Corporate Finance and Equity QBank
A
A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments made during this discussion is the least accurate? A) A project's internal rate of return decreases when a breakpoint is reached. B) An increase in the after-tax cost of debt may occur at a break point. C) Any given project's NPV will decline when a breakpoint is reached. Explanation References The internal rate of return is independent of the firm's cost of capital. It is a function of the amount and timing of a project's cash flows.
A
A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the YTM on these bonds is 14%. If the tax rate is 40%, what is the after tax cost of debt? A) 8.4%. B) 5.6%. C) 7.2%. Explanation References (0.14)(1 - 0.4)
A
A company is considering a $10,000 project that will last 5 years. Annual after tax cash flows are expected to be $3,000 Cost of capital = 9.7% What is the project's net present value (NPV)? A) +$1,460. B) -$1,460. C) +$11,460. Explanation References Calculate the PV of the project cash flows N = 5, PMT = -3,000, FV = 0, I/Y = 9.7, CPT → PV = 11,460 Calculate the project NPV by subtracting out the initial cash flow NPV = $11,460 − $10,000 = $1,460
B
A company's required return on equity is 15% and its dividend payout ratio is 55%. If its return on equity (ROE) is 17% and its beta is 1.40, then its sustainable growth rate is closest to: A) 6.75%. B) 7.65%. C) 9.35%. Explanation References USE ROE not REQUIRED ROE Growth rate = (ROE)(Retention Ratio) = (0.17)(0.45) = 0.0765 or 7.65%
A
A financial analyst is estimating the effect on the cost of capital for a company of a decrease in the marginal tax rate. The company is financed with debt and common equity. A decrease in the firm's marginal tax rate would: A) increase the cost of capital because of a higher after-tax cost of debt. B) increase the cost of capital because of a higher after-tax cost of debt and equity. C) decrease the cost of capital because of a lower after-tax cost of debt and equity. Explanation References The cost of debt capital is affected by the marginal tax rate because interest costs are tax-deductible. A lower marginal tax rate decreases the value to the firm of the tax deduction for interest and therefore increases the after-tax cost of debt capital. Cost of equity capital is not affected by the marginal tax rate.
C
A firm is evaluating two mutually exclusive projects of the same risk class, Project X and Project Y. Both have the same initial cash outlay and both have positive NPVs. Which of the following is a sufficient reason to choose Project X over Project Y? A) Project X has both a shorter payback period and a shorter discounted payback period compared to Project Y. B) Project Y has a lower internal rate of return than Project X. C) Project Y has a lower profitability index than Project X. Explanation References The correct method of choosing between two mutually exclusive projects is to choose the one with the higher NPV. The profitability index is calculated as the present value of the future cash flows divided by the initial outlay for the project. Because both projects have the same initial cash outlay, the one with the higher profitability index has both higher present value of future cash flows and the higher NPV. Ranking projects on their payback periods or their internal rates of return can lead to incorrect ranking.
B
A firm is reviewing an investment opportunity that requires an initial cash outlay of $336,875 and promises to return the following irregular payments: Year 1: $100,000 Year 2: $82,000 Year 3: $76,000 Year 4: $111,000 Year 5: $142,000 If the required rate of return for the firm is 8%, what is the net present value of the investment? (You'll need to use your financial calculator.) A) $86,133. B) $64,582. C) $99,860. Explanation References In order to determine the net present value of the investment, given the required rate of return; we can discount each cash flow to its present value, sum the present value, and subtract the required investment. Year Cash Flow PV of Cash flow at 8% 0 -336,875.00 -336,875.00 1 100,000.00 92,592.59 2 82,000.00 70,301.78 3 76,000.00 60,331.25 4 111,000.00 81,588.31 5 142,000.00 96,642.81 Net Present Value 64,581.74
C
A result that is most likely to give a financial manager concern that his firm's credit policy may have become too lenient is: A) receivables turnover has increased significantly. B) inventory turnover has decreased considerably. C) weighted average collection period has increased. Explanation References The weighted average collection period is the average number of days it takes to collect a dollar of receivables. A decreased percentage of sales made on credit or an increase in the receivables turnover ratio might result from more strict credit terms. Inventory turnover is not directly affected by credit terms, only though the effect of credit terms on overall sales.
A
Additional debt should be used in the firm's capital structure if it increases: A) the value of the firm. B) firm earnings. C) earnings per share. Explanation References The key to finding the optimal capital structure is identifying the level of debt that will maximize firm value. Earnings and earnings per share are not critical in and of themselves when assessing firm value, because they do not consider risk.
