rates.

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33.

Foreign debt is a debt instrument sold by a foreign borrower but denominated in the currency of the
country in which it is sold.

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34.

Eurobonds have a higher level of required disclosure than normally is found for bonds issued in domestic
markets, particularly the United States.

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35.

Floating rate debt is advantageous to investors because the interest rate moves up if market rates rise.
Floating rate debt shifts interest rate risk to companies and thus has no advantages for issuers.

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36.

A 20-year original maturity bond with 1 year left to maturity has more interest rate price risk than a 10-year
original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and
equal coupon rates.)

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37.

A bond's value will increase as interest rates rise over time.

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38.

You have just noticed in the financial pages of the local newspaper that you can buy a bond ($1,000 par)
for $800. If the coupon rate is 10 percent, with annual interest payments, and there are 10 years to
maturity, should you make the purchase if your required return on investments of this type is 12 percent?

ANSWER:

T
Cash flow time line:
Tabular solution:
Vd

= $100 (PVIFA 12%, 10) + $1,000 (PVIF 12%, 10)

= $100 (5.6502) + $1,000 (0.3220) = $877.02.

Thus, the value is significantly higher than the market price and the bond should be
purchased.
Financial calculator solution:
Inputs: N = 10; I = 12; PMT = 100; FV = 1,000.
Output: PV = -$887.00.
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39.

If you buy a bond that is selling for less than its face, or maturity, value then the price (value) of the bond
will increase the maturity date nears if market interest rates do not change during the life of the bond.

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40.

The longer the maturity of a bond, the more its price will change in response to a given change in interest
rates; this is called interest rate price risk.

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41.

American depository receipts (ADRs) are foreign stocks listed on a domestic exchange.

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42.

Founders' shares is a type of classified stock where the shares are owned by the firm's founders and they
retain the sole voting rights to those shares but have restricted dividends for a specified time period.

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43.

After a new issue is brought to market it is the marginal investor who determines the price at which the
stock will trade.

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44.

A stock's par value is equal to the market value of the stock on the last day of the fiscal year for a firm.

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45.

The book value per share is computed by taking the sum of common stock, additional paid in capital, and
retained earnings and dividing the number by the number of shares outstanding.

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46.

A proxy fight is an attempt by a group to gain control of a firm by convincing its stockholders to give the
group the authority to vote their shares in order to elect a new management team.

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47.

Preemptive rights are important to stockholders because they provide protection against a dilution of
value when new shares are issued.

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48.

When a firm issues new equity, market pressure applies first to the new shares issued and then to
existing shares. Subsequent to the new issue, the value of the new shares will rise to the equilibrium price
of the old shares.

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49.

According to the textbook model, under conditions of nonconstant growth, the discount rate utilized to find
the present value of the expected cash flows will be the same for the initial growth period as for the
normal growth period.

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50.

Other things held constant, P/E ratios are higher for firms with high growth prospects. At the same time,
P/E's are lower for riskier firms, other things held constant. These two factors, growth prospects and
riskiness, may either be offsetting or reinforcing as P/E determinants.

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Multiple Choice
Identify the choice that best completes the statement or answers the question.

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51.

All of the following represent cash outflows to the firm except

a.

Taxes.

b.

Interest payments.

c.

Dividends.

d.

Purchase of plant and equipment.

e.

Depreciation.

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52.

Which of the following financial statements includes information about a firm's assets, equity, and
liabilities?
a.

Income statement

b.

Cash flow statement

c.

Balance sheet

d.

Statement of retained earnings

e.

All of the above

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53.

When constructing a Statement of Cash Flows, which of the following actions would be considered a
source of funds?
a.

increase in the cash account

b.

decrease in accounts payable

c.

increase in inventory

d.

increase in long-term bonds

e.

increase in fixed assets

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54.

If your goal is determine how effectively a firm is managing its assets, which of the following sets of ratios
would you examine?
a.

profit margin, current ratio, fixed charge coverage ratio

b.

quick ratio, debt ratio, time interest earned

c.

inventory turnover ratio, days sales outstanding, fixed asset turnover ratio

d.

total assets turnover ratio, price earnings ratio, return on total assets

e.

time interest earned, profit margin, fixed asset turnover ratio

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55.

A firm's current ratio has steadily increased over the past 5 years, from 1.9 five years ago to 3.8 today.
What would a financial analyst be most justified in concluding?
a.

The firm's fixed assets turnover probably has improved.

b.

The firm's liquidity position probably has improved.

c.

The firm's stock price probably has increased.

d.

Each of the above is likely to have occurred.

e.

The analyst would be unable to draw any conclusions from this information.

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56.

Which of the following statements about ratio analysis is incorrect?

a.

Classifying a large, well-diversified firm into a single industry often is difficult because many of the
firm's divisions are involved with different products from different industries.

b.

