Finance Test Chp. 8 - 13

One year ago, you purchased 600 shares of stock for $14 a share. The stock pays $.41 a share in dividends each year. Today, you sold your shares for $15.30 a share. What is your total dollar return on this investment?

Total dollar return = 600 ×($15.30 -14 + .41) = $1,026

What is minimized when the value of a firm is maximized?

WACC

Country Cook's cost of equity is 16.2 percent and its aftertax cost of debt is 5.8 percent. What is the firm's weighted average cost of capital if its debt-equity ratio is .42 and the tax rate is 34 percent?

WACC = (1/1.42)(.162) + [(.42 /1.42)(.058)] = .1312, or 13.12 percent

Long-term U.S. government bonds

a portfolio of U.S. government bonds with 20 years to maturity

Average accounting return rule:

a project is acceptable if its average accounting return exceeds a target average accounting return

Sensitivity Analysis

a variation on scenario analysis that is useful in pinpointing the areas where forecasting risk is especially severe

beta coefficient

amount of systematic risk present in a particular risky asset relative to that in an average risky asset

IRR Rule:

an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

NPV Rule

an investment should be accepted if the NPV is positive and rejected if the NPV is negative

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

automatically gives preferential treatment in the allocation of funds to its riskiest division.

Average Accounting Return (AAR)

average net income/average book value

Payback Period Rule

based on the payback rule, an investment is acceptable if its calculated payback period is less than some pre-specified number of years

When using the pure play approach for a proposed investment, a firm is primarily seeking a rate of return that:

best matches the risk level of the proposed investment.

The capital asset pricing model:

considers the relationship between the fluctuations in a securitys returns versus the markets returns.

The weighted average cost of capital is defined as the weighted average of a firm's:

cost of equity, cost of preferred, and its aftertax cost of debt.

The level of financial risk to which a firm is exposed is dependent on the firm's:

debt-equity ratio.

The internal rate of return is the:

discount rate that results in a zero net present value for the project

Total dollar Return =

dividend income + capital gain (or loss)

Forecasting risk is best defined as:

estimation risk

The security market line is a linear function that is graphed by plotting data points based on the relationship between the:

expected return & beta

Total return =

expected return + unexpected return R = E(R) + U

Scenario analysis

helps determine the reasonable range of expectations for a project's anticipated outcome

The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:

homemade leverage.

A firm that uses its weighted average cost of capital as the required return for all of its investments will:

increase the risk level of the firm over time.

Any changes to a firm's projected future cash flows that are caused by adding a new project are referred to as:

incremental cash flows

The cost of preferred stock:

is equal to the stock's dividend yield.

The addition of a risky security to a fully diversified portfolio:

may or may not affect the portfolio beta.

The average accounting return

measures profitability rather than cash flow

The possibility that more than one discount rate can cause the net present value of an investment to equal zero is referred to as:

multiple rates of return

Total cash flow formula

operating cash flow - Change in NWC - Capital spending

Large company stocks

portfolio is based on the S&P 500 index, which contains 500 of the largest companies (in terms of total market values of outstanding stock) in the U.S.

Long-term corporate bonds

portfolio of high-quality bonds with 20 years to maturity

The net working capital invested in a project is generally:

recouped at the end of a project

Kate is analyzing a proposed project to determine how changes in the sales quantity would affect the project's net present value. What type of analysis is being conducted?

sensitivity analysis

Over the period of 1926-2014, what had the highest volatility of returns?

small-company stocks

principle of diversification

spreading an investment across a number of assets will eliminate some, but not all, of the risk

Dan is a chemist for ABC, a major drug manufacturer. Dan cannot earn excess profits on ABC stock based on the knowledge he has related to his experiments if the financial markets are:

strong form efficient

One year ago, you purchased 600 shares of a stock. This morning you sold those shares and realized a total return of 3.1 percent. Given this information, you know for sure the:

sum of the dividend yield and the capital gains yield is 3.1 percent.

The amount by which a firm's tax bill is reduced as a result of the depreciation expense is referred to as the depreciation:

tax shield

Variance

the average squared difference between the actual return and the average return

indirect bankruptcy costs

the costs of avoiding a bankruptcy filing incurred by a financially distressed firm

direct bankruptcy costs

the costs that are directly associated with bankruptcy, such as legal and administrative expenses

Net Present Value (NPV)

the difference between an investment's market value and its cost

Financial distress costs

the direct and indirect costs associated with going bankrupt or experiencing financial distress

The systematic risk principle

the expected return on a risky asset depends only on that asset's systematic risk

opportunity cost

the most desirable alternative given up as the result of a decision

cost of equity

the return that equity investors require on their investment in the firm

Cost of debt

the return that lenders require on the firm's debt

M&M Proposition I

the value of a firm is independent of its capital structure

Weighted average cost of capital (WACC)

the weighted average of the cost of equity and the aftertax cost of debt

Small-company stocks

this portfolio is composed of stock from smaller companies, where "small" corresponds to the smallest 20 percent of the companies listed on the NYSE (measured by market value & outstanding stock)

Standard deviation measures _____ risk while beta measures _____ risk.

total; systematic

Calculating IRR

use the same concept as NPV, except it sets the NPV equal to 0

The standard deviation measures the _____ of a security's returns over time.

volatility

The Tattle Teller has a printing press sitting idly in its back room. The press has no market value to another printer because the machine utilizes old technology. The firm could get $480 for the press as scrap metal. The press is six years old and originally cost $174,000. The current book value is $3,570. The president of the firm is considering a new project and feels he can use this press for that project. What value, if any, should be assigned to the press as an initial cost of the new project?