A
All else equal, which of the following statements about operating leverage is least accurate? A) Lower operating leverage generally results in a higher expected rate of return. B) Operating leverage reflects the tradeoff between variable costs and fixed costs. C) Firms with high operating leverage experience greater variance in operating income. Explanation References Operating leverage is the trade off between fixed and variable costs. Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.
C
An analyst collected the following data for three possible investments. *Expected price one year from today. The expected return on the market is 12% and the risk-free rate is 4%. Assuming that capital markets are in equilibrium, what is the required return for Omega? A) 17.4%. B) 1.2%. C) 13.6%. Explanation References RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, Rf = risk-free rate, and (RMarket − Rf) = market premium RRStock = 4 + (12 − 4) × 1.2 = 4 + 9.6 = 13.6%.
A
An equally weighted portfolio of a risky asset and a risk-free asset will exhibit: A) half the returns standard deviation of the risky asset. B) less than half the returns standard deviation of the risky asset. C) more than half the returns standard deviation of the risky asset. Explanation References A risk free asset has a standard deviation of returns equal to zero and a correlation of returns with any risky asset also equal to zero. As a result, the standard deviation of returns of a portfolio of a risky asset and a risk-free asset is equal to the weight of the risky asset multiplied by its standard deviation of returns. For an equally weighted portfolio, the weight of the risky asset is 0.5 and the portfolio standard deviation is 0.5 × the standard deviation of returns of the risky asset.
A
An example of a primary source of liquidity is: A) using trade credit from vendors. B) renegotiating debt agreements. C) filing for bankruptcy. Explanation References Primary sources of liquidity include cash resulting from selling goods and services, collecting receivables, generating cash from other sources and sources of short-term funding such as trade credit from vendors and lines of credit from banks. Filing for bankruptcy and renegotiating debt agreements are secondary sources of liquidity.
A
An investor can profit from a stock price decline by: A) selling short. B) placing a stop buy order. C) purchasing a call option. Explanation References Short selling provides a way for an investor to profit from a stock price decline. In order to sell short, the broker borrows the security and then sells it for the short seller. Later, if the investor can replace the borrowed securities by repurchasing them at a lower price, then the investor will profit from the transaction.
A
An investor is evaluating the following possible portfolios. Which of the following portfolios would least likely lie on the efficient frontier? Portfolio Expected Return Standard Deviation A 26% 28% B 23% 34% C 14% 23% D 18% 14% E 11% 8% F 18% 16% Explanation References Portfolio B cannot lie on the frontier because its risk is higher than that of Portfolio A's with lower return. Portfolio C cannot lie on the frontier because it has higher risk than Portfolio D with lower return. Portfolio F cannot lie on the frontier cannot lie on the frontier because its risk is higher than Portfolio D.
A
An objective of the risk management process is to: A) identify the risks faced by an organization. B) minimize the risks faced by an organization. C) eliminate the risks faced by an organization. Explanation References The risk management process should identify an organization's risk tolerance, identify the risks it faces, and monitor or address these risks. The goal is not to minimize or eliminate risks.
C
Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets. Korotkin views the Expo as primarily a marketing tool and is happy to breakeven (that is, cover her booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth rental fee. This year, she decided to make all blankets for the Expo out of high-tech waterproof/breathable material that is more expensive to produce, but that she believes she can sell for a higher profit margin. Information on the two types of blankets is as follows: Per Unit Last Year's (Basic) Blanket Sales Price $25 Variable Cost $40 This Year's (New Blanket) Sales Price $20 Variable Cost $33 Assuming that Korotkin remains most interested in covering the booth cost (which has increased to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth cost? To cover this year's booth costs, Korotkin needs to sell: Explanation References To obtain this result, we need to calculate Last Year's Breakeven Quantity, This Year's Breakeven Quantity, and calculate the difference. Step 1: Determine Last Year's (Basic Blanket) breakeven quantity: QBE = (Fixed Costs) / (Sales Price per unit − Variable Cost per unit) = 750 / (25 − 20) = 150 Step 2: Determine This Year's (New Blanket) breakeven quantity: QBE = (Fixed Costs) / (Sales Price per unit - Variable Cost per unit) = 840 / (40 − 33) = 120 Step 3: Determine Change in Units: DQ = QThis Year - QLast Year = 120 − 150 = −30. Korotkin needs to sell 30 fewer blankets.
C
Asset-based valuation models are most appropriate for a firm that: A) has cyclical earnings. B) has significant intangible assets. C) is being liquidated. Explanation References Asset-based valuation models are appropriate for a firm that is being liquidated because when a firm ceases to operate as a going concern, its value to equity owners depends on the difference between the fair value of its assets and liabilities. Asset-based models are unlikely to be reliable for estimating the value of firms that have significant intangible assets because fair values of such assets are often difficult to determine. Such a firm may or may not have cyclical earnings.
