Exam 3 practice problems principles of finance

Asset allocation is not recommended by financial planners because mixing different types of assets, such as stocks with bonds, makes it more difficult to track performance and adjust portfolios to changing market conditions.

False

Beta represents the average movement of a company's stock returns in response to a movement in the market's returns.

True

Bondholders and preferred stockholders can be viewed as creditors, whereas the common stockholders are the true owners of the firm.

True

Common stock does not mature.

True

Company unique risk can be virtually eliminated with a portfolio consisting of approximately 20 securities.

True

Diversifying among different kinds of assets is called asset allocation.

True

The capital asset pricing model uses three variables to evaluate required returns on common equity: the risk free rate, the beta coefficient, and the market risk premium.

True

The cost of capital is the rate that must be earned on an investment project if the project is to increase the value of the common shareholders' investment.

True

The cost of internal common equity is already on an after-tax basis since dividends paid to common stockholders are not tax deductible.

True

The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds per preferred share.

True

The expected rate of return from an investment is equal to the expected cash flows divided by the initial investment.

True

The firm's best financial structure is determined by finding the capital structure that minimizes the firm's cost of capital.

True

The required rate of return for an asset is equal to the risk-free rate plus a risk premium.

True

Total risk equals systematic risk plus unsystematic risk.

True

Dynamic Industries paid a dividend of $1.65 on its common stock yesterday. The dividends of Wallace Industries are expected to grow at 9% per year indefinitely. If the risk free rate is 3% and investors' risk premium on this stock is 8%, estimate the value of Wallace Industries stock 2 years from now.

$106.84

ACME, Inc. expects its current annual $2.50 per share common stock dividend to remain the same for the foreseeable future. Therefore, the value of the stock to an investor with a required return of 12% is

$20.83

The Western State Company's common stock is expected to pay a $2.00 dividend in the coming year. If investors require a 17% return and the growth rate in dividends is expected to be 8%, what will the market price of the stock be?

$22.22

Bacon Signs Company preferred stock pays a perpetual annual dividend of 4.5% of its $100 par value. If investors' required rate of return on this stock is 12%, what is the value per share?

$37.50

Stimpson Inc. preferred stock pays a $.50 annual dividend. What is the value of the stock if your required rate of return is 10%?

$5.00

Perrine Industrial Inc. just paid a dividend of $5 per share. Future dividends are expected to grow at a constant rate of 7% per year. What is the value of the stock if the required return is 16%?

$59.44

You are considering the purchase of a common stock that paid a dividend of $2.00 yesterday. You expect this stock to have a growth rate of 15 percent for the next 3 years, resulting in dividends of D1=$2.30, D2=$2.645, and D3=$3.04. The long-run normal growth rate after year 3 is expected to be 10 percent (that is, a constant growth rate after year 3 of 10% per year forever). If you require a 14 percent rate of return, how much should you be willing to pay for this stock?

$62.57

Most stocks have betas between

0.60 and 1.60

Assume that you have $165,000 invested in a stock whose beta is 1.25, $85,000 invested in a stock whose beta is 2.35, and $235,000 invested in a stock whose beta is 1.11. What is the beta of your portfolio?

1.37

Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the market risk premium is 7.5%, the risk-free rate of return is

1.5%

Tempo Corp. will issue preferred stock to finance a new artillery line. The firm's existing preferred stock pays a dividend of $4.00 per share and is selling for $40 per share. Investment bankers have advised Tempo that flotation costs on the new preferred issue would be 5% of the selling price. Tempo's marginal tax rate is 30%. What is the relevant cost of new preferred stock?

10.53%

Backford Company just paid a dividend yesterday of $2.25 per share. The company's stock is currently selling for $60 per share, and the required rate of return on Backford Company stock is 16%. What is the growth rate expected for Backford Company dividends assuming constant growth?

11.81%

Baxter Inc. has a target capital structure of $30 million debt, $15 million preferred stock, and $55 million common equity. The company's after-tax cost of debt is 7%, its cost of preferred stock is 11%, its cost of retained earnings is 15%, and its cost of new common stock is 16%. The company stock has a beta of 1.5 and the company's marginal tax rate is 35%. What is the company's weighted average cost of capital if retained earnings are used to fund the common equity portion?