$480 - the relevant cost is the opportunity cost

NPV formula

(Cash flows) / (1+r) ^ t

WACC =

(E/V) * RE + (P/V) * RP + (D/V) * RD * (1-Tc)

2 key lessons from capital market history

1. risky assets, on average, earn a risk premium. There is a reward for bearing risk. 2. the greater the potential reward from a risky investment, the greater is the risk.

What was the average annual risk premium on small-company stocks for the period 1926-2014?

13.2 percent

geometric average return

= [(1+R1) X (1 + R2) X .... (1 + RT)]^ (1/T) - 1

A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. Which one of the following will lower the overall expected rate of return on this stock?

A decrease in the probability of an economic boom

M&M Proposition II

A firm's cost of equity capital is a positive linear function of its capital structure

legal bankruptcy

A legal proceeding for liquidating or reorganizing a business

Boone Brothers remodels homes and replaces windows. Ace Builders constructs new homes. If Boone Brothers considers expanding into new home construction, it should evaluate the expansion project using what as the required return for the project?

Ace Builders' cost of capital

Windsor stock has produced returns of 13.8 percent, 11.7 percent, 2.3 percent, -21.4 percent, and 8.9 percent over the past five years, respectively. What is the variance of these returns?

Average return = (.138 + .117 + .023-.214 + .089)/5 = .0306 σ2 = [(.138-.0306)2 + (.117 -.0306)2 + (.023 -.0306)2 + (-.214 -.0306)2 + (.089 -.0306)2]/(5 - 1) = .020574

Which one of the following is the equity risk arising from the capital structure selected by a firm? A. Strategic risk B. Financial risk C. Liquidity risk D. Industry risk E. Business risk

B. Financial Risk

Which one of the following is the primary determinant of an investment's cost of capital? A. Life of the investment B. Amount of the initial cash outlay C. The investment's level of risk D. The source of funds used for the investment E. The investment's net present value

C. The investment's level of risk

Which one of the following best exemplifies unsystematic risk? A. Unexpected economic collapse B. Unexpected increase in interest rates C. Unexpected increase in the variable costs for a firm D. Sudden decrease in inflation E. Expected increase in tax rates

C. Unexpected increase in the variable costs for a firm

A new project is expected to generate an operating cash flow of $38,728 and will initially free up $11,610 in net working capital. Purchases of fixed assets costing $52,800 will be required to start up the project. What is the total cash flow for this project at Time zero? -$64,410

CF0 = $11,610 - 52,800 = -$41,190

Suppose a stock had an initial price of $36 per share, paid a dividend of $.42 per share during the year, and had an ending share price of $34. What was the capital gains yield?

Capital gains yield = ($34 -36)/$36 = -.0556, or -5.56 percent

Kyle Electric has three positive net present value opportunities. Unfortunately, the firm has not been able to find financing for any of these projects. Which one of the following terms best fits the situation facing the firm?

Capital rationing

City Rentals has 44,000 shares of common stock outstanding at a market price of $32 a share. The common stock just paid a $1.50 annual dividend and has a dividend growth rate of 2.5 percent. There are 7,500 shares of $9 preferred stock outstanding at a market price of $72 a share. The outstanding bonds mature in 11 years, have a total face value of $825,000, a face value per bond of $1,000, and a market price of $989 each, and a pretax yield to maturity of 8.3 percent. The tax rate is 35 percent. What is the firm's weighted average cost of capital? 7.76 percent

Common stock:44,000 ×$32 = $1,408,000 Preferred stock:7,500 ×$72 = $540,000 Debt:$989 / $1,000 ×$825,000 = $815,925 Value = $1,408,000 + 540,000 + 815,925 = $2,763,925 RE = [($1.50 ×1.025)/$32] + .025 = .073047 Rp = $9/$72= .125 WACC = ($1,408,000/$2,763,925)(.073047) + ($540,000/$2,763,925)(.125) + ($815,925/$2,763,925)(.083)(1 -.35) = .0776, or 7.76 percent

The stock of Wiley United has a beta of .98. The market risk premium is 7.6 percent and the risk-free rate is 3.9 percent. What is the expected return on this stock?

E(R) = .039 + .98(.076) = .1135, or 11.35 percent

Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security? A. Security beta multiplied by the market rate of return B. Market risk premium C. Security beta multiplied by the market risk premium D. Risk-free rate of return E. Zero

E. Zero

Mary owns a risky stock and anticipates earning 16.5 percent on her investment in that stock. Which one of the following best describes the 16.5 percent rate?

