Comprehensive Review - Spring 2007

savannahstate.edu/misc/dowlingw/3155/Quizes%20-%20AY%202004/comprehensive_review_-_spring_2007.htm

1.

When an individual buys stock through a secondary market (e.g., the NYSE), the firm receives the sales
proceeds.

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2.

An investment banker specializes in corporate loans.

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3.

Firms whose securities are already publicly held may file a shelf registration for possible future sales of
stocks and bonds.

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4.

If a company went public at $10 per share and the shares immediately upon reaching the public sell for
$13, the $3 windfall gain goes to the underwriter.

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5.

A brokerage firm that offers to buy and sell a stock at specified bid and ask prices is "making a market."

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6.

In general, banks prefer loans that stress liquidity and safety.

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7.

When the Federal Reserve sells securities, the money supply is increased.

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8.

Open market operations is a more flexible tool of monetary policy than the reserve requirements.

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9.

Reserve requirements are infrequently changed to affect commercial bank lending.

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10.

If the Treasury borrows from the Federal Reserve, the lending capacity of banks is reduced.

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11.

Under a system of fluctuating exchange rates, a currency will depreciate if supply exceeds the demand
for the currency.

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12.

The devaluation (depreciation) of one currency implies the revaluation (appreciation) of other currencies.

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13.

It takes longer than 8 years to retire a $24,000 loan at 8% if the annual payment is $3,000.

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14.

Higher rates of interest are associated with greater present values.

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15.

If a person owes $50,000 at 10 percent and annually pays $10,000, the loan will be retired in 5 years.

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16.

The future value of an ordinary annuity will exceed the future value of an annuity due.

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17.

The larger an investment's standard deviation, the smaller is the element of risk.

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18.

Accountants suggest that assets should always be valued at their market value.

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19.

The return on equity represents what the firm is earning on stockholders' investment in the firm.

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20.

If the "times-interest-earned" were 1.5, that implies the interest payments will not be made.

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21.

Cumulative voting concentrates voting power in the hands of a majority of corporate voters.

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22.

Dividend reinvestment plans are a convenient means to encourage individuals to save.

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23.

The dividend-growth model may be applied only if it is assumed that the growth in dividends will be
constant.

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24.

If management increases a firm's dividends, its growth rate should increase.

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25.

An increase in the required return will tend to increase the value of a stock.

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26.

The risk-adjusted model for the valuation of common stock excludes yields on competitive securities.

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27.

The interest paid by municipal bonds is not subject to federal income taxation.

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28.

Treasury bills are short-term debt issued by the federal government.

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29.

An investor may anticipate that a bond will be called if interest rates have risen.

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30.

Some preferred stocks are not perpetual and must be retired at some specified time period.

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31.

Generally, convertible bonds lack a call provision.

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32.

The value of a convertible bond as a debt instrument sets a floor (i.e., minimum price) on the bond.

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33.

The value of a convertible bond as stock depends in part on the bond's coupon.

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34.

If a convertible bond is not called nor converted, the firm must ultimately retire it.

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35.

Over time, holding period returns tend to overstate the annual rate of return.

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36.

Investments in mutual funds reduce the systematic risk associated with investing in stocks.

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37.

The loading fee reduces a fund's net asset value.

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38.

Purchases of shares in mutual funds reduce systematic and unsystematic risk.

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39.

Since a corporation is responsible for its debts, creditors may sue it for payment.

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40.

If a firm needs additional equity financing through the retention of earnings, it may be advantageous to
incorporate.

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41.

If a corporation operates at a loss, the loss is initially carried forward to offset future income.

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42.

One use for break-even analysis is to examine the effect of substituting fixed for variable costs.

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43.

The numerical value of the slope of the fixed cost schedule is 1.0.

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44.

If variable costs exceed fixed costs, the firm must be operating at a loss.

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45.

Since high use of financial leverage is associated with less risk, higher financial leverage may also result
in higher stock prices.

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46.

A recession will cause earnings to fall more rapidly for less financially leveraged firms.

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47.

The weighted cost of capital includes the cost of debt and the cost of equity.

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48.

Low correlation among cash inflows is associated with lower net present values.

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49.

Certainty equivalents adjust an investment's cash outflows in terms of a risk-free return.

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50.

Greater risk is associated with larger beta coefficients.

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

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51.

Which of the following is not part of the underwriting process?

a.

the prospectus

b.

the Federal Reserve

c.

the Securities and Exchange Commission

d.

the syndicate

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52.

An investment banker
1.

is usually not a banker

2.

is frequently a division of a brokerage firm

3.

serves as a middleman between financial intermediaries and firms issuing new securities

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 3

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53.

Which of the following is not part of the underwriting process?

a.

the syndicate

b.

the originating house

c.

the prospectus

d.

the secondary market

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54.

An investment banker is not a financial intermediary because

a.

it does not transfer money from investors to firms

b.

it does not create claims on itself

c.

it does facilitate the transfer of funds

d.

it creates claims on itself

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55.

The Securities Investor Protection Corporation protects individuals from

a.

fraud by corporations

b.

making poor investment decisions

c.

other investors who fail to make delivery

d.

brokerage firm failures

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56.

The Securities and Exchange Commission regulates

a.

trading in publicly held securities

b.

trading in privately held securities

c.

the margin requirement

d.

the amount a stock's price may change

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57.

The regulation of securities markets

a.

discourages investing by requiring the registration of investors

b.

is enforced by the Federal Reserve

c.

protects investors from their own mistakes

d.

provides investors with information to make informed decisions

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58.

Buying stock on margin

1.

is an example of financial leverage

2.

is buying stock with borrowed funds

3.

requires leaving the stock with the broker

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

all three

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59.

M-2 includes
1.

demand deposits

2.

savings accounts

3.

negotiable certificates of deposit

a.