B
Betsy Minor is considering the diversification benefits of a two stock portfolio. The expected return of stock A is 14 percent with a standard deviation of 18 percent and the expected return of stock B is 18 percent with a standard deviation of 24 percent. Minor intends to invest 40 percent of her money in stock A, and 60 percent in stock B. The correlation coefficient between the two stocks is 0.6. What is the variance and standard deviation of the two stock portfolio? A) Variance = 0.04666; Standard Deviation = 21.60%. B) Variance = 0.03836; Standard Deviation = 19.59%. C) Variance = 0.02206; Standard Deviation = 14.85%. Explanation References (0.40)2(0.18)2 + (0.60)2(0.24)2 + 2(0.4)(0.6)(0.18)(0.24)(0.6) = 0.03836. 0.038360.5 = 0.1959 or 19.59%. Previous Next 12 | Check for Review
B
Buying insurance is best described as a method for an organization to: A) prevent a risk. B) transfer a risk. C) shift a risk. Explanation References Buying insurance transfers a risk to the insurance company. Shifting a risk is changing the distribution of outcomes, typically with a derivatives contract. Preventing a risk refers to taking steps such as strengthening security procedures.
B
Calculate the value of a common stock that last paid a $2.00 dividend if the required rate of return on the stock is 14 percent and the expected growth rate of dividends and earnings is 6 percent. What growth model is an example of this calculation? Value of stock Growth model A) $26.50 Supernormal growth B) $26.50 Gordon growth C) $25.00 Gordon growth Explanation References $2(1.06)/0.14 - 0.06 = $26.50. This calculation is an example of the Gordon Growth Model also known as the constant growth model.
B
Carlos Rodriquez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital structure, capital budgets, and net present value (NPV) analysis. Which of the following comments made by these two individuals is least accurate? A) "The optimal capital budget is determined by the intersection of a firm's marginal cost of capital curve and its investment opportunity schedule." B) "For projects with more risk than the average firm project, NPV computations should be based on the marginal cost of capital instead of the weighted average cost of capital." C) "A break point occurs at a level of capital expenditure where one of the component costs of capital increases." Explanation References The marginal cost of capital (MCC) and the weighted average cost of capital (WACC) are the same thing. If a firm's capital structure remains constant, the MCC (WACC) increases as additional capital is raised.
A
Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-diversified portfolios with approximately equal market values. He expects Portfolio X to return 13% and Portfolio Y to return 14% over the upcoming year. Because of an unexpected need for cash, Smith is forced to sell at least one of the portfolios. He uses the security market line to determine whether his portfolios are undervalued or overvalued. Portfolio X's beta is 0.9 and Portfolio Y's beta is 1.1. The expected return on the market is 12% and the risk-free rate is 5%. Smith should sell: A) portfolio Y only. B) both portfolios X and Y because they are both overvalued. C) either portfolio X or Y because they are both properly valued. Explanation References Portfolio X's required return is 0.05 + 0.9 × (0.12-0.05) = 11.3%. It is expected to return 13%. The portfolio has an expected excess return of 1.7% Portfolio Y's required return is 0.05 + 1.1 × (0.12-0.05) = 12.7%. It is expected to return 14%. The portfolio has an expected excess return of 1.3%. Since both portfolios are undervalued, the investor should sell the portfolio that offers less excess return. Sell Portfolio Y because its excess return is less than that of Portfolio X.
A
Corporate governance defines the appropriate rights, role, and responsibilities of: A) management, the board of directors, and shareholders. B) management only. C) management and the board of directors. Explanation References Corporate governance defines the appropriate rights, roles, and responsibilities of a corporation's management, the board of directors, and shareholders.
B
Genoa Corp. pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year's earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. The firm's tax rate is 30%. The cost of common equity is closest to: A) 16.1%. B) 14.2%. C) 13.8%. Explanation References ROE × retention ratio = growth rate 15% × (1 - 0.40) = 9% D0 = $5.00 × 0.40 = $2.00 [$2.00(1.09) / $42.00] + 0.09 = 14.19%
B
If a project has a negative cash flow during its life or at the end of its life, the project most likely has: A) multiple net present values. B) more than one internal rate of return. C) a negative internal rate of return. Explanation References Projects with unconventional cash flows (where the sign of the cash flow changes from minus to plus to back to minus) will have multiple internal rates of return. However, one will still be able to calculate a single net present value for the cash flow pattern.