As a rule of thumb, it is safe to conclude that any firm with a current ratio greater than 1.0 should
be able to meet its current obligationsthat is, pay bills that come due in the current period.
[Current ratio = (Current assets) / (Current liabilities)]

c.

Sometimes firms attempt to use "window dressing" techniques to make their financial statements
look better than they actually are in the current period.

d.

Computing the values of the ratios is fairly simple; the toughest and most important part of ratio
analysis is interpretation of the values derived from the computations.

e.

General conclusions about a firm should not be made by examining one or a few ratios ratio
analysis should be comprehensive.

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57.

Bubbles Soap Corporation has a quick ratio of 1.0 and a current ratio of 2.0 implying that
a.

the value of current assets is equal to the value of inventory.

b.

the value of current assets is equal to the value of current liabilities.

c.

the value of current liabilities is equal to the value of inventory.

d.

All of the above.

e.

None of the above.

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58.

All other things constant, an increase in a firm's profit margin would

a.

increase the additional funds needed for financing a growth in operations.

b.

decrease the additional funds needed for financing a growth in operations.

c.

have no effect on the additional funds needed for financing a growth in operations.

d.

decrease its taxes.

e.

none of the above.

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59.

Cannon Company has enjoyed a rapid increase in sales in recent years, following a decision to sell on
credit. However, the firm has noticed a recent increase in its collection period. Last year, total sales were
$1 million, and $250,000 of these sales were on credit. During the year, the accounts receivable account
averaged $41,664. It is expected that sales will increase in the forthcoming year by 50 percent, and, while
credit sales should continue to be the same proportion of total sales, it is expected that the days sales
outstanding will also increase by 50 percent. If the resulting increase in accounts receivable must be
financed by external funds, how much external funding will Cannon need?
a.

$41,664

b.

$52,086

c.

$47,359

d.

$106,471

e.

$93,750

ANSWER:

B
DSO = ($41,664/$250,000)/360 = 60 days.
New A/R = (($250,000)(1.5)/(360))(60)(1.5) = $93,750.
Hence, increase in receivables = $93,750 - $41,664 = $52,086.

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60.

The Meryl Corporation's common stock currently is selling at $100 per share, which represents a P/E
ratio of 10. If the firm has 100 shares of common stock outstanding, a return on equity of 20 percent, and
a debt ratio of 60 percent, what is its return on total assets (ROA)?
a.

8.0%

b.

10.0%

c.

12.0%

d.

16.7%

e.

20.0%

ANSWER:

A
P/E = 10 = $100/EPS
EPS = $100/10 = $10.
Earnings = NI = $10(100 shares) = $1,000.
ROE = NI/Equity = $1,000/Equity = 20%
Equity = $1,000/0.20 = $5,000.
Debt ratio = 60%, so Equity ratio = 40% = Equity/TA
TA = Equity/0.40 = $5,000/0.40 = $12,500.
ROA = NI/TA = $1,000/$12,500 = 0.08 = 8%.

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61.

Assume Meyer Corporation is 100 percent equity financed. Calculate the return on equity, given the
following information:
(1)

Earnings before taxes = $1,500;

(2)

Sales = $5,000;

(3)

Dividend payout ratio = 60%;

(4)

Total assets turnover = 2.0;

(5)

Applicable tax rate = 30%.

a.

25%

b.

30%

c.

35%

d.

42%

e.

50%

ANSWER:

D
NI = $1,500(1 - 0.3) = $1,050.
Total assets turnover = Sales/TA = 2.0.
TA = Sales/2.0 = $5,000/2.0 = $2,500 = Equity.
ROE = NI/Equity = $1,050/$2,500 = 42%.

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62.

Aurillo Equipment Company (AEC) projected that its ROE for next year would be just 6%. However, the
financial staff has determined that the firm can increase its ROE by refinancing some high interest bonds
currently outstanding. The firm's total debt will remain at $200,000 and the debt ratio will hold constant at
80%, but the interest rate on the refinanced debt will be 10%. The rate on the old debt is 14%.
Refinancing will not affect sales which are projected to be $300,000. EBIT will be 11% of sales, and the
firm's tax rate is 40%. If AEC refinances its high interest bonds, what will be its projected new ROE?
a.

3.0%

b.

8.2%

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c.

10.0%

d.

15.6%

e.

18.7%

ANSWER:

D
Relevant information: Old ROE = NI/Equity = 0.06 = 6%.
Sales = $300,000; EBIT = 0.11(Sales) = 0.11($300,000) = $33,000.
Debt = $200,000; D/A = 0.80 = 80%.
Tax rate = 40%.
Interest rate change: Old bonds 14%; new bonds 10%.
Calculate total assets and equity amounts:
Since debt = $200,000, total assets = $200,000/0.80 = $250,000.
E/TA = 1 - D/A = 1 - 0.80 = 0.20.
Equity = E/TA TA = 0.20 $250,000 = $50,000.
Construct comparative Income Statements from EBIT, and calculate new ROE:

EBIT
Less:

Interest

EBT
Less:

Old

New

$33,000

$33,000

28,000

20,000

5,000
Taxes (40%)

Net income

13,000

2,000

5,200

$ 3,000

$ 7,800

New ROE = NI/Equity = $7,800/$50,000 = 0.1560 = 15.6%.