1 and 2

b.

2 and 3

c.

1 and 3

d.

all three

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60.

An investment bank is not a financial intermediary because

a.

it does not transfer money from investors to firms

b.

it does not create claims on itself

c.

it does facilitate the transfer of funds

d.

it creates claims on itself

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61.

When commercial banks grant loans,

a.

the money supply is reduced

b.

the money supply is increased

c.

total reserves increase

d.

total reserves decrease

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62.

If commercial banks grant loans,

a.

the money supply is increased

b.

total reserves are increased

c.

excess reserves are increased

d.

the money supply is reduced

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63.

If a nation exports fewer goods than it imports, it

1.

experiences an outflow of currency

2.

experiences an inflow of currency

3.

has a surplus in its current account

4.

has a deficit in its current account

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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64.

If a nation has a surplus in its current account,

1.

it exports fewer goods than it imports

2.

it exports more goods than it imports

3.

the value of its currency should fall

4.

the value of its currency should rise

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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65.

The future value of a dollar

1.

increases with lower interest rates

2.

increases with higher interest rates

3.

increases with longer periods of time

4.

decreases with longer periods of time

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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66.

A diversified portfolio
a.

increases systematic risk

b.

reduces systematic risk

c.

increases unsystematic risk

d.

reduces unsystematic risk

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67.

An investor may reduce risk by selecting

a.

high beta stocks

b.

stocks with poorly correlated returns

c.

a cross-section of firms in the same industry

d.

stocks traded on organized exchanges

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68.

Components of the capital asset pricing model include

a.

a stock's market price

b.

the standard deviation of a stock's return

c.

the rate on a risk-free security

d.

the investor's need for income versus capital gains

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69.

Which of the following is not a source of systematic risk?

a.

inflation

b.

reduction in the value of the British pound

c.

how a firm finances its assets

d.

a decline in the Dow Jones industrial average

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70.

Operating income does not consider

a.

depreciation

b.

cost of goods sold

c.

taxes paid

d.

salaries

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71.

Equity includes
a.

cash

b.

investments

c.

retained earnings

d.

assets

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72.

Determination of earnings (profits) requires knowing

a.

paid-in capital (capital surplus)

b.

cash

c.

retained earnings

d.

depreciation

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73.

The use of accelerated depreciation

a.

initially increases the firm's profits

b.

initially decreases the firm's taxes

c.

discourages investment in plant and equipment

d.

increases expenses and decreases cash flow

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74.

Owners of long-term debt instruments such as bonds would prefer

1.

a debt ratio of 50% to a debt ratio of 30%

2.

a debt ratio of 30% to a debt ratio of 50%

3.

a times-interest-earned of 3.0 to a times-interest-earned ratio of 5.0

4.

a times-interest-earned of 5.0 to a times-interest-earned ratio of 5.0

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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75.

Times-interest-earned uses
a.

gross earnings

b.

operating earnings

c.

net earnings

d.

per share earnings

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76.

If a stock's price is $90 and the stock is split three for one, the price becomes
a.

$90

b.

$60

c.

$45

d.

$30

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77.

Debt instruments subject their owners to risk from

1.

loss of purchasing power

2.

higher credit ratings

3.

default

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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78.

Which of the following bonds is supported by collateral?

a.

zero coupon bond

b.

mortgage bond

c.

debenture bond

d.

income bond

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79.

The price of a bond depends on

1.

the bond's coupon

2.

the maturity date

3.

current interest rates

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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80.

The current price of a bond is not affected by

a.

current interest rates

b.

the risk classification of the bond

c.

the maturity date

d.

last year's interest rates

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81.

Which of the following is not equity?

a.

paid-in capital

b.

retained earnings

c.

preferred stock

d.

debentures

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82.

Convertible bonds have a call feature to

a.

protect stockholders from early conversions

b.

protect bondholders from conversions by stockholders

c.

force stockholders to convert

d.

force bondholders to convert

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83.

Features of convertible bonds include

1.

fixed dividends

2.

call feature

3.

maturity date

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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84.

Studies of rates of return on large stocks suggest

a.

the average return is about 7.4 percent annually

b.

over a period of years, the rate is approximately 10 percent

c.

equity investors rarely sustain losses

d.

dividends account for over half the return

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85.

The Ibbotson Associates studies of rates of return suggest that

1.

Treasury bills match the rate of inflation

2.

stocks of smaller companies generate higher returns than larger companies

3.

corporate bonds generate higher returns than Treasury bonds

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

all three

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86.

Corporate federal income tax rates

a.

decrease as income increases

b.

are the same for all level of corporate income

c.

phase out the benefits of lower tax brackets as corporate income increases

d.

reach a high of 50 percent for earnings over $18,300,000

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87.

Break-even analysis may be used to show

a.

the relationship between debt financing and earnings

b.

the level of sales necessary to avoid losses

c.

the level of output required to maximize profits

d.

the relationship between sales and equity

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88.

Fixed costs
a.

are greater than variable costs

b.

are paid before variable costs

c.

do not change with the level of output

d.

do not change with the size of the firm

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89.

To determine the break-even level of output, management must know

1.

fixed costs of operation

2.

per unit variable costs of output

3.

total sales

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

all three

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90.

The lower the debt ratio,

a.

the higher is the use of financial leverage

b.

the lower is the use of financial leverage

c.

the lower are the firm's total assets

d.

the higher are the firm's total assets

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91.

Operating leverage
a.

is affected by the demand for the product

b.

results from use of fixed instead of variable costs

c.

is the result of using debt financing

d.

is associated with less risk and more certainty

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92.

The use of financial leverage

a.

alters operating leverage

b.

magnifies the impact of changes in sales on operations

c.

magnifies changes in operating income relative to changes in revenues

d.

implies the volatility of net income is increased

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93.