C
If the calculated net present value (NPV) is negative, which of the following must be CORRECT. The discount rate used is: A) equal to the internal rate of return (IRR). B) less than the internal rate of return (IRR). C) greater than the internal rate of return (IRR). Explanation References When the NPV = 0, this means the discount rate used is equal to the IRR. If a discount rate is used that is higher than the IRR, the NPV will be negative. Conversely, if a discount rate is used that is lower than the IRR, the NPV will be positive.
C
In a market-capitalization weighted index firms with: A) higher stock prices have greater impacts on the index. B) larger market caps have lesser impacts on the index. C) greater market caps have greater impacts on the index. Explanation References In a value weighted index, firms with greater market caps have a greater impact on the index than firms with lower market caps. A higher stock price does not necessarily mean a higher market cap.
C
In equilibrium, investors should only expect to be compensated for bearing systematic risk because: A) individual securities in equilibrium only have systematic risk. B) systematic risk is specific to the securities the investor selects. C) nonsystematic risk can be eliminated by diversification. Explanation References In equilibrium, investors should not expect to earn additional return for bearing nonsystematic risk because this risk can be eliminated by diversification. Individual securities have both systematic and nonsystematic risk. Systematic risk is market risk; nonsystematic risk is specific to individual securities.
B
In the top-down approach to asset allocation, industry analysis should be conducted before company analysis because: A) the goal of the top-down approach is to identify those companies in non-cyclical industries with the lowest P/E ratios. B) an industry's prospects within the global business environment are a major determinant of how well individual firms in the industry perform. C) most valuation models recommend the use of industry-wide average required returns, rather than individual returns. Explanation References In general, an industry's prospects within the global business environment determine how well or poorly individual firms in the industry do. Thus, industry analysis should precede company analysis. The goal is to find the best companies in the most promising industries; even the best company in a weak industry is not likely to perform well.
A
Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury's taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is least likely to be affected by the proposed tax change? A) Waterbury's after-tax cost of noncallable, nonconvertible preferred stock. B) Waterbury's after-tax cost of corporate debt. C) Waterbury's return on equity (ROE). Explanation References Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterbury's after-tax cost of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on interest will increase. Also, since taxes impact net income, Waterbury's ROE will be affected by the change.
A
Lane Industries has a project with the following cash flows: Year Cash Flow 0 −$200,000 1 60,000 2 80,000 3 70,000 4 60,000 5 50,000 The project's cost of capital is 12%. The discounted payback period is closest to: A) 3.9 years. B) 3.4 years. C) 2.9 years.
A
One advantage of using price-to-book value (PBV) multiples for stock valuation is that: A) it is a stable and simple benchmark for comparison to the market price. B) most of the time it is close to the market value. C) book value of a firm can never be negative. Explanation References Book value provides a relatively stable measure of value that can be compared to the market price. For investors who mistrust the discounted cash flow estimates of value, it provides a much simpler benchmark for comparison. Book value may or may not be closer to the market value. A firm may have negative book value if it shows accounting losses consistently.
C
Paying a cash dividend is most likely to result in: A) an increase in liquidity ratios. B) the same impact on liquidity and leverage ratios as a stock dividend. C) an increase in financial leverage ratios. Explanation References A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets, reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios such as the current ratio and cash ratio, due to the decrease in cash in the numerator. Unlike a cash dividend, a stock dividend or a stock split has no impact on liquidity or financial leverage ratios.
A
Pearl City Breweries has 8 million shares outstanding that are currently trading at $34 per share. The company is choosing whether to distribute $22 million as dividends or to use the same amount to repurchase its shares. Ignoring tax effects, what will be the amount of total wealth from owning one share of Pearl City Breweries under each of these alternatives? Cash dividend Share repurchase A) $34.00 $34.00 B) $31.25 $34.00 C) $31.25 $37.00
C
Project sequencing is best described as: A) prioritizing funds to achieve the maximum value for shareholders, given capital limitations. B) arranging projects in an order such that cash flows from the first project fund subsequent projects. C) an investment in a project today that creates the opportunity to invest in other projects in the future. Explanation References Projects are often sequenced through time so that investing in a project today may create the opportunity to invest in other projects in the future. Note that funding from the first project is not a requirement for project sequencing.
B
Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most accurate? A) The variables "k" and "g" are easy to forecast. B) The model is most influenced by the estimates of "k" and "g." C) Dividend forecasts are less reliable than estimates of other inputs. Explanation References The relationship between "k" and "g" is critical - small changes in the difference between these two variables results in large value fluctuations.
B
Regarding the technical points affecting the short sales of a stock, which of the following statements is most accurate? A) Stocks can only be shorted in a down market. B) The short seller must pay all dividends due to the lender of the shorted stock. C) The lender must deposit margin to guarantee the eventual return of the stock. Explanation References The short seller must pay any dividends on the stock to the owner of the borrowed shares. The short seller must also deposit margin money to guarantee the eventual repurchase of the security.