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63.

On its December 31st balance sheet, LCG Company reported gross fixed assets of $6,500,000 and net
fixed assets of $5,000,000. Depreciation for the year was $500,000. Net fixed assets a year earlier on
December 31st, had been $4,700,000. What figure for "Cash Flows Associated with Long-Term
Investments (Fixed Assets)" should LCG report on its Statement of Cash Flows for the current year?
a.

$500,000

b.

$600,000

c.

$700,000

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d.

$800,000

e.

$900,000

ANSWER:

D
Funds

= NFA 1 NFA 0 + Depreciation

= $5,000,000 $4,700,000 + $500,000 = $800,000.

Alternative long-form solution:

Current Year

One Year Ago

Gross fixed assets

$6,500,000

$5,700,000

Accumulated depreciation

1,500,000

1,000,000

Net fixed assets

5,000,000

4,700,000

Accumulated assets Year ago

= $4,700,000 + ($1,500,000 - $500,000)

= $5,700,000.

Funds used to purchase

= GFA Current - GFA Year ago fixed assets

= $6,500,000 - $5,700,000 = $800,000.

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64.

Lombardi Trucking Company has the following data:

Assets:

$10,000

Profit margin:

3.0%

Debt ratio:

60.0%

Interest rate:

10.0%

Tax rate:

40%

Total asset turnover:

2.0

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What is Lombardi's TIE ratio?

a.

0.95

b.

1.75

c.

2.10

d.

2.67

e.

3.45

ANSWER:

D
TA Turnover = S/A = 2
S/$10,000 = 2
S = $20,000
Debt = $6,000
INT = $6,000 (0.1) = $600
NI = $600
EBIT
Int.
EBT
Taxes (40%)
NI

$1,600
600
$1,000
400
$ 600

TIE = $1,600/$600 = 2.67

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65.

Capital markets are markets for

a.

commercial paper.

b.

short-term debt securities.

c.

long-term debt securities.

d.

Treasury notes.

e.

none of the above.

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66.

The facilities needed to conduct over-the-counter market transactions include all of the following except:
a.

physical stock exchange to sell and buy stocks

b.

securities dealers who make the market

c.

brokers acting as agent to bring investors and dealers together

d.

electronic networks that provide communication links between brokers and dealers.

e.

all of the above are needed for over-the-counter market transactions.

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67.

A corporation that is owned by a few individuals who are typically associated with the firm's management
is a ____ corporation.
a.

private

b.

public

c.

diversified

d.

closely held

e.

listed

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68.

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

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69.

Which of the following is usually cited as a disadvantage of issuing new common stock as a method of
financing?
a.

Common stock does not have a maturity date, thus it is an open-end commitment of the firm's
earnings.

b.

Since sale of common stock increases the number of owners and the amount of capital at risk,
the firm's bond rating is usually negatively affected and its cost of debt rises.

c.

If the firm currently has more equity than its optimal capital structure dictates and it issues more
equity, then the average cost of capital will most likely rise.

d.

Common stock is not an attractive option if the firm seeks to increase its reserve borrowing
capacity.

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70.

Which form of informational market efficiency states that the market price of an asset contains all of the
pertinent information regarding the value of that security?
a.

Strong-form

b.

Semistrong-form

c.

Weak-form

d.

Economic-form

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71.

Which of the following statements is correct?

a.

For the most part, our federal tax rates are progressive, because higher incomes are taxed at
higher average rates.

b.

Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than
bonds with the same risk and maturity issued by a private corporation such as Florida Power &
Light.

c.

Our federal tax laws tend to encourage corporations to finance with debt rather than with equity
securities.

d.

Our federal tax laws encourage the managers of corporations with surplus cash to invest it in
stocks rather than in bonds. However, other factors may offset tax considerations.

e.

All of the above statements are true.

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72.

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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73.

As a corporate investor paying a marginal tax rate of 34 percent, if 70 percent of dividends are
excludable, what would be your after-tax dividend yield on preferred stock with a 16 percent before-tax
dividend yield?
a.

6.36%

b.

7.36%

c.

12.19%

d.

13.01%

e.

14.37%

ANSWER:

E
16%[1 - 0.34(0.30)] = 14.368% 14.37%.

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74.

Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to
be 5% each of the next three years and 6% each year after the third year. The maturity risk premium is
estimated to be 0.1%(t - 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a
one-year bond is zero). The real risk-free rate is assumed to be constant over time. What is the real riskfree rate of interest?
a.

0.25%

b.

0.50%

c.