The greater the usage of financial leverage, the larger is the variability of
a.

revenues

b.

gross profits

c.

operating earnings

d.

net earnings

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94.

Which of the following involves a fixed payment?

1.

bonds

2.

preferred stock

3.

common stock

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 1

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95.

Successful use of financial leverage may

1.

increase the firm's earnings per share

2.

decrease the firm's earnings per share

3.

increase investors' return on their funds

4.

decrease investors' return on their funds

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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96.

If the net present value is positive,

1.

the internal rate of return exceeds the firm's cost of capital

2.

the internal rate of return is less than the firm's cost of capital

3.

the present value of cash inflows exceeds the present cost of an investment

4.

the present value of cash inflows is less than the present cost of an investment

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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97.

Risk analysis may be introduced by

a.

estimating an investment's beta

b.

using the firm's cost of capital

c.

reducing an investment's expected life

d.

using accelerated depreciation

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98.

A firm should make an investment if the present value of the cash inflows is
a.

less than zero

b.

greater than zero

c.

less than the cost of the investment

d.

greater than the cost of the investment

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99.

If the net present value of two mutually exclusive investments is positive, the firm should
a.

make both investments

b.

make neither investment

c.

make the investment with the higher present value

d.

make the investment with the higher net present value

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100.

If the internal rate of return of two mutually exclusive investments is less than the firm's cost of capital, the
firm should make
a.

both investments

b.

neither investment

c.

the investment with the higher internal rate of return

d.

the investment with the lower net present value

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Problem

101.

You bought an asset for $10,000 and sold it for $20,000 after 10 years. What was the annual rate of
return on this investment?

RESPONSE:
ANSWER:

$10,000(1 + g) 10 = $20,000
(1 + g) 10 = $20,000/$10,000 = 2
The rate of return or growth rate (g) is approximately 7%.
(PV = -10000; N = 10; I = ?; PMT = 0, and FV = 20,000. I = 7.18.)

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102.

You borrow $100,000 to buy a house; if the annual interest rate is 6% and the term of the loan is 20
years, what is the annual payment required to retire the mortgage loan?

RESPONSE:
ANSWER:

X = $100,000/11.470 = $8,718.40
8.514 is the interest factor for the present value of an annuity at 6% for twenty years.
(PV = 100000; N = 20; I = 6; PMT = ?, and FV = 0. PMT = -8718.46.)

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103.

A firm has a $1,000,000 debt (e.g., a bond) outstanding that matures after 10 years. The sinking fund
requires the firm to set aside annually an amount so the debt may be retired at maturity. If the firm can
earn 10% annually on these funds, how much must it invest annually to meet the sinking fund?

RESPONSE:
ANSWER:

X(15.937) = $1,000,000
X = $1,000,000/15.937 = $62,747
15.937 is the interest factor for the future value of $1 at 10% for 10 years. (PV = 0; N
= 10; I = 10; PMT = ?, and FV = 1000000. PMT = -62745.39.)

POINTS:

-- / 1

REF:

44/80

104.

You are offered two jobs. One initially pays $25,000 annually, and your salary will grow annually at 10%.
The other pays $22,000 annually, but your salary will grow at 12%. After 10 years, which job pays the
higher salary?

RESPONSE:
ANSWER:

$25,000(1 + .1) 10 = $25,000(2.594) = $64,850

(PV = -25000; N = 10; I = 10; PMT = 0, and FV = ?. FV = 64843.)
$22,000(1 + .12) 10 = $22,000(3.106) = $68,332
(PV = -22000; N = 12; I = 10; PMT = 0, and FV = ?. FV = 68328.)
The job with the lower initial paying salary generates the higher salary after 10 years.

POINTS:

-- / 1

REF:

105.

You bought a stock for $30 and after 10 years sold it for $50. It paid an annual dividend of $2. Set up an
equation that illustrates how the annual return is determined. Show that this return is not 14%.

RESPONSE:
ANSWER:

Does $30 = $2(PVAIF 14I, 10N) + $50(PV$IF 14I, 10N)?

If 14% is the rate of return, the sides of the equation will be equal.
$2(5.216) + $30(.270) = $23.93, so the return is not 14%. 14% is too high.
(PV = -30; N = 10; I = ?; PMT = 2, and FV = 50. I = 10.71.)

POINTS:

-- / 1

REF:

45/80

106.

The New Jersey lotto awarded a prize of $560,000 a year for the next 20 years starting today. If the state
sold $21,900,000 in lotto tickets, what proportion of the sales will the state distribute if it earns 8%
annually on invested funds?

RESPONSE:
ANSWER:

This problem illustrates the present value of an annuity due. The present value of the
promised payments is $560,000(9.818)(1.08) = $5,937,930.
9.818 is the interest factor for the present value of the ordinary annuity at 8% for 20
years, and the 1.08 converts the interest factor into the interest factor for an annuity
due.
The state will distribute 27.1 percent of the ticket sales:
$5,937,930/$21,900,000 = 27.1%.

POINTS:

-- / 1

REF:

107.

You purchase a home for $100,000 with a 20-year mortgage at 12%. If you make annual mortgage
payments that pay the interest and reduce the principal, by how much is the loan reduced at the end of
the first year?

RESPONSE:
ANSWER:

The mortgage payment is

X(7.469) = $100,000
X = $100,000/7.469 = $13,389.
(PV = -100000; N = 20; I = 12; PMT = ?, and FV = 0. PMT = 13388.)
Since the interest payment is $100,000(0.12) = $12,000,
the principal repayment is $13,389 - 12,000 = $1,389.

POINTS:

-- / 1

REF:

46/80

108.

AZ's dividend rose from $1 to $1.61 in five years. What has the dividend's annual rate of growth?