B
Steven's Bakery produces snack cakes and bread. Listed below are the operating costs for the snack cakes division and the bread division. Snack cakes Bread Price per package $2.00 $2.50 Variable cost per package $1.00 $1.30 Fixed operating costs $25,000 $30,000 Fixed financing costs $10,000 $10,000 Compared to the snack cakes division, the operating breakeven quantity for the bread division is: A) less. B) the same. C) greater. Explanation References The OPERATING breakeven quantity for the snack cakes division is $25,000/($2.00 − $1.00) = 25,000. The OPERATING breakeven quantity for the bread division is $30,000/($2.50 − $1.30) = 25,000.
B
Stock A has a standard deviation of 0.5 and Stock B has a standard deviation of 0.3. Stock A and Stock B are perfectly positively correlated. According to Markowitz portfolio theory how much should be invested in each stock to minimize the portfolio's standard deviation? A) 50% in Stock A and 50% in Stock B. B) 100% in Stock B. C) 30% in Stock A and 70% in Stock B. Explanation References Since the stocks are perfectly correlated, there is no benefit from diversification. So, invest in the stock with the lowest risk.
C
The average number of days that it takes to turn raw materials into cash proceeds is a firm's: A) receivables cycle. B) inventory turnover cycle. C) operating cycle. Explanation References Operating cycle = days of inventory + days of receivables, and is the number of days that it takes to turn raw materials into cash from sales.
A
The basic premise of the risk-return trade-off suggests that risk-averse individuals purchasing investments with higher non-diversifiable risk should expect to earn: A) higher rates of return. B) lower rates of return. C) rates of return equal to the market. Explanation References Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk (Es) and the risk return line (capital market line [CML] and security market line [SML]) is upward sweeping.
B
The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm's existing debt. The company's marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is: A) 5.0%. B) More than 5.0%. C) Between 3.3% and 5.0%. Explanation References The after-tax cost of debt similar to Savanna's existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company's debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.
A
The effects that the acceptance of a project may have on other firm cash flows are best described as: A) externalities. B) opportunity costs. C) pure plays. Explanation References Externalities refer to the effects that the acceptance of a project may have on other firm cash flows. Cannibalization is one example of an externality.
C
The following information applies to a corporation: The company has $200 million of equity and $100 million of debt. The company recently issued bonds at 9%. The corporate tax rate is 30%. The company's beta is 1.125. If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company's after-tax weighted average cost of capital is closest to: A) 11.2%. B) 10.5%. C) 12.1%. Explanation References ks = RFR + β(Rm − RFR) = 6% + 1.125(14% − 6%) = 15% WACC = [D/(D + E)] × kd(1 − t) + [E/(D + E)] × ks = (100/300)(9%)(1 − 0.3) + (200/300)(15%) = 12.1% Previous Next 19 | Check for Review
C
The following is a schedule of Tiger Company's new debt and equity capital costs ($ millions): The company has a target capital structure of 30% debt and 70% equity. Tiger needs to raise an additional $135.0 million of capital for a new project while maintaining its target capital structure. The company's second debt break point and its marginal cost of capital (MCC) are closest to: Debt Break Point #2 MCC A) $200 million 8.4% B) $100 million 8.4% C) $200 million 10.0% Explanation References Debt break point #2 = $60 million / 0.30 = $200 million. $135 million × 30% = $40.5 million new debt $135 million × 70% = $94.5 million new equity MCC = 4.0%(0.30) + 12.5%(0.70) = 9.95%.
A
The industry experience curve illustrates the relationship between: A) cumulative output and cost per unit. B) productivity and average years of employment. C) company age and profitability. Explanation References The industry experience curve shows cost per unit relative to cumulative output. Cost per unit typically decreases over time due to higher utilization rates for fixed capital, improvements in the efficiency of labor, and better product design and manufacturing methods.
B
The market portfolio in Capital Market Theory is determined by: A) the intersection of the efficient frontier and the investor's highest utility curve. B) a line tangent to the efficient frontier, drawn from the risk-free rate of return. C) a line tangent to the efficient frontier, drawn from any point on the expected return axis. Explanation References The Capital Market Line is a straight line drawn from the risk-free rate of return (on the Y axis) through the market portfolio. The market portfolio is determined as where that straight line is exactly tangent to the efficient frontier.
C
The optimal capital budget is the amount of capital determined by the: A) point of tangency between the marginal cost of capital curve and the investment opportunity schedule. B) downward sloping marginal cost of capital curve's intersection with a upward sloping investment opportunity schedule. C) upward sloping marginal cost of capital curve's intersection with a downward sloping investment opportunity schedule. Explanation References The marginal cost of capital increases as additional capital is raised, which means the curve is upward sloping. The investment opportunity schedule slopes downward, representing the diminishing returns of additional capital invested. The point where the two curves intersect is the firm's optimal capital budget, the amount of capital that will finance all the projects that have positive net present values.