1.00%

d.

1.75%

e.

2.50%

ANSWER:

E
IP6 = [5%(3) + 6%(3)]/6 = 5.5%.
MRP = 0.1%(t - 1) = 0.1%(5) = 0.5%.
rRF = r * + MRP + IP
8.5% = r * + 0.5% + 5.5%
r* = 2.5%.

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75.

Your corporation has the following cash flows:

Operating income

$250,000

Interest received

10,000

Interest paid

45,000

Dividends received

20,000

Dividends paid

50,000

If the applicable income tax rate is 40 percent, and if 70 percent of dividends received are exempt from
taxes, what is the corporation's tax liability?
a.

$74,000

b.

$88,400

c.

$91,600

d.

$100,000

e.

$106,500

ANSWER:

B
Operating income

$250,000

Interest received

10,000

Interest paid

(45,000)
6,000*

Dividends received (taxable)

Taxable income

$221,000

*$20,000(0.30) = $6,000.

Taxes = 0.4($221,000) = $88,400.

POINTS:

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76.

Solarcell Corporation has $20,000 which it plans to invest in marketable securities. It is choosing between
AT&T bonds which yield 11%, State of Florida municipal bonds which yield 8%, and AT&T preferred stock
with a dividend yield of 9%. Solarcell's corporate tax rate is 40%, and 70% of the preferred stock
dividends it receives are tax exempt. Assuming that the investments are equally risky and that Solarcell
chooses strictly on the basis of after-tax returns, which security should be selected? Answer by giving the
after-tax rate of return on the highest yielding security.
a.

8.46%

b.

8.00%

c.

7.92%

d.

9.00%

e.

9.16%

ANSWER:

B
Florida muni bond
After-tax yield on FLA bond = 8%. (The munis are tax exempt.)
AT&T bond
After-tax yield on AT&T bond = 11% - Taxes = 11% - 11%(0.4) = 6.6%.
Alternate solution: AT&T bond
Invest $20,000 @ 11% = $2,200 interest.
Pay 40% tax, so after-tax income = $2,200(1 - T) = $2,200(0.6) = $1,320.
After-tax rate of return = $1,320/$20,000 = 6.6%.
AT&T preferred stock
After-tax yield = 9% - Taxes = 9% - 0.3(9%)(0.4) = 9% - 1.08% = 7.92%.
Therefore, invest in the Florida muni bonds which yield 8% after taxes. Note: this
problem can be made harder by asking for the tax rate that would cause the
company to prefer the AT&T bonds or the preferred stock.

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77.

The terms and conditions to which a bond is subject are set forth in its
a.

Debenture.

b.

Underwriting agreement.

c.

Indenture.

d.

Restrictive covenants.

e.

Call provision.

ANSWER:

POINTS:

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78.

A contract negotiated directly with a bank in which the borrower agrees to make a series of interest and
principal payments on specific dates to the bank is called
a.

preferred stock.

b.

commercial paper.

c.

convertible debt.

d.

a term loan.

e.

a bond issue.

ANSWER:

POINTS:

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79.

Which of the following types of debt are backed by some form of specific property?
a.

Debenture.

b.

Mortgage bond.

c.

Subordinated debt.

d.

All of the above.

e.

None of the above.

ANSWER:

POINTS:

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80.

A bond that only pays interest if the firm has sufficient earnings to cover the interest payments is called
what?
a.

Callable bond.

b.

Putable bond.

c.

Convertible bond.

d.

Income bond.

e.

Indexed bond.

ANSWER:

POINTS:

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81.

A bond that pays no annual interest but is sold at a discount below its par value is called what?
a.

Mortgage bond.

b.

Callable bond.

c.

Convertible bond.

d.

Putable bond.

e.

Zero coupon bond.

ANSWER:

POINTS:

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82.

Which of the following ratings by Moody's represent bonds that are at least investment grade?
a.

Caa

b.

Baa

c.

d.

Ba

e.

None of the above.

ANSWER:

POINTS:

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83.

Which of the following types of debt protect a bondholder against an increase in interest rates?
a.

Floating rate debt.

b.

Bonds that are redeemable ("putable") at par at the bondholders' option.

c.

Bonds with call provisions.

d.

All of the above.

e.

Only answers a and b above.

ANSWER:

POINTS:

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84.

Which type of investor would be most likely to purchase zero coupon bonds?
a.

Retired individuals seeking income for current consumption.

b.

Individuals in high tax brackets.

c.

Tax free investors such as pension funds.

d.

Risk averse individuals anticipating increases in interest rates.

e.

None of the above.

ANSWER:

POINTS:

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85.

Omega Software Corporation's bond is currently selling at a discount in the financial markets. If the
bond's yield to maturity is 11.5 percent, what is its coupon rate of interest?
a.

greater than 11.5 percent

b.

less than 11.5 percent

c.

equal to 11.5 percent

d.