RESPONSE:
ANSWER:

This is an example of future value. Solve for the interest factor:

$100(FVIF) = $161
The interest factor is $161/$100 = 1.61
Find 1.61 in the interest table for the future value of a dollar using five years. The
growth rate is 10 percent. (PV = -100; N = 5; PMT = 0; FV = 161; I = ?; I = 9.99.)

POINTS:

-- / 1

REF:

109.

If a new college graduate wants a car costing $15,000, how much must be saved annually if the funds
earn 5 percent?

RESPONSE:
ANSWER:

This is an example of the future value of an annuity. The question is, what amount
(X) times the interest factor for the future sum of an ordinary annuity of $1.00 for 4
years at 5 percent (interest factor = 4.310) equals $10,000?
X(4.310) = $15,000
X = $15,000/4.310 = $3,480
The graduate will have to save $3,480 annually to have accumulated the $15,000.
(PV = 0; N = 4; I = 5; FV = 15000; PMT = ?; PMT = 3480.18.)

POINTS:

-- / 1

REF:

47/80

110.

A firm earns 10 percent annually on its investments. One possible investment offers $50,000 a year for
10 years and costs $300,000. Should the firm make this investment?

RESPONSE:
ANSWER:

This problem is an example of the present value of an annuity. The interest factor for
the present value of the annuity of $1.00 at 10 percent for 10 years is 6.145.
X = $50,000 6.145
X = $307,250
The firm should make this investment because the present value of the cash inflow
generated by the investment ($307,250) exceeds the cost (cash outflow) of the
investment ($300,000). (PMT = 50000; N = 10; FV = 0; I = 10; PV = ? PV = 307228.36.)

POINTS:

-- / 1

REF:

111.

What is the expected return on a stock if the firm will earn 24% during a period of economic boom, 14%
during normal economic periods, and 2% during a period of recession if the probabilities of these
economic environments are 20%, 65%, and 15%, respectively?

RESPONSE:
ANSWER:

The expected return is a weighted average of the individual possible returns, each
weighted by the probability of their occurring:
Expected return

= (0.2)(0.24) + (0.65)(0.14) + (0.15)(0.02)

= 14.2%.

POINTS:

-- / 1

REF:

48/80

112.

You bought a stock with a beta of 1.4 and earned a return of 8.3%. Did you outperform the market if,
during the same period, the market rose by 7.4% and you could have earned 5.4% by investing in a
Treasury bill?

RESPONSE:
ANSWER:

The material in this problem was not explicitly covered in the chapter. You may use
the problem to set up the question, "What return should you have earned during a
particular investment horizon?" The answer uses the capital asset model to evaluate
performance. Thus, the return that should have been realized is
Rf + (R m - Rf) beta = 5.4% + (8.3 - 5.4)1.4 = 9.46%.
The actual return (8.3% return) is less than the return that would be expected given
the beta and the market performance. The stock under-performed the market on a
risk-adjusted basis.

POINTS:

-- / 1

REF:

113.

Construct a balance sheet from the following information.

Accrued interest payable

4,000

Accumulated depreciation

30,000

Trade accounts payable

10,000

Retained earnings

86,000

Accrued wages

11,000

Work in process

5,000

Finished goods

30,000

Plant and equipment

100,000

Cash and marketable securities

10,000

Land

10,000

Accounts receivable

32,000

Allowance for doubtful accounts

2,000

Bank note (due in six months)

15,000

Long-term debt

15,000

Raw materials

7,000

49/80

Investments

10,000

Taxes due

1,000

Additional paid-in capital

(capital surplus)

20,000

$1 par value common stock

20,000 shares authorized
10,000 shares outstanding

RESPONSE:
ANSWER:
Firm XYZ
Balance Sheet for the Period Ending December 31, 20XX
Assets
Current assets
Cash and marketable securities
Accounts receivable

$10,000
$32,000

Less allowance for doubtful

accounts

(2,000)

30,000

Inventory
Finished goods

30,000

Work in process

5,000

Raw materials

7,000

Total current assets

42,000
$82,000

Long-term assets
Plant and equipment

$100,000

Less accumulated

50/80

depreciation
Land

(30,000)

70,000
10,000

Total long-term assets

$80,000

Investments

$ 10,000

Total assets

$172,000

Liabilities and Stockholders' Equity

Current liabilities
Accounts payable

$10,000

Accrued wages

11,000

Bank notes

15,000

Accrued interest payable

4,000

Accrued taxes

1,000

Total current liabilities

$41,000

Long-term debt

$15,000

Total liabilities

$56,000

Stockholders' equity
Common stock ($1 par value; 20,000
shares authorized; 10,000 shares
outstanding)

$ 10,000

Paid-in capital

20,000

Retained earnings
Total stockholders' equity

Total liabilities and stockholders' equity

86,000
$116,000

$172,000

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POINTS:

-- / 1

REF:

114.

Given the following information, construct the statement of cash flow. What happened to the firm's
liquidity position during the year?
Net income

$16.7

Decrease in accounts receivable

6.1

Increase in accounts payable

13.6

Sale of bonds

55.1

Dividends

14.8

Retirement of bonds

10.8

Increase in inventory

15.2

Depreciation expense

56.0

Cost of goods sold

72.1

Reduction in income taxes payable

5.0

Sale of stock

0.4

Purchase of plant and equipment

91.0

Beginning cash

1.1

Repurchase of stock

5.6

RESPONSE:
ANSWER:
Statement of Cash Flows for the Period Ending
December 31, 20XX

Operating activities
Net income

$16.7

Depreciation

56.0

52/80

Decrease in accounts receivable

6.1

Increase in inventory

(15.2)

Increase in accounts payable

13.6

Decrease in income taxes payable

(5.0)

Net cash provided by operating activities

$72.2

Investment activities
Increase in plant

(91.0)

Net cash used in investing activities

($91.0)

Financing activities
Proceeds from sale of long-term debt

55.1

Payments on long-term debt

(10.8)

Dividends

(14.8)

Repurchase of stock

(5.6)

Sale of stock

0.4

Net cash provided by financing activities

$24.3

Cash at beginning of the year

$1.1

Cash at the end of the year

$6.6

The firm's cash position has increased, but that does not mean the firm is more liquid
since inventory and accounts payable increased while accounts receivable declined.
You should also note that the firm increased its investment in plant by using the cash
generated through depreciation and the issuing of new long-term debt. The earnings
and sale of stock did not cover dividends and stock repurchases. This indicates that
the firm is more financially leveraged.
POINTS:

-- / 1

REF:

115.