C
The quick ratio is considered a more conservative measure of liquidity than the current ratio because the quick ratio excludes: A) short-term marketable securities, which may need to be sold at a significant loss. B) accounts receivable, which may not be collectible in the short term. C) inventories, which are not necessarily liquid. Explanation References The quick ratio is usually defined as (current assets - inventory) / current liabilities. It is a more restrictive measure of liquidity than the current ratio, which equals current assets / current liabilities. The numerator of the quick ratio includes cash, receivables, and short-term marketable securities.
A
The share price of Solar Automotive Industries is $50 per share. It has a book value of $500 million and 50 million shares outstanding. What is the book value per share (BVPS) after a share repurchase of $10 million? A) $9.84. B) $10.12 C) $10.00. Explanation References The share buyback is $10 million / $50 per share = 200,000 shares. Remaining shares: 50 million − 200,000 = 49.8 million shares. Solar Automotive Industries' current BVPS = $500 million / 50 million = $10. Book value after repurchase: $500 million − $10 million = $490 million. BVPS = $490 million / 49.8 million = $9.84. BVPS decreased by $0.16. Book value per share (BVPS) decreased because the share price is greater than the original BVPS. If the share prices were less than the original BVPS, then the BVPS after the repurchase would have increased.
A
The strong-form efficient market hypothesis (EMH) asserts that stock prices fully reflect which of the following types of information? A) Public and private. B) Public, private, and future. C) Market. Explanation References The strong-form EMH assumes that stock prices fully reflect all information from public and private sources.
B
There are a lot of issues to consider in determining board independence. What would be the best definition of true "independence"? Independence, as it relates to board members, refers to: A) avoidance of material conflicts of interest. B) the degree to which these persons are not biased or otherwise controlled by firm management or other groups which may have some degree of control over management. C) the degree to which these persons are not biased or otherwise controlled by firm management or the outside audit group. Explanation References Avoiding material conflicts of interest is important, but this is not a true definition of independence. Independent board members should be independent from the outside audit group, but this is not part of the actual definition. Benefiting management interests should not be a board priority.
A
Three portfolios have the following expected returns and risk: Portfolio Expected return Standard deviation Jones 4% 2% Kelly 6% 5% Lewis 7% 8% A risk-averse investor choosing from these portfolios could rationally select: A) any of these portfolios. B) Jones or Kelly, but not Lewis. C) Jones, but not Kelly or Lewis. Explanation References Risk aversion means that to accept greater risk, an investor must be compensated with a higher expected return. For the three portfolios given, higher risk is associated with higher expected return. Therefore a risk-averse investor may select any of these portfolios. A risk-averse investor will not select a portfolio if another portfolio offers a higher expected return with the same risk, or lower risk with the same expected return.
B
Two investors, Craig Tower and Erin Gray, own 100 shares each of the same company. Tower receives a quarterly dividend while Gray does not. This is most likely because Tower: A) purchased his shares after Gray purchased her shares. B) owns a different class of stock than Gray. C) owns common shares while Gray owns preferred shares. Explanation References Different classes of common stocks can have different features with respect to dividends, stock splits, voting power and seniority if the firm's assets are liquidated. If Gray owns preferred shares, she would be more likely to receive a dividend than Tower's common shares. If Gray had purchased shares before an ex-dividend date and Tower purchased the same class of shares after that ex-dividend date, Gray would receive a dividend that Tower did not.
A
Under the efficient market hypothesis (EMH), the major effort of the portfolio manager should be to: A) achieve complete diversification of the portfolio. B) minimize systematic risk in the portfolio. C) follow a strict buy and hold strategy. Explanation References In an efficient market, portfolio managers must create and maintain the appropriate mix of assets to meet their client's needs. The portfolio should be diversified to eliminate unsystematic risk. The appropriate systematic risk will depend on the clients risk tolerance and return requirement. Over time the needs of the client and environment will justify changes to the portfolio. The manager should also try to minimize transaction costs and at least try to match the performance of a benchmark.