Expected return

S&S stock is expected to return 17.5 percent in a booming economy, 12.4 percent in a normal economy, and 1.2 percent in a recession. The probabilities of an economic boom, normal state, or recession are 2 percent, 90 percent, and 8 percent, respectively. What is the expected rate of return on this stock?

Expected return = (.02 ×.175) + (.90 ×.124) + (.08 ×.012) = .1161, or 11.61 percent

The common stock of The DownTowne should return 23 percent in a boom, 16 percent in a normal economy, and lose 32 percent in a recession. The probabilities of a boom, normal economy, and recession are 5 percent, 90 percent, and 5 percent, respectively. What is the variance of the returns on this stock?

Expected return = (.05 ×.23) + (.90 ×.16) + [.05 ×(-.32)] =.1395 Variance = .05(.23-.1395)2 + .90(.16-.1395)2 + .05(-.32 -.1395)2 = .011345

Blue Bell stock is expected to return 8.4 percent in a boom, 8.9 percent in a normal economy, and 9.2 percent in a recession. The probabilities of a boom, normal economy, and a recession are 6 percent, 92 percent, and 2 percent, respectively. What is the standard deviation of the returns on this stock?

Expected return = (.06 ×.084) + (.92 ×.089) + (.02 ×.092) = .0888 Variance = .06(.084-.0888)2 + .92(.089 -.0888)2 + .02(.092-.0888)2 = .000002 Standard deviation = .000002.5 = .0013, or .13 percent

CFOs tend to use which two methods of investment analysis the most frequently?

Internal rate of return and net present value

Which one of the following is specifically designed to compute the rate of return on a project that has a multiple negative cash flows that are interrupted by one or more positive cash flows?

Modified internal rate of return

Molly is considering a project with cash inflows of $811, $924, $638, and $510 over the next four years, respectively. The relevant discount rate is 11.2 percent. What is the net present value of this project if it the start-up cost is $2,700?

NPV = -$2,700 + $811 / 1.112 + $924 / 1.1122 + $638 / 1.1123 + $510 / 1.1124 NPV = -$425.91

What is the net present value of a project that has an initial cost of $42,700 and produces cash inflows of $9,250 a year for 9 years if the discount rate is 14.65 percent?

NPV = -$42,700 + $9,250 ×{1 - [1 / (1 + .1465)9]} / .1465 NPV = $1,992.43

The Tool Box needs to purchase a new machine costing $1.46 million. Management is estimating the machine will generate cash inflows of $223,000 the first year and $600,000 for the following three years. If management requires a minimum 12 percent rate of return, should the firm purchase this particular machine based on its IRR? Why or why not?

NPV = 0 = -$1,460,000 + $223,000 / (1 + IRR) + $600,000 / (1 + IRR)2 + $600,000 / (1 + IRR)3 + $600,000 / (1 + IRR)4 IRR = 12.74 percent The project should be accepted because the IRR is greater than the required rate.

How is net present value related to required rate of return?

NPV decreases as the required rate of return increases

Jim's Hardware is adding a new product to its sales lineup. Initially, the firm will stock $36,000 of the new inventory, which will be purchased on 30 days' credit from a supplier. The firm will also invest $13,000 in accounts receivable and $11,000 in equipment. What amount should be included in the initial project costs for net working capital?

Net working capital = -$36,000 + 36,000 -13,000 = -$13,000

A debt-free firm has net income of $107,400, taxes of $38,700, and depreciation of $19,300. What is the operating cash flow?

Operating cash flow = $107,400 + $19,300 = $126,700

Stock A comprises 28 percent of Susan's portfolio. Which one of the following terms applies to the 28 percent?

Portfolio weight

Which one of the following can be defined as a benefit-cost ratio?

Profitability index

Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share?

Re = [($1.48× 1.022) / $29.60] + .022 = .0731, or 7.31 percent

Assume that last year, Isaac earned 13.6 percent on his investments while U.S. Treasury bills yielded 2.7 percent, and the inflation rate was 2.2 percent. What real rate of return did he earn on his investments last year?

Real return = (1.136/1.022) - 1 = .1115, or 11.15 percent

The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to:

Recoup its initial cost

Diversifying a portfolio across various sectors and industries might do more than one of the following. However, this diversification must do what?

Reduce the portfolio's unique risks

On a particular risky investment, investors require an excess return of 7 percent in addition to the risk-free rate of 4 percent. What is this excess return called?

Risk premium

The preferred stock of Dolphin Pools pays an annual dividend of $5.25 a share and sells for $48a share. The tax rate is 35 percent. What is the firm's cost of preferred stock?

Rp = $5.25/$48 = .1094, or 10.94 percent

Green Woods sells specialty equipment for mountain climbers. Its sales for last year included $387,000 of tents and $718,000 of climbing gear. For next year, management has decided to sell specialty sleeping bags also. As a result of this change, sales projections for next year are $411,000 of tents, $806,000 of climbing gear, and $128,000 of sleeping bags. How much of next year's sales are derived from the side effects of adding the new product to its sales offerings?

Side effects = ($411,000 + 806,000) - ($387,000 + 718,000) = $112,000

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's weighted average cost of capital (WACC)?

The arithmetic average of 12.4 percent and 18.7 percent

Capital cost

The minimum required return on a new investment