Using the income statement and balance sheet constructed in (1) and (2), compute the following ratios.

53/80

115.

Compare the results with the industry averages. What strengths and weaknesses are apparent?
RATIO

INDUSTRY AVERAGE

Current ratio

2:1

Acid test (quick ratio)

1:1

Inventory turnover
a.

annual sales

2.5

b.

cost of goods sold

1.2

Receivables turnover
a.

annual credit sales

5.0x

b.

annual sales

6.0x

Average collection period

2.5 months

Operating profit margin

26%

Net profit margin

19%

Return on assets

10%

Return on equity

15%

Debt/equity

33%

Debt ratio (debt/total assets)

25%

Times-interest-earned

7.1x

ADDITIONAL INFORMATION:
last year's inventory

$40,000

credit sales

$90,000

RESPONSE:
ANSWER:
Ratio analysis of financial statements

Current ratio:
Current assets/Current liabilities

54/80

$82,000/$41,000 = 2

Acid test (quick ratio):

(Current assets - inventory)/Current liabilities
($82,000 - 42,000)/$41,000 = .976

Inventory turnover:
Sales/Average inventory
$100,000/[($42,000 + 40,000)/2] = 2.4
or
Cost of goods sold/Average inventory
$60,000/[($42,000 + 40,000)/2] = 1.5

Receivables turnover:
Annual credit sales/Accounts receivable
$90,000/$30,000 = 3
or
Annual sales/Accounts receivable
$100,000/$30,000 = 3.3

Average collection period:

Receivables/ Credit sales per day =
$30,000/($90,000/365) = 122 days

Operating profit margin:

Earnings before interest and taxes/Sales
$25,000/$100,000 = 25%

55/80

Net profit margin:

Earnings after taxes/Sales
$16,800/$100,000 = 16.8%

Return on assets:
Earnings after taxes/Assets
$16,800/$172,000 = 9.8%

Return on equity:
Earnings after taxes/Equity
$16,800/$116,000 = 14.5%

Debt/Net worth ratio:

$56,000/$116,000 = 48.3%

Debt ratio:
Debt/Total assets
$56,000/$172,000 = 32.6%

Times-interest earned:
Earnings before interest and taxes/Interest
$25,000/$5,000 = 5.0

Times-interest earned (using net interest expense):

Earnings before interest and taxes/Interest
$25,000/($5,000 - 2,400) = 9.6

Strengths: The current ratio, acid test, and inventory turnover are comparable to the

56/80

industry averages. The operating profit margin exceeds the industry average. In
general, the firm's financial performance is acceptable.
Weaknesses: There are two basic weaknesses. The first is the slow collection of
accounts receivable which take 120 days to collect while the industry average is only
75 days. The firm is also using more financial leverage than the average firm as its
debt ratio is 32.6 percent versus an industry average of 24 percent. This increased
use of debt financing may be the result of carrying too many accounts receivable. If
the firm were to collect its accounts receivable more rapidly, then it could retire some
of its debt financing and reduce the debt ratio.
The increased use of debt financing could explain why the net profit margin is below
the industry average. Since the operating profit margin is higher than the industry
average, the lower net profit margin cannot be explained by the firm's operations.
Either interest expense or higher taxes must be the source of the lower net profit
margin. If the lower net profit margin is the result of higher interest expense, then this
is probably the result of carrying too many accounts receivable.

POINTS:

-- / 1

REF:

116.

What is the debt/net worth ratio and the debt to total assets ratio for a firm with total debt of $600,000 and
equity of $400,000?

RESPONSE:
ANSWER:

Debt/Net worth: $600,000/$400,000 = 1.5

Debt ratio (Debt/Total assets):
$600,000/($600,000 + $400,000) = 0.6 = 60%

POINTS:

-- / 1

REF:

57/80

117.

If the industry days sales outstanding is 65 days and a firm with sales of $1,034,550 has receivables of
$268,700, how much in interest expense could the firm save if the receivables turn over as quickly as the
industry average and the cost of carrying the receivables is 9%?

RESPONSE:
ANSWER:

Desired receivables based on the industry average:

65 = X/($1,034,550/365)
X = $184,235
Reduction in receivables: $268,700 - $184,235 = $84,465
Reduction in interest expense: 0.09 $84,465 = $7,602

POINTS:

-- / 1

REF:

58/80

118.

What is the value of a common stock if 2

a.

the firm's earnings and dividends are growing annually at 10 percent, the current dividend is
$1.32, and investors require a 15 percent return on investments in common stock?

b.

What is the value of this stock if you add risk to the analysis and the firm's beta coefficient is 0.8,
the risk-free rate is 9 percent, and the return on the market is 15 percent?

c.

If the price of the stock is $35, what is the rate of return offered by the stock? Should the investor
acquire this stock?

RESPONSE:
ANSWER:
a.

b.

k = .09 + (.15 - .09).8 = .138 = 13.8%

c.

r = $1.32(1+.1)/$35 + .10 = 14.15%

The rate of return is less than the required rate (14.15% versus 15%) until the risk
adjustment is made. After this adjustment, the expected rate of return exceeds the
required rate of return (14.15% versus 13.8%); therefore, buy the stock.
POINTS:

-- / 1

REF:

119.