12%

Assume that you have $330,000 invested in a stock that is returning 11.50%, $170,000 invested in a stock that is returning 22.75%, and $470,000 invested in a stock that is returning 10.25%. What is the expected return of your portfolio?

12.87%

You hold a portfolio made up of the following stocks: Investment Value Beta Stock L $8,000 2.0 Stock M $18,000 1.5 Stock N $14,000 0.4 If the market's expected return is 14%, and the risk free rate of return is 5%, what is the expected return of the portfolio?

15.935%

Stock W has the following returns for various states of the economy: State of the Economy Probability Stock W's Return Recession 10% -30% Below Average 20% -2% Average 40% 10% Above Average 20% 18% Boom 10% 40% Stock W's standard deviation of returns is

16.98%

A company has preferred stock that can be sold for $21 per share. The preferred stock pays an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferred stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the cost of preferred stock is

17.72%

The prices for the National Gasworks Corporation for the second quarter of 2012 are given below. The price of the stock on April 1, 2012 was $130. Find the holding period return for an investor who purchased the stock on April 1, 2012 and sold it the last day of June 2012. Assume the company did not pay any dividend during this period. Month End Price April $125.00 May 138.50 June 132.75

2.1%

The risk free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%. Rogue Transport's marginal tax rate is 35%. Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future. Using the capital asset pricing model, what is Rogue Transport's cost of retained earnings?

20.1%

Whistle Corp. has a preferred stock that pays a dividend of $2.40. If you are willing to purchase the stock at $11, what is your required rate of return (round your answer to the nearest .1% and assume that there are no transaction costs)?

21.8%

The risk-free rate of interest is 4% and the market risk premium is 9%. Howard Corporation has a beta of 2.0, and last year generated a return of 16% with a standard deviation of returns of 27%. The required return on Howard Corporation stock is

22%

Sentry Manufacturing paid a dividend yesterday of $5 per share. The dividend is expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock today is $29 per share. If Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.50 per share. Sentry Manufacturing's marginal tax rate is 35%. Based on the above information, the cost of retained earnings is

26.62%

Sentry Manufacturing paid a dividend yesterday of $5 per share. The dividend is expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock today is $29 per share. If Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.50 per share. Sentry Manufacturing's marginal tax rate is 35%. Based on the above information, the cost of new common stock is

28.38%

Crandal Dockworks is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Crandal's flotation expense on the new bonds will be $50 per bond. Crandal's marginal tax rate is 35%. What is the after tax cost of debt for the newly-issued bonds?

5.7%

Crandal Dockworks is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Crandal's flotation expense on the new bonds will be $50 per bond. Crandal's marginal tax rate is 35%. What is the yield to maturity on the newly-issued bonds?

8.17%

Stock A has the following returns for various states of the economy: State of the Economy Probability: Stock A's Return Recession 10% -30% Below Average 20% -2% Average 40% 10% Above Average 20% 18% Boom 10% 40% Stock A's expected return is

8.2%

You are considering investing in a project with the following possible outcomes: Probability of Investment States Occurrence Returns State 1: Economic boom 18% 20% State 2: Economic growth 42% 16% State 3: Economic decline 30% 3% State 4: Depression 10% -25% Calculate the expected rate of return and standard deviation of returns for this investment, respectively

8.72%, 12.99%

Crandal Dockworks is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Crandal's flotation expense on the new bonds will be $50 per bond. Crandal's marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds?

8.76%

Using the weighted average cost of capital as the required rate of return for every project will result in maximization of shareholder wealth. A and B above cause a firm to accept projects that were too risky. cause a firm to reject projects that should have been accepted.

A and B above (cause a firm to accept projects that were too risky. cause a firm to reject projects that should have been accepted.)

Which of the following features, or benefits, belong to a firm's common stockholders? limited liability voting rights ownership of the firm all of the above

All of the above

Stock Z has an expected return of 12% with a standard deviation of 8%. If returns are normally distributed, then approximately two-thirds of the time the return on stock Z will be

Between 4% and 20%

Most preferred stocks have a feature that requires all past unpaid preferred dividend payments be paid before any common stock dividends can be paid. What is the name of this feature?

Cumulative

A company's cost of capital is equal to a weighted average of its investors' required returns.

False

ABC Corp 5% preferred stock with a par value of $100 and a market price of $125 will pay an annual dividend this year of $12 per share.