C
Use the following information on Brown Partners, Inc. to compute the current stock price. Dividend just paid = $6.10 Expected dividend growth rate = 4% Expected stock price in one year = $60 Risk-free rate = 3% Equity risk premium = 12% A) $59.55. B) $57.48. C) $57.70. Explanation References The current stock price is equal to (D1 + P1) / (1 + ke). D1 equals $6.10(1.04) = $6.34. The equity discount rate is 3% + 12% = 15%. Therefore the current stock price is ($6.34 + $60)/(1.15) = $57.70
C
When a company is evaluating two mutually exclusive projects that are both profitable but have conflicting NPV and IRR project rankings, the company should: A) accept the project with the higher internal rate of return. B) use a third method of evaluation such as discounted payback period. C) accept the project with the higher net present value. Explanation References Net present value is the preferred criterion when ranking projects because it measures the firm's expected increase in wealth from undertaking a project.
A
When using margin to invest in equities, which of the following defines initial margin and what level will the margin be brought back to in the event of a margin call? Initial Margin Margin Call Action A) minimum amount of equity required of the investor / a deposit must be made to bring the margin back to the maintenance margin B) amount of borrowed funds in the transactions / a deposit must be made to bring the margin back to the maintenance margin C) minimum amount of equity required of the investor / a deposit must be made to bring the margin back to the initial margin Explanation References The initial margin requirement refers to the minimum amount of equity required of the investor. With equities, if the margin falls below the maintenance margin, funds must be deposited to bring it back up to the maintenance margin level.
A
Which of the following industries is most likely to operate in a fragmented market? A) Oil services. B) Pharmaceuticals. C) Confections. Explanation References Most areas of the oil services industry are characterized by many small competitors. The confections and pharmaceutical industries each have a small number of very large firms. FRAGMENTED = MANY COMPETITORS
A
Which of the following inputs is least likely required for the Markowitz efficient frontier? The: A) level of risk aversion in the market. B) covariation between all securities. C) expected return of all securities. Explanation References The level of risk aversion in the market is not a required input. The model requires that investors know the expected return and variance of each security as well as the covariance between all securities.
C
Which of the following institutional investors is most likely to have low liquidity needs? A) Bank. B) Property insurance company. C) Defined benefit pension plan. Explanation References A defined benefit pension plan has less need for liquidity than a bank or a property and casualty insurance company. Banks have high liquidity needs because assets may have to be sold quickly if depositors withdraw their funds. Property and casualty insurance companies need to keep liquid assets to meet claims as they arise.
C
Which of the following is NOT a rationale for the importance of the policy statement in investing? It: A) allows the investor to judge performance by objective standards. B) specifies a benchmark against which to judge performance. C) forces investors to take risks. Explanation References By no means should the policy statement force the investor to take risks. The statement forces investors to understand the risks of investing.
A
Which of the following is an assumption of capital market theory? All investors: A) see the same risk/return distribution for a given stock. B) have multiple-period time horizons. C) select portfolios that lie above the efficient frontier to optimize the risk-return relationship. Explanation References All investors select portfolios that lie along the efficient frontier, based on their utility functions. All investors have the same one-period time horizon, and have the same risk/return expectations.
C
Which of the following is least likely a method by which firms repurchase their shares? A) Tender offer. B) Direct negotiation. C) Exercise a call provision. Explanation References Call provisions are not relevant to common stock and are not considered a repurchase in any case. There are three repurchase methods. The first is to buy in the open market. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price. The third way is to repurchase by direct negotiation. Companies may negotiate directly with a large shareholder to buy back a block of shares, usually at a premium to the market price.
A
Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm's fixed-rate debt? A) The coupon rate on the firm's existing debt. B) Seniority and any special covenants of the firm's anticipated debt. C) The yield to maturity of the firm's existing debt. Explanation References Ideally, an analyst would use the YTM of a firm's existing debt as the pretax cost of new debt. When a firm's debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm's existing debt. If you are provided with both coupon and YTM on the exam, you should use the YTM.
A
Which of the following orders is said to be "behind the market"? A) Limit buy order at 38 when the best bid is 39. B) Market sell order when the best bid is 38 and the best ask is 39. C) Limit sell order at 38 when the best ask is 39. Explanation References A limit buy order is behind the market if its limit price is below the best bid. A limit sell order is behind the market if its limit price is above the best ask. Market orders are never said to be behind the market.
A
Which of the following practices should be included in a firm's code of ethics? A) Providing the board with relevant corporate information in a timely manner and prohibiting board members or other insiders from purchasing stock before shareholders can make purchases. B) Providing the board with relevant corporate information in a timely manner and allowing board members or other insiders to purchase stock before shareholders can make purchases. C) Prohibiting board members or other insiders from purchasing stock before shareholders can make purchases. Explanation References The firm's code of ethics establishes the basic principles of integrity, trust, and honesty. Two of the practices listed in the reading discuss providing the board with relevant corporate information in a timely manner and prohibiting board members or other insiders from purchasing stock before shareholders can make purchases.