A bond has the following terms:

principal amount

$1,000

semi-annual interest

$50

maturity

10 years

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a.

What is the bond's price if comparable debt yields 12%?

b.

What would be the price if comparable debt yields 12% and the bond matures after five years?

c.

What are the current yields and yields to maturity in a. and b.?

d.

What would be the bond's price in a. and b. if interest rates declined to 8%?

e.

What are the current yields and yield to maturity in d.?

f.

What two generalizations may be drawn from the above price changes?

RESPONSE:
ANSWER:
a.

P = interest(PV of an annuity at 6% for 20 periods)

+ principal (PV of $1 at 6% for 20 years)
= $50(11.470) + $1,000(.312) = $885

(PV = ?; I = 6; N = 10; PMT = 50, and FV = 1000.

PV = -885.)

b.

P = $50(7.360) + $1,000(.558) = $926

(PV = ?; I = 6; N = 10; PMT = 50, and FV = 1000.

PV = -926.)

c.

Current yield

Yield to maturity

in a:
$100/$885 =
11.3%

12%

in b:
$100/$926 =
10.8%

12%

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Notice that the yield to maturity is the yield on the comparable debt. Students
may confirm this by calculating the yield to maturity.

d.

Price at 4% for 20 periods:

P = $50(13.590) + $1,000(.456) = $1,136

(PV = ?; I = 4; N = 20; PMT = 50, and FV = 1000.

PV = -1136.)

Price at 4% for 10 periods:

P = $50(8.111) + $1,000(.676) = $1,082

(PV = ?; I = 4; N = 10; PMT = 50, and FV = 1000.

PV = -1081.)

e.

f.

POINTS:

Current
yields

Yield to maturity

a:
$100/$1,136
= 8.8%

8%

b:
$100/$1,082
= 9.2%

8%

(1)

The inverse relationship between bond prices and current interest

rates: when interest rates fall (12% to 8%), the price of the bond rises.

(2)

The longer the term of the bond (ten versus five years), the greater is
the price fluctuation.

-- / 1

61/80

REF:

120.

Determine the current market prices of the following $1,000 bonds if the comparable rate is 10 percent
and answer the following questions.
XY 5 1/4 percent (interest paid annually) for 20 years
AB 14 percent (interest paid annually) for 20 years
a.

Which bond has a current yield that exceeds the yield to maturity?

b.

Which bond may you expect to be called? Why?

c.

If CD, Inc. has a bond with a 5 1/4 percent coupon and a maturity of 20 years but which was lower
rated, what would be its price relative to the XY, Inc bond? Explain.

RESPONSE:
ANSWER:

Price of the XY, Inc. bond:

(PV = ?; I = 10; N = 20; PMT = 52.50, and FV = 1000, PV = -596.)
Price of the AB, Inc. bond:
(PV = ?; I = 10; N = 20; PMT = 140, and FV = 1000, PV = -1341.)
The current yields are
a.

The current yield of the AB, Inc. bond exceeds the yield to maturity (10.25%
versus 10%) because the current yield does not consider the loss of the
premium the investors will suffer over the lifetime of the bond.

b.

There is no reason to expect the firm to call the XY bond, because the firm
could repurchase the bonds at a discount. The AB bond, however, may be
called. Current interest rates are lower (10% versus the 14% coupon on that
bond), so the firm could refund the debt. (The instructor should ask what
impact the expectation of such refunding may have on the price of the bond.)

c.

Since the CD and XY bonds are identical with regard to interest paid and
term to maturity, the factor that differentiates them is the credit rating. The
CD bond has a lower credit rating, so its value relative to the XY bond should
be less. Such a lower price will increase the yield to the investor and
presumably would be necessary to induce the investor to purchase the
riskier bond.

62/80

POINTS:

-- / 1

REF:

121.

An investor buys a $1,000, 20 year 7 percent (interest paid semiannually) bond at par. After five years
have passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond?

RESPONSE:
ANSWER:

Price of the bond with 15 years (30 time periods) to maturity:

(PV = ?; I = 5; N = 30; PMT = 35.50, and FV = 1000, PV = -777.10.)
Since the investor purchased the bond for $1,000, the loss is $1,000 - $776 = $224.

POINTS:

-- / 1

REF:

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122.

A convertible bond has the following features:

Coupon

6.5%

Maturity date

10

Exercise price

$20

Principal

$1,000

Call price

$1,065

years

Convertible preferred stock

Annual dividend
$2.25
Convertible into 2.5 shares of common stock
Callable at $25 a share
Currently the common stock is selling for $13; the yield on non-convertible bonds is 10%, and the yield on
comparable preferred stocks is 14%. What is the value of the above securities in terms of the common
stock? What would be the value of each security if it lacked the conversion feature?

RESPONSE:
ANSWER:

Value of the convertible bond as stock:

First, determine the number of shares into which the bond may be converted:
$1,000/$20 = 50 shares.
Next, multiply the number of shares by the price per share: 50 $13 = $650.
Value of the convertible bond as debt: $65(6.145) + $1,000(0.386) = $785.43
(6.145 and 0.386 are respectively the interest factors for the present value of an
annuity and the present value of a dollar at 10 percent for ten years. If a financial
calculator is used, enter PMT = 65, FV = 1000, I = 10, N = 10, and solve for PV. In
this example, PV = -784.94.)
Since the bond's value as debt exceeds its value as stock, the bond will sell for at
least $785.43, its value as debt. (The bond will probably sell for more than $785.43,
as it will command a premium over the bond's value as debt.)
Value of the convertible preferred stock as common stock: 2.5 shares $13 = $32.50
Value of the convertible preferred stock as non-convertible preferred stock:
$2.25/.14 = $16.07
Since the conversion value of the stock exceeds its value as non-convertible
preferred stock, the convertible preferred stock will sell for at least $32.50, its value
as common stock.