There is not enough information to answer this question.

e.

None of the above is a correct answer.

ANSWER:

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86.

If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the largest
percentage increase in its value?
a.

A 10-year zero-coupon bond.

b.

A 10-year bond with a 10 percent semiannual coupon.

c.

A 10-year bond with a 10 percent annual coupon.

d.

A 5-year zero-coupon bond.

e.

A 5-year bond with a 12 percent annual coupon.

ANSWER:

A
Statement a is correct. The present value of the 10-year, zero-coupon bond at an 8
percent interest rate is $463.19, while its value at a 7 percent interest rate is
$508.34. The percentage change is $45.15/$463.19 = 9.75%. If you work out the
other percentage increases in values due to the change in interest rates, you'll obtain
the following results:

POINTS:

b.

10-year, 10% semiannual coupon: 6.80%.

c.

10-year, 10% annual coupon: 6.75%.

d.

5-year, zero-coupon: 4.76%.

e.

5-year, 12% annual coupon: 3.91%.

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87.

Which of the following statements is most correct?

a.

All else equal, an increase in interest rates will have a greater effect on the prices of long-term
bonds than it will on the prices of short-term bonds.

b.

All else equal, and increase in interest rate will have a greater effect on higher-coupon bonds
than it will have on lower-coupon bonds.

c.

An increase in interest rates will have a greater effect on a zero-coupon bond with 10 years
maturity than it will have on a 9-year bond with a 10 percent annual coupon.

d.

All of the above are correct.

e.

Answers a and c are both correct.

ANSWER:

E
Statements a and c are correct; therefore, statement e is the correct choice. The
longer the maturity of a bond, the greater the impact an increase in interest rates will
have on the bond's price. Statement b is false. To see this, assume interest rates
increase from 7 percent to 10 percent. Evaluate the change in the prices of a 10-year,
5 percent coupon bond and a 10-year, 12 percent coupon bond. The 5 percent
coupon bond's price decreases by 19.4 percent, while the 12 percent coupon bond's
price decreases by only 16.9 percent. Statement c is correct. To see this, evaluate a
10-year, zero-coupon bond and a 9-year, 10 percent annual coupon bond at 2
different interest rates, say 7 percent and 10 percent. The zero-coupon bond's price
decreases by 24.16 percent, while the 9-year, 10 percent coupon bond's price
decreases by only 16.33 percent.

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88.

Assume that a 15-year, $1,000 face value bond pays interest of $37.50 every 3 months. If you require a
simple annual rate of return of 12 percent, with quarterly compounding, how much should you be willing
to pay for this bond?
a.

$821.92

b.

$1,207.57

c.

$986.43

d.

$1,120.71

e.

$1,358.24

ANSWER:

B
Cash flow time line:
Financial calculator solution:
Inputs: N = 60; I = 3; PMT = 37.50; FV = 1,000
Output: PV = -$1,207.57; V d = $1,207.57.
Note: Tabular solution differs from calculator solution due to interest factor rounding.

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89.

Due to a number of lawsuits related to toxic wastes, a major chemical manufacturer has recently
experienced a market reevaluation. The firm has a bond issue outstanding with 15 years to maturity and a
coupon rate of 8 percent, with interest being paid semiannually. The required simple rate on this debt has
now risen to 16 percent. What is the current value of this bond?
a.

$1,273

b.

$1,000

c.

$7,783

d.

$550

e.

$450

ANSWER:

D
Cash flow time line:
Financial calculator solution:
Inputs: N = 30; I = 8; PMT = 40; FV = 1,000.
Output: PV = -$549.69; V d = $549.69 = $550.

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90.

You are contemplating the purchase of a 20-year bond that pays $50 in interest each six months. You
plan to hold this bond for only 10 years, at which time you will sell it in the marketplace. You require a 12
percent annual return, but you believe the market will require only an 8 percent return when you sell the
bond 10 years hence. Assuming you are a rational investor, how much should you be willing to pay for the
bond today?
a.

$1,126.85

b.

$1,081.43

c.

$737.50

d.

$927.68

e.

$856.91

ANSWER:

D
Cash flow time line:
Financial calculator solution:
Calculate value of bond at Year 10
Inputs: N = 20; I = 4; PMT = 50; FB = 1,000.
Output: PV = -1,135.90.
Calculate value of bond at Year 0 using V 10 as FV
Inputs: N = 20; I = 6; PMT = 50; FV = 1,135.90.
Output: PV = -$927.675 = $927.98; V d = $927.68.

POINTS:

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91.

Cold Boxes Ltd. has 100 bonds outstanding (maturity value = $1,000). The required rate of return on
these bonds is currently 10 percent, and interest is paid semiannually. The bonds mature in 5 years, and
their current market value is $768 per bond. What is the annual coupon interest rate?
a.

8%

b.

6%

c.

4%

d.

2%

e.

