Finance 305 Final

If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.

A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT? The bond should currently be selling at its par value. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. The bond is currently selling at a price below its par value. If market interest rates decline, the price of the bond will also decline. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today.

The bond's yield to maturity is greater than its coupon rate.

A 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT? If the yield to maturity stays constant until the bond matures, the bond's price will remain at $850. The bond's current yield exceeds its yield to maturity. The bond's current yield is equal to its coupon rate. The bond's yield to maturity is greater than its coupon rate. The bond's coupon rate exceeds its current yield.

False

A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline.

Stock B.

A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter? Neither A nor B, as neither has a return sufficient to compensate for risk. Stock A. Add A, since its beta must be lower. Stock B. Either A or B, i.e., the investor should be indifferent between the two.

$32.61

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 8.2%. What is the stock's current price? $32.61 $27.39 $27.07 $38.80 $29.02

A project's NPV increases as the WACC declines.

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? A project's IRR increases as the WACC declines. A project's discounted payback increases as the WACC declines. A project's regular payback increases as the WACC declines. A project's MIRR is unaffected by changes in the WACC. A project's NPV increases as the WACC declines.

Default risk and liquidity differences.

Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows: T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were most probably caused primarily by: Inflation differences. Maturity risk differences. Default risk and liquidity differences. Real risk-free rate differences. Tax effects.

9.49%

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $45.00; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach? 9.49% 11.10% 10.15% 7.59% 8.63%

False

Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.

Increase the percentage of debt in the target capital structure.

Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? Increase the proposed capital budget. Increase the percentage of debt in the target capital structure. Reduce the amount of short-term bank debt in order to increase the current ratio. Increase the dividend payout ratio for the upcoming year. Reduce the percentage of debt in the target capital structure.

$286.36

Barry Company is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected. WACC: 11.75% Year 0 1 2 3 4 5 Cash flows -$1,100 $400 $390 $380 $370 $360 0$355.08 0$286.36 0$294.95 0$349.36 0$309.27

False

Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more price risk if you purchased a 30-day bond than if you bought a 30-year bond.

True

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV.

13.84%

Ehrmann Data Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 9.00% Year 0 1 2 3 Cash flows -$1,000 $450 $450 $450 13.28% 13.84% 13.70% 17.29% 14.53%

True

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

True

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

$1,646

Gupta Corporation is undergoing a restructuring, and its free cash flows are expected to vary considerably during the next few years. However, the FCF is expected to be $85.00 million in Year 5, and the FCF growth rate is expected to be a constant 6.5% beyond that point. The weighted average cost of capital is 12.0%. What is the horizon (or continuing) value (in millions) at t = 5? $1,432 $2,041 $1,234 $1,646 $1,662

the stock is a good buy.

If in the opinion of a given investor a stock's expected return exceeds its required return, this suggests that the investor thinks the stock is experiencing supernormal growth. management is probably not trying to maximize the price per share. dividends are not likely to be declared. the stock is a good buy. the stock should be sold.

False

If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

False

If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0. We do not know if the cost of capital is to the right or left of the crossover point. Therefore, NPVX may be either higher or lower than NPVY.

False

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

True

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

2.14 years

Masulis Inc. is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? WACC: 10.00% Year 0 1 2 3 4 Cash flows -$925 $525 $485 $445 $405 2.40 years 2.25 years 1.86 years 1.95 years 2.14 years

16.50%

Mikkelson Corporation's stock had a required return of 12.50% last year, when the risk-free rate was 3% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.) Do not round your intermediate calculations. 12.71% 13.04% 14.36% 12.87% 16.50%

$1,235.47

Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 5.00%, based on semiannual compounding. What is the bond's price? $976.02 $1,050.15 $1,235.47 $1,359.01 $1,457.85

True

Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

False

Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

Project L

Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the WACC? Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. Project L. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs. Project S.

5.31%

Sadik Inc.'s bonds currently sell for $1,300 and have a par value of $1,000. They pay a $105 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100. What is their yield to call (YTC)? 4.30% 5.10% 4.94% 6.00% 5.31%

The market risk premium declines.

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? The flotation costs associated with issuing preferred stock increase. The flotation costs associated with issuing new common stock increase. The company's beta increases. The market risk premium declines. Expected inflation increases.

11.76%

Simms Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC or negative, in both cases it will be rejected. Year 0 1 2 3 Cash flows -$1,025 $425 $425 $425 11.76% 12.58% 9.64% 10.82% 11.29%

True

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk.

In equilibrium, the expected return on Stock A will be greater than that on B.