POINTS:

-- / 1

REF:

123.

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123.

Given the following information, answer the following questions.

TR = $3Q
TC = $1,500 + $2Q
a.

What is the break-even level of output?

b.

If the firm sells 1,300 units, what are its earnings or losses?

c.

If sales rise to 2,000 units, what are the firm's earnings or losses?

d.

If the total cost equation were

TC = $2,000 + $1.80Q,
what happens to the break-even level of output units?

RESPONSE:
ANSWER:
a.

Break-even level of output:

$1,500/($3 - $2) = 1,500 units

b.

Earnings

= $3Q - $1,500 - $2Q

= $3(1,300) - 1,500 - 2(1,300) = ($200)

c.

Earnings

= $3Q - $1,500 - $2Q

= 3(2,000) - 1,500 - 2(2,000) = $500

d.

Break-even level of output:

$2,000/($3 - $1.80) = 1,667 units

POINTS:

-- / 1

65/80

REF:
124.

Given the following information:

interest rate

8%

tax rate

30%

dividend

$ 1

price of the common stock

$50

growth rate of dividends

7%

debt ratio

40%

a.

Determine the firm's cost of capital.

b.

If the debt ratio rises to 50 percent and the cost of funds remains the same, what is the new cost
of capital?

c.

If the debt ratio rises to 60 percent, the interest rate rises to 9 percent, and the price of the stock
falls to $30, what is the cost of capital? Why is this cost different?

RESPONSE:

66/80

ANSWER:
a.

Cost of debt: .08(1 - .3) = .056 = 5.6%

Cost of equity: $1(1 + .07)/$50 + .07 = 9.1%
Cost of capital:
weights

costs

.4

.056

.0224

.6

.091

.0546
.0770 = 7.7%

b.

The cost of debt and equity are unchanged. Only the weights are changed.
Cost of capital:
weights

costs

.5

.056

.0280

.5

.091

.0455
.0735 = 7.35%

c.

Both the cost of debt and equity are changed.

Cost of capital:
weights

costs

.6

.063

.0378

.4

.106

.0424
.0802 = 8.02%

The cost of capital changes as any of the components are changed. As the
firm initially substitutes cheaper debt financing, the cost of capital declines
(7.7% to 7.35%). However, as the firm uses more debt financing and
becomes more financial leveraged, it becomes riskier, and the cost of capital
rises (7.35% to 8.02%).

67/80

POINTS:
125.

-- / 1

REF:
Fill
in the table using the following information.
Assets required for operation: $2,000
Case A

- firm uses only equity financing

Case B

- firm uses 30% debt with a 10% interest rate and 70% equity

Case C

- firm uses 50% debt with a 12% interest rate and 50% equity

Debt outstanding

300

300

300

Stockholders' equity
Earnings before
interest and taxes
Interest expense
Earnings before taxes
Taxes (40% of earnings)
Net earnings
Return on stockholders'
investment

What happens to the rate of return on the stockholders' investment as the amount of debt increases?
Why did the rate of interest increase in case C?

RESPONSE:

68/80

ANSWER:
A
0

$ 600

$1,000

Debt outstanding

Stockholders' equity

2,000

1,400

1,000

Earnings before

300

300

300

Interest expense

60

120

Earnings before taxes

300

240

180

Taxes (40% of earnings)

120

96

72

Net earnings

$ 180

$ 144

$ 108

Return on stockholders'

9%

10.3%

10.8%

interest and taxes

investment

The rate of return to stockholders rises because the after tax cost of debt in B is .1(1
- .4) = 6%. The after tax cost of debt in C is .12(1 - .4) = 7.2%. These costs are less
than the 9 percent the firm earns after taxes on its assets ($180/$2,000). The interest
rate increases because the firm becomes riskier when it uses more financial
leverage.
POINTS:

-- / 1

REF:

126.

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126.

The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm
exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management
believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital
structure.
a.

What is the firm's cost of capital if it uses only retained earnings?

b.

What is the firm's cost of capital if it uses new equity?

c.

How much total financing may the firm have before the marginal cost of capital rises?

RESPONSE:
ANSWER:
a.

The cost of capital using retained earnings:

(.35)(.08) + (.65)(.14) = 11.9%

b.

The cost of capital using new equity:

(.35)(.08) + (.65)(.149) = 12.485%

Notice that the marginal cost of capital rises after the firm exhausts its
retained earnings and must start using more expensive new equity.

c.

The break-point in the marginal cost of capital schedule:

$23,678/.65 = $36,428

The retained earnings can support up to $36,428 in total financing and still
maintain the optimal combination of debt and equity financing. However,
after $36,428 of total financing, the retained earnings are exhausted, and the
firm must start using more expensive new equity.

POINTS:

-- / 1

REF:

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127.

Two mutually exclusive investments cost $10,000 each and have the following cash inflows. The firm's
cost of capital is 12%.
Investment
Cash inflow:

$12,407

--

--

--

--

--

--

$19,390

Year

a.

What is the net present value of each investment?

b.

What is the internal rate of return of each investment?

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c.

Which investment(s) should the firm make?

d.

Would your answers be different to c if the funds received in year 1 for investment A could be
reinvested at 12%, 16%, or 20%?

RESPONSE:
ANSWER:
a.

NPVA

= $12,407/(1 + .12) - $10,000

= $12,407(.893) - $10,000 = $1,079

NPVB

= 19,390/(1 + .12) 4 - $10,000

= $19,390(.636) - $10,000 = $2,332

b.