0%

ANSWER:

C
Cash flow time line:
Tabular solution:
$768 = (PVIFA5%, 10) + $1,000 (PVIF 5%, 10) = (7.7217) + $1,000 (0.6139)
154.10 = (7.7217)
= $19.96 = $20
PMT $40 and coupon rate 4%.
Financial calculator solution:
Inputs: N = 10; I = 5; PV = -768; FV = 1,000.
Output: PMT = $19,955 (semi-annual PMT).
Annual coupon rate = PMT 2/M = $19,955 2/1,000 = 3.99% = 4%.

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92.

The current price of a 10-year, $1,000 par value bond is $1,158.91. Interest on this bond is paid every six
months, and the simple annual yield is 14 percent. Given these facts, what is the annual coupon rate on
this bond?
a.

10%

b.

12%

c.

14%

d.

17%

e.

21%

ANSWER:

D
Cash flow time line:
Financial calculator solution:
Inputs: N = 20; I = 7; PV = -1,158.91; FV = 1,000.
Output: PMT = $85.00 (Semiannual PMT).
Annual coupon rate = $85 (2) / $1,000 = 17.0%.

POINTS:

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Financial Calculator Section

The following question(s) may require the use of a financial calculator.
Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive
cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par
value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal
tax rate is 40 percent.

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93.

Refer to Gargoyle Unlimited. What is the expected after-tax cost of this debt issue?
a.

11.20%

b.

4.48%

c.

6.72%

d.

6.10%

e.

4.00%

ANSWER:

C
Financial calculator solution:
Solve for YTM using the information from the previous question
Inputs: N = 3; PV = +727.25; FV = -1,000
Output: I = 11.20.
Before-tax cost debt of this issue = 11.20%
rdT = 11.20% (1 - T) = 11.2% (0.6) = 6.72%
Alternate solution using cash flows
Inputs: = 727.25; = 32.58; = 36.23; = -959.71
Output: IRR% = 6.72%.

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Financial Calculator Section

The following question(s) may require the use of a financial calculator.

94.

A 15-year zero coupon bond has a yield to maturity of 8 percent and a maturity value of $1,000. What is
the amount of tax that an investor in the 30 percent tax bracket would pay during the first year of owning
the bond?
a.

$7.57

b.

$10.41

c.

$15.89

d.

$20.44

e.

$25.22

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ANSWER:

A
Step 1:

Find PV of bond:
N = 15
I=8
PMT = 0
FV = 1,000
Solve for PV = -315.24.

Step 2:

Find interest for the first year:

Value at t=0

$315.24

Interest rate

0.08

Interest income

Step 3:

$ 25.22

Find tax due:

Interest income

$ 25.22

Tax rate
Tax due

POINTS:

0.30
$

7.57

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REF:

95.

Semiannual payment bonds with the same risk (Aaa) and maturity (20 years) as your company's bonds
have a simple (not EAR) yield of 9 percent. Your company's treasurer is thinking of issuing at par some
$1,000 par value, 20-year, quarterly payment bonds. She has asked you to determine what quarterly
interest payment, in dollars, the company would have to set in order to provide the same effective annual
rate (EAR) as those on the 20-year, semiannual payment bonds. What would the quarterly interest
payment be, in dollars?
a.

$45.00

b.

$25.00

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c.

$22.25

d.

$27.50

e.

$23.00

ANSWER:

C
Cash flow time lines:
Semi-annual
Quarterly
Numerical solution:
Step 1:

Solve for the EAR of 9% simple compounded semiannually .

.

Step 2:

Solve for rSIMPLE of 9.2025% EAR but with quarterly compounding.

.
rSIMPLE/4 = (1.092025) 0.25 - 1 = 0.02225.
rSIMPLE = 0.02225 4 = 0.08901.

Step 3:

Calculate the quarterly payment using the periodic rate.

Multiple 0.02225 $1,000 = $22.25 = quarterly payment

Financial calculator solution:

Step
1:

Calculate the EAR of 9% simple yield bond compounded semi-annually.

Use interest rate conversion feature.

Inputs: P/YR = 2; NOM% = 9.

Output: EFF% = 9.2025%

Step
2:

Calculate the simple rate, r SIMPLE, of a 9.2025% EAR but with quarterly
compounding.

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Inputs: P/YR = 4; EFF% = 9.2025.

Output: NOM% = 8.90%

Step
3:

Calculate the quarterly periodic rate from r SIMPLE of 8.9% and calculate
the quarterly payment.

rPer = r SIMPLE/4 = 8.90%/4 = 2.225%

Inputs: N = 80; I = 2.225; PV = -1,000; FV = 1,000.
Output: PMT = $22.25.

POINTS:

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96.

Assume that the State of Florida sold tax-exempt, zero coupon bonds with a $1,000 maturity value 5
years ago. The bonds had a 25-year maturity when they were issued, and the interest rate built into the
issue was 8 percent, compounded semiannually. The bonds are now callable at a premium of 4 percent
over the accrued value. What effective annual rate of return would an investor who bought the bonds
when they were issued and who still owns them earn if they were called today?
a.