A
Which of the following statements about risk and return is least accurate? A) Risk and return may be considered on a mutually exclusive basis. B) Specifying investment objectives only in terms of return may expose an investor to inappropriately high levels of risk. C) Return objectives may be stated in absolute terms. Explanation References Risk and return must always be considered together when expressing investment objectives. Return objectives may be expressed either in absolute terms (dollar amounts) or in percentages.
B
Which of the following statements about risk is NOT correct? A) Unsystematic risk is diversifiable risk. B) Total risk = systematic risk - unsystematic risk. C) The market portfolio consists only of systematic risk. Explanation References Total risk = systematic risk + unsystematic risk
B
Which of the following statements about the role of the marginal cost of capital in determining the net present value of a project is most accurate? The marginal cost of capital should be used to discount the cash flows: A) of all projects the firm is considering. B) for potential projects that have a level of risk near that of the firm's average project. C) if the firm's capital structure is expected to change during the project's life. Explanation References Net present values of projects with the average risk for the firm should be determined using the firm's marginal cost of capital. The discount rate should be adjusted for projects with above-average or below-average risk. Using the marginal cost of capital assumes the firm's capital structure does not change over the life of the project.
B
Which of the following statements concerning Board committees is least accurate? A) The nominations committee is responsible for recruiting qualified board members and preparing an executive management succession plan. B) The audit committee has authority over the procedures used to audit the entire corporate group including subsidiaries and affiliates. C) Members of the audit committee should be independent experts in accounting and finance. Explanation References The independent auditor has authority over the audit procedures. The audit committee is responsible for hiring and supervising the independent auditor.
B
Which of the following statements regarding price multiples is most accurate? A) A disadvantage of the price/book value ratio is that it is not an appropriate measure for firms that primarily hold liquid assets. B) An advantage of the price/sales ratio is that it is meaningful even for distressed firms. C) A rationale for using the price/cash flow ratio is that there is only one clear definition of cash flow. Explanation References The P/S ratio is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for the P/E and P/BV ratios, which can be negative. In the P/BV ratio book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Analysts use several different definitions of cash flow (CFO, adjusted CFO, FCFE, EBITDA, etc.) to calculate P/CF ratios. When earnings are negative, the P/E ratio is meaningless.
B
Which of the following strategies is most likely to be considered good payables management? A) Taking trade discounts only if the firm's annual return on short-term investments is less than the discount percentage. B) Paying invoices on the last possible day to still get the supplier's discount for early payment. C) Paying trade invoices on the day they arrive. Explanation References Paying invoices on the last day to get a discount (for early payment) is often the most advantageous strategy for a firm. If the annualized percentage cost of not taking advantage of the discount is less than the firm's short-term cost of funds, it would be advantageous to pay on the due date. However, the discount percentage is not an annualized rate, so it cannot be compared directly to the firm's annual return on short-term investments. Paying prior to the discount cut-off date or prior to the due date sacrifices interest income for no advantage.
A
Which of the following types of investors is likely to have the shortest investment horizon? A) Property and casualty insurance company. B) Life insurance company. C) Foundation. Explanation References Foundations and life insurance companies typically have long investment horizons. Property and casualty insurance companies typically have shorter investment horizons than life insurance companies because claims against their policies occur sooner on average.
C
Which of the following would NOT be a good source for information about a company's proxy voting rules? A) Firm's corporate governance statement. B) Company's articles of organization and by-laws. C) Firm's annual report. Explanation References The annual report would typically not contain this detailed information.
C
Which one of the following statements about the marginal cost of capital (MCC) is most accurate? A) The MCC is the cost of the last dollar obtained from bondholders. B) The MCC falls as more and more capital is raised in a given period. C) A breakpoint on the MCC curve occurs when one of the components in the weighted average cost of capital changes in cost. Explanation References A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital changes by the weight of that component in the capital structure. The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The marginal cost of capital is the weighted average rate across all sources of long-term financings—bonds, preferred stock, and common stock—when the final dollar was obtained, regardless of its specific source.
B
With regard to stock market indexes, it is least likely that: A) the use of price weighting versus market value weighting produces a downward bias on the index. B) a market-cap weighted index must be adjusted for stock splits but not for dividends. C) buying 100 shares of each stock in a price-weighted index will result in a portfolio that tracks the index quite well. Explanation References A price-weighted index needs to be adjusted for stock splits, but a market-cap weighted index does not. Neither type of index considers dividend income unless it is designed as a total return index. Price weighting produces a downward bias compared to market weighting because firms that split their stocks (which tend to be the more successful firms) decrease in weight within a price-weighted index. The returns on a price-weighted index can be matched by purchasing a portfolio with an equal number of shares of each stock in the index.