$10,000 = $12,407/(1 + r)
(1 + r) = $12,407/$10,000 = .806
r = 24%

$10,000 = $19,390/(1 + r) 4
(1 + r) 4 = $19,390/$10,000 = .516
r = 18%

c.

Since the investments are mutually exclusive, the firm can only make one.
The NPVB exceeds the NPVA; therefore, B is to be preferred. However, the
IRR of A exceeds the IRR of B, which argues for A.

d.

Reconciliation of the conflict may be achieved by considering the

reinvestment rate of the funds earned in year 1 by investment A.

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At 12%: $12,407(1 + .12) 3 = $12,407(1.405) = $17,432

At 16%: $12,407(1 + .16) 3 = $12,407(1.561) = $19,367

At 20%: $12,407(1 + .20) 3 = $12,407(1.728) = $21,439

At both 12% and 16%, B is preferred because it produces the higher terminal
value. However, at 20%, A is now preferred because it produces the higher
terminal value.

The break-even point between A and B is

$12,407(1 + r) 3 = $19,390.
(1 + r) 3 = $19,390/$12,407 = 1.5628
r = 16.05%

Below a reinvestment rate of 16.05%, B is always the preferred investment.

POINTS:

-- / 1

REF:

128.

A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The
cost of capital is 6 percent.
Year

Cash Inflow
A

$175

$1,100

175

175

175

175

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175

175

175

a.

What is the internal rate of return on each investment? Which investment should the firm make?

b.

What is the net present value of each investment? Which investment should the firm make?

c.

If the cash inflows can be reinvested at 8 percent, which investment should be made?

RESPONSE:
ANSWER:
a.

Determination of the internal rates of return:

A:

$175(PVAIF x%, 8y) = $1,000

Interest factor = $1,000/$175 = 5.174
rA = approximately 8%
(PV = -1000; N = 8; I = ?; PMT = 175, and FV = 0.
I = 8.15.)

B:

$1,100/(1 + r B) = $1,000
Interest factor = $1,000/$1,100 = .909
rB = 10%

Since the investments are mutually exclusive, the firm should select B
because it has the higher internal rate of return.

b.

Determination of the net present values:

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A:

Net present value A:

$175(PVAIF 6%, 8y) - $1,000 = $175(6.210) - $1,000
= $87

B:

Net present value B:

$1,100/(1 + .06) - $1,000 = $1,100(.943) - $1,000 = $37

Since the investments are mutually exclusive, the firm should select A
because it has the higher net present value.(This contradicts part a, which
selected investment B.)

c.

If the firm is able to reinvest the annual payments of $175, the terminal value
of A is $175(10.637) = $1,861.48
(10.637 is the interest factor for the future value of an ordinary annuity at 8%
for eight years.)

If the firm selects B, it receives $1,100 in year one, which is reinvested at 8%

for seven years. The terminal value is $1,100(1.714) = $1,885.40. This is
higher than the terminal value for A, so the firm should make investment B.

POINTS:

-- / 1

REF:

129.

A firm has the following investment alternatives:

Cash Inflows
Year

$400

$ ---

$ ---

400

400

---

400

800

---

400

800

1,800

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Each investment costs $1,400 and the firm's cost of capital is 10 percent.
a.

What is each investment's internal rate of return?

b.

Should the firm make any of these investments?

c.

What is each investment's net present value?

d.

Should the firm make any of these investments?

RESPONSE:
ANSWER:
a.

Determination of the internal rates of return:

Investment A:
$400(PVAIF x%, 4y) = $1,400
Interest factor = $1,400/$400 = 3.5
rA = approximately 5.6%
(PV = -1400; N = 4; I = ?; PMT = 400, and FV = 0.
I = 5.56.)

Investment B:
$1,400 = $400/(1 + r B)2 + $800/(1 + r B)3 + $800/(1 + r B)4

Use 12%:
$400(.780) + $800(.712) + $800(.634) = $1,389
rB = approximately 12% (11.9%)

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Investment C:
$1,400 = $1,800/(1 + r C)4
Interest factor = $1,400/$1,800 = .778
rC = approximately 7% (6.5%)

b.

The firm should make only investment B.

c.

Determination of the net present values:

Investment A:
$400(PVAIF 10%, 4y) $1,400 = $400(3.170) - $1,400 = ($132)

Investment B:
$400/(1 + .1) 2 + $800/(1 + .1) 3 + $800/(1 + .1) 4 - 1,400
= $400(.826) + $800(.751) + $800(.683) - $1,400
= $1,477.60 - $1,400 = $77.60

Investment C:
$1,800/(1 + .1) 4 - $1,400 = $1,800(.683) - $1,400
= ($170.60)

d.

POINTS:

According to the net present value, only investment B should be made. (This
confirms the answer to part b.)

-- / 1

REF:

130.

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130.

A risky $1,000 investment is expected to generate the following cash flows:

Year

$600

$600

$600.

a.

If the firm's cost of capital is 10 percent, should the investment be made?

b.

An alternative use for the $1,000 is a three-year U.S. Treasury note that pays $50 annually and
repays the $1,000 at maturity for an annual risk-free return of 5 percent. Management believes
that the cash inflows from the risky investment are only equivalent to 70 percent of the certain
investment. Does this information alter the decision in (a)?

RESPONSE:
ANSWER:
a.

The net present values if the firm's cost of capital is 10 percent:

$600(PVAIF 10I, 3N) - $1,000 =
$600(2.487) - $1,000 = $492.20.

The net present value is positive. The investment should be made.

b.

If the cash flows are considered to be only 70 percent certain and the riskfree, certain discount rate is 5 percent, the net present value is
(0.7)$600(PVAIF 5I, 3N) - $1,000 =
$420(2.723) - $1,000 = $143.66.

The adjusted net present value remains positive, so the investment should
be made.

POINTS:

-- / 1

REF:

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