4.41%

b.

6.73%

c.

8.25%

d.

9.01%

e.

9.52%

ANSWER:

D
Cash flow time line:
Calculate PV of zero coupon bond at Time 0:
N = 50; I = 4; PMT = 0; and FV = 1,000.
Solve for PV = $140.71.
Calculate accrued value at Year 5:
$140.71(1.04)2(5) = $208.29.
Calculate EAR as follows:
N = 10; PV = -140.71; PMT = 0; and FV = 216.62.
Solve for I = 4.41%; however, this is a semiannual rate.
EAR = (1.0441) 2 - 1 = 9.01%.

POINTS:

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97.

Assume an all equity firm has been growing at a 15 percent annual rate and is expected to continue to do
so for 3 more years. At that time, growth is expected to slow to a constant 4 percent rate. The firm
maintains a 30 percent payout ratio, and this year's retained earnings net of dividends were $1.4 million.
The firm's beta is 1.25, the risk-free rate is 8 percent, and the market risk premium is 4 percent. If the
market is in equilibrium, what is the market value of the firm's common equity (1 million shares
outstanding)?
a.

$6.41 million

b.

$12.96 million

c.

$9.18 million

d.

$10.56 million

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e.

$7.32 million

ANSWER:

C
Calculate required rate of return
rs = 8% + 4%(1.25) = 13.0%.
Calculate net income, total dividends, and D 0
Net income

= $1.4 million / (1 payout ratio)

= $1.4 million / 0.7 = $2.0 million

Dividends

= $2.0 million 0.3 = $0.6 million

D0

= $600,000 / 1,000,000 shares = $0.60

Financial calculator solution:

Inputs: = 0; = 0.69; = 0.794; = 11.469; I = 13.
Output: NPV = $9.18; = P0 = $9.18.
Total market value = P 0 shares outstanding = $9.18 1,000,000 = $9,180,000.
POINTS:

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98.

Shareholders exert control of the management of the firm by

a.

electing board members who can replace management.

b.

directly replacing management with themselves.

c.

buying shares in an IPO at a discounted price.

d.

running the daily operations of the firm.

e.

None of the above.

ANSWER:

POINTS:

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99.

Stock owned by the organizers of the firm who have sole voting rights is
a.

preferred stock.

b.

common equity.

c.

founders' shares.

d.

convertible equity.

e.

retained earnings.

ANSWER:

POINTS:

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100.

Velcraft Company has 20,000,000 shares of common stock authorized, but to date, has only 12,000,000
shares outstanding, each with a $1.00 par value. The company has $24,000,000 in additional paid-in
capital and retained earnings are $96,000,000. What is Velcraft's current book value per share?
a.

$1.00

b.

$3.00

c.

$11.00

d.

$6.60

e.

$9.00

ANSWER:

C
Construct a summary of the common stockholders' equity accounts:
Account balance
Common stock (20 million authorized, 12 million outstanding,
$1.00 par value)
Additional paid-in capital
Retained earnings
Total common stockholders' equity

$ 12,000,000
24,000,000
96,000,000
$132,000,000

Calculate the book value per share:

Book value per share = $132,000,000/12,000,000 = $11.00.
POINTS:

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101.

A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is
currently $50, what is the simple annual rate of return?
a.

12%

b.

18%

c.

20%

d.

23%

e.

28%

ANSWER:

C
Annual dividend = $2.50(4) = $10.
rps = D ps /Vps = $10/$50 = 0.20 = 20%.

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102.

The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a constant 5
percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein's
required rate of return on equity (rs ) is 12 percent. What is the current price of Klein's common stock?
a.

$21.00

b.

$33.33

c.

$42.25

d.

$50.16

e.

$58.75

ANSWER:

D
Enter in CFLO register = 0, = 1.05, and = 61.74.
Then enter I = 12, and press NPV to get NPV = P 0 = $50.16.

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103.

A firm expects to pay dividends at the end of each of the next four years of $2.00, $1.50, $2.50, and
$3.50. If growth is then expected to level off at 8 percent, and if you require a 14 percent rate of return,
how much should you be willing to pay for this stock?
a.

$67.81

b.

$22.49

c.

$58.15

d.

$31.00

e.

$43.97

ANSWER:

E
Numerical solution:
P4

= ($3.50)(1.08) / (0.06) = $63.00

= $2.00 / (1.14) + $1.50 / (1.14) 2 + $2.50 / (1.14) 3 + $3.50 / (1.14) 4
+ $63.00 / (1.14) 4
= $1.754 + $1.154 + $1.687 + $39.373 = $43.97.