False

Actual returns are always less than expected returns because actual returns are determined at the end of the period and must be discounted back to present value.

False

Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks have higher standard deviations of returns than bonds.

False

Because risk is measured by variability of returns, how long we hold our investments does not matter very much when it comes to reducing risk.

False

Flotation costs cause a corporation's cost of capital to be lower than its investors' required returns.

False

If a firm does not have enough money to pay any common stock dividends, it is technically in default to the common shareholders.

False

Preferred dividends are paid with before-tax dollars because the dividend rate is known, whereas common stock dividends are paid with after-tax dollars.

False

Preferred stock and common stock issued by the same firm will have the same required return because the riskiness of the firm's cash flows is the same for both securities.

False

Public perception and reputation do not affect stock prices, which are strictly a function of dividends and required returns.

False

The market risk premium remains constant over time because the risk free rate of return moves inversely with beta.

False

Consider the following four types of payments that could be made by a normal operating firm: interest, common dividends, income taxes, and preferred dividends. Compared to the other payments mentioned, where would you rank common dividend payments in terms of the order of payment if the firm is liquidating?

Fourth

You are considering buying some stock in Continental Grain. Which of the following are examples of non-diversifiable risks? I. Risk resulting from a general decline in the stock market. II. Risk resulting from a possible increase in income taxes. III. Risk resulting from an explosion in a grain elevator owned by Continental. IV. Risk resulting from a pending lawsuit against Continental.

I and II

Changes in the general economy, like changes in interest rates or tax laws represent what type of risk?

Market risk

What is the name given to the equation that financial managers use to measure an investor's required rate of return?

The capital asset pricing model

A corporation's cost of common equity may be estimated using either a dividend valuation model or the capital asset pricing model.

True

A preferred stock that pays an annual dividend of $10, has a par value of $100, and has a required return of 5% will be valued at $200.

True

A stock with a beta of 1 has systematic or market risk equal to the "typical" stock in the marketplace.

True

A well-diversified portfolio typically has systematic risk equal to about 40% of the portfolio's total risk.

True

According to the CAPM, for each unit of Beta an asset's required rate of return increases by the market's risk premium.

True

Beta is a measurement of the relationship between a security's returns and the general market's returns.

True

In general, common stock and preferred stock are both valued by calculating the present value of all expected future cash flows, using the required return as the discount rate.

True

In terms of risk, preferred stock is safer than common stock because it has a prior claim on assets and income.

True

In theory, shareholders select the board of directors, but in reality, management effectively selects the directors.

True

One reason investors require higher rates of return is to compensate for purchasing power losses resulting from inflation.

True

Preferred stock is less risky than common stock, but more risky than debt.

True

Preferred stock is referred to as a hybrid security because it has many characteristics of both common stock and bonds.

True

Preferred stock is riskier than long-term debt because its claim on assets and income come after those of bonds.

True

Small company stocks have historically had higher average annual returns than large company stocks, and also a higher risk premium.

True

The Beta of a T-bill is zero.

True

The amount of the preferred stock dividend is generally fixed either as a dollar amount or as a percentage of the par value.

True

The benefits of diversification occur as long as the investments in a portfolio are not perfectly positively correlated.

True

A typical measure for the risk-free rate of return is the

U.S Treasury Bill Rate

Beginning with an investment in one company's securities, as we add securities of other companies to our portfolio, which type of risk declines?

Unsystematic risk

Portfolio risk is typically measured by ________ while the risk of a single investment is measured by ________.

beta; standard deviation

Higher flotation costs will result in all of the following EXCEPT higher weighted average cost of capital. higher after-tax cost of debt. higher cost of common equity when new common shares are sold. higher cost of retained earnings.

higher cost of retained earnings.

The minimum rate of return necessary to attract an investor to purchase or hold a security is referred to as the

investor's required rate of return

Preferred stock valuation usually treats the preferred stock as a

perpetuity

Beta is a statistical measure of

the relationship between an investment's returns and the market return

Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta of 1.8 and a standard deviation of returns of 18%. If the market risk premium increases, then

the required return on stock B will increase more than the required return on stock A.

Nogrowth Corporation expects their dividend to stay at $0.50 per share each year into the foreseeable future. Therefore

the value of the stock can be estimated as $0.50 divided by an investor's required rate of return