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct. In equilibrium, the expected return on Stock A will be greater than that on B. Stock A would be a more desirable addition to a portfolio then Stock B. In equilibrium, the expected return on Stock B will be greater than that on Stock A. When held in isolation, Stock A has more risk than Stock B. Stock B would be a more desirable addition to a portfolio than A.

False

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt

True

The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method.

False

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

True

The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities.

False

The corporate valuation model can be used only when a company doesn't pay dividends.

False

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

The stock price is expected to be $54 a share one year from now.

The expected return on Natter Corporation's stock is 14%. The stock's dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? The current dividend per share is $4.00. The stock's dividend yield is 7%. The stock's dividend yield is 8%. The stock price is expected to be $54 a share one year from now. The stock price is expected to be $57 a share one year from now.

True

The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

False

The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold.

Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year.

Three $1,000 face value, 10-year, noncallable, bonds have the same amount of risk, hence their YTMs are equal. Bond 8 has an 8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12 has a 12% annual coupon. Bond 10 sells at par. Assuming that interest rates remain constant for the next 10 years, which of the following statements is CORRECT? Bond 8's current yield will increase each year. Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity. Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year. Over the next year, Bond 8's price is expected to decrease, Bond 10's price is expected to stay the same, and Bond 12's price is expected to increase. Bond 12 sells at a premium (its price is greater than par), and its price is expected to increase over the next year.

1.10

Tom O'Brien has a 2-stock portfolio with a total value of $100,000. $47,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is his portfolio's beta? Do not round your intermediate calculations. Round your final answer to 2 decimal places. 1.04 1.10 1.05 1.09 1.06

True

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

A 10-year, $1,000 face value, zero coupon bond.

Which of the following bonds has the greatest price risk? A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments. A 10-year $100 annuity. A 10-year, $1,000 face value, 10% coupon bond with annual interest payments. All 10-year bonds have the same price risk since they have the same maturity. A 10-year, $1,000 face value, zero coupon bond

Accounts Payable

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? Retained earnings. Long-term debt. Accounts payable. Preferred stock. Common stock.

The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

Which of the following statements is CORRECT, assuming stocks are in equilibrium? Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. A stock's dividend yield can never exceed its expected growth rate. A required condition for one to use the constant growth model is that the stock's expected growth rate exceeds its required rate of return. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. Other things held constant, the higher a company's beta coefficient, the lower its required rate of return.

All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

Which of the following statements is CORRECT? All else equal, senior debt generally has a lower yield to maturity than subordinated debt. If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors will also exceed its yield to maturity. An indenture is a bond that is less risky than a mortgage bond. The expected return on a corporate bond will generally exceed the bond's yield to maturity. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.

Which of the following statements is CORRECT? One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project's full life whereas IRR does not. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.

One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

Which of the following statements is CORRECT? One defect of the IRR method is that it does not take account of the cost of capital. One defect of the IRR method is that it does not take account of cash flows over a project's full life. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. One defect of the IRR method is that it does not take account of the time value of money. Rationale: The IRR assumes reinvestment at the IRR, and that is generally not as valid as assuming reinvestment at the WACC, which is the reinvestment rate assumption of the NPV method.

The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future

Which of the following statements is CORRECT? The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.

The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.

Which of the following statements is CORRECT? The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.

The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

Which of the following statements is CORRECT? The regular payback method recognizes all cash flows over a project's life. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect. The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project. Statement d is true. The payback does indicate how long it should take to recover the investment; hence, it is a measure of liquidity.

To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. To find a project's IRR, we must find a discount rate that is equal to the WACC. To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. A project's regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. If a project's IRR is greater than the WACC, then its NPV must be negative.

The corporate valuation model discounts free cash flows by the required return on equity.

Which of the following statements is NOT CORRECT? Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or continuing, value. The corporate valuation model discounts free cash flows by the required return on equity. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements. The corporate valuation model can be used to find the value of a division.

True

You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%.

bA < 0; bB = 0

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B? Years Market Stock A Stock B 1 0.03 0.16 0.05 2 -0.05 0.20 0.05 3 0.01 0.18 0.05 4 -0.10 0.25 0.05 5 0.06 0.14 0.05 bA > +1; bB = 0. bA > 0; bB = 1. bA < -1; bB = 1. bA = 0; bB = -1. bA < 0; bB = 0.

B; A.

You have the following data on three stocks: Stock Standard Deviation Beta A 20% 0.59 B 10% 0.61 C 12% 1.29 If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. A; B. C; A. A; A. B; A. C; B.

8.93%

You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.00%. The firm will not be issuing any new stock. What is its WACC? 6.96% 7.68% 8.93% 7.59% 6.69%