Tabular solution:
= $2.00 (PVIF 14%,1) + $1.50 (PVIF 14%,2) + $2.50 (PVIF 14%,3) + $66.50
(PVIF14%,4)
= $2.00(0.8772) + $1.50(0.7695) + $2.50(0.6750) + $66.50(0.5921)
= $43.97.

Financial calculator solution:

Inputs: = 0; = 2.00; = 1.50; = 2.50; = 66.50; I = 14.
Output: NPV = $43.969 $43.97.
= $43.97.
POINTS:

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104.

The Satellite Building Company has fallen on hard times. Its management expects to pay no dividends for
the next 2 years. However, the dividend for Year 3, D3, will be $1.00 per share, and the dividend is
expected to grow at a rate of 3 percent in Year 4, 6 percent in Year 5, and 10 percent in Year 6 and
thereafter. If the required return for Satellite is 20 percent, what is the current equilibrium price of the
stock?
a.

$0

b.

$5.26

c.

$6.34

d.

$12.00

e.

$13.09

ANSWER:

POINTS:

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105.

A share of stock has a dividend of D 0 = $5. The dividend is expected to grow at a 20 percent annual rate
for the next 10 years, then at a 15 percent rate for 10 more years, and then at a long-run normal growth
rate of 10 percent forever. If investors require a 10 percent return on this stock, what is its current price?
a.

$100.00

b.

$82.35

c.

$195.50

d.

$212.62

e.

The data given in the problem are internally inconsistent, i.e., the situation described is
impossible in that no equilibrium price can be produced.

ANSWER:

E
The data in the problem are unrealistic and inconsistent with the requirements of the
growth model; r less than g implies a negative stock price. If r equals g, the
denominator is zero, and the numerical result is undefined, r must be greater than g
for a reasonable application of the model.

POINTS:

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106.

Suppose you are willing to pay $30 today for a share of stock which you expect to sell at the end of one
year for $32. If you require an annual rate of return of 12 percent, what must be the amount of the annual
dividend which you expect to receive at the end of Year 1?
a.

$2.25

b.

$1.00

c.

$1.60

d.

$3.00

e.

$1.95

ANSWER:

C
Total yield = 12%.
Capital gains yield = ($32 - $30)/$30 = 6.67%.
Dividend yield = 12.0% - 6.67% = 5.33%.
Expected dividend = P 0(Dividend yield) = $30(0.0533) = $1.60.

POINTS:

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FEEDBACK:
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107.

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%

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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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108.

The Hart Mountain Company has recently discovered a new type of kitty litter which is extremely
absorbent. It is expected that the firm will experience (beginning now) an unusually high growth rate (20
percent) during the period (3 years) it has exclusive rights to the property where the raw material used to
make this kitty litter is found. However, beginning with the fourth year the firm's competition will have
access to the material, and from that time on the firm will achieve a normal growth rate of 8 percent
annually. During the rapid growth period, the firm's dividend payout ratio will be relatively low (20 percent)
in order to conserve funds for reinvestment. However, the decrease in growth in the fourth year will be
accompanied by an increase in dividend payout to 50 percent. Last year's earnings were E0 = $2.00 per
share, and the firm's required return is 10 percent. What should be the current price of the common
stock?
a.

$66.50

b.

$87.96

c.

$71.53

d.

$61.78

e.

$93.50

ANSWER:

POINTS:

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109.

Modular Systems Inc. just paid dividend D 0, and it is expecting both earnings and dividends to grow by 0
percent in Year 2, by 5 percent in Year 3, and at a rate of 10 percent in Year 4 and thereafter. The
required return on Modular is 15 percent, and it sells at its equilibrium price, P0 = $49.87. What is the
expected value of the next dividend? (Hint: Set up and solve an equation with the unknown.)
a.

It cannot be estimated without more data.

b.

$1.35

c.

$1.85

d.

$2.35

e.

$2.85

ANSWER:

POINTS:

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REF:

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110.

Laserclok Corporation paid a dividend for 50 years until it experienced financial difficulty three years ago,
at which time the dividend payment was suspended (that is, a dividend has not been paid during the past
three years). The company is now much stronger financially, but Laserclok does not expect to pay a
dividend for the next five years. Beginning six years from today, the company will pay a dividend equal to
$2.10, which is 5 percent greater than the last dividend paid three years ago. After the dividend payments
start again, Laserclok expects the dividend to continue to be paid and to grow at a constant rate of 5
percent. If the appropriate market rate for investments similar to Laserclok's stock is 15 percent, at what
price should the stock currently be selling in the financial markets?
a.

$21.00

b.

$10.44

c.

$14.00

d.

There is not enough information to answer the question.

e.

None of the above.

ANSWER:

B
Following is the cash flow timeline for Laserclok's dividends:
Because the first dividend that is affected by the constant growth is , the constant
growth model can be used to compute , and then the present value of this amount
represents P 0:
;

POINTS:

0/1

FEEDBACK:
REF:

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