Finance Final

The cost of capital depends primarily on the source of funds, not the use.

False

A company that has a policy of making only cash sales is considering allowing customers to buy on credit. Which one of the following will probably occur? A) The accounts receivable will likely increase. B) The change will provide a source of funds. C) Total sales will likely decrease. D) Net working capital will decrease if funding needs are met with long-term liabilities. E) Expenses will decrease due to monthly billing and collection efforts.

A

Consider a $10,000 machine that will reduce pretax operating costs by $3,000 per year over a 5-year period. Assume no changes in net working capital and a zero scrap value after five years. For simplicity, assume straight-line depreciation to zero, a marginal tax rate of 34 percent, and a required return of 10 percent. The net present value of acquiring this machine is: A) $83. B) $449. C) $689. D) $827. E) $1,235.

A

KCE Corporation is currently operating at its target capital structure with market values of $140 million of equity and $155 million of debt. KCE plans to finance a new $25 million project while maintaining the current debt-equity ratio. How much new debt must be issued to fund the project? A) $13.1 million B) $18.5 million C) $19.6 million D) $24.8 million E) $32.0 million

A

Options for future, related business products or strategies are known as: A) strategic options. B) capital rationing options. C) options to expand. D) options to wait. E) contingent options.

A

The bonds of Topstone Industries are currently selling for 103.3 percent of their face value. These bonds mature in 14 years and pay an annual coupon of 7 percent of face value. What is Topstone's pre-tax cost of debt? A) 6.63 percent B) 7.35 percent C) 7.84 percent D) 8.60 percent E) 9.45 percent

A

Which one of the following is an accurate statement? A) To calculate an expected risk premium you need to compute the expected return on an average risky asset and the return on a risk-free asset. B) The risk premium is the difference between the return on a risky asset and the return on a market portfolio. C) The expected return on an asset decreases as the firm-specific risk increases. D) A comparison of two different risky assets can not be simplified by computing the expected return on each asset. E) The expected return on a security depends on the expected states of the economy but not on the associated probabilities of those states occurring.

A

A condominium developer buys three times as much land as is needed to build a planned 50-unit development so that, if things go well, two additional 50-unit developments can be built without having to acquire additional land. The developer is prepared to exercise the option to: A) quit. B) expand. C) abandon. D) wait. E) rebuild.

B

After careful analysis of previous stock prices, you discover you can make above normal returns on your investments if you buy oil company stocks just before noon on any given trading day and then sell them immediately before the market closes that day. This is: A) not a violation of market efficiency. B) a violation of weak form efficiency. C) a violation of semistrong form efficiency. D) a violation of strong form efficiency. E) a violation of all forms of market efficiency.

B

An investment earned the following returns over a four-year period: 28 percent, 21 percent, 1 percent, and -36 percent. What is the variance of the returns on this investment? A) 0.0618 B) 0.0824 C) 0.1400 D) 0.1739 E) 0.2473

B

Given the following historical returns, what is the variance? Year Return 1 7 percent 2 3 percent 3 19 percent 4 -11 percent 5 -1 percent A) .009664 B) .012080 C) .034018 D) .039644 E) .048322

B

Hartley Psychiatric, Inc., needs to purchase office equipment for its 2,000 drive-in therapy centers nationwide. The total cost of the equipment is $2,000,000. It is estimated that the aftertax cash inflows from the project will be $210,000 annually forever. Hartley has a debt-to-value ratio of 60 percent. The firm's cost of equity is 13 percent and its pre-tax cost of debt is 8 percent. The tax rate is 34 percent. What is Hartley's weighted average cost of capital (WACC)? A) 6.09 percent B) 8.37 percent C) 8.95 percent D) 9.05 percent E) 9.91 percent

B

Over the 1926 to 2004 period, the nominal risk premium on long-term government bonds has averaged _____ percent per year. A) 0.0 B) 2.0 C) 2.2 D) 8.8 E) 13.4

B

The Sedgwick Company estimates sales of a new product at 5,000 units and $3.00 per unit. Management feels the sales quantity is accurate within a 10 percent plus-or-minus range while the sales price is accurate within a 5 percent plus-or-minus range. What dollar amount should the company use for total sales in their worst-case scenario analysis of this product? A) $12,150 B) $12,825 C) $13,500 D) $14,250 E) $15,000

B

There are two expected states of the economy. The probability of a boom is 60 percent and the probability of a bust is 40 percent. If the economy booms, stock A is expected to earn 15 percent and stock B is expected to earn 8 percent. If the economy goes bust, stock A is expected to earn 5 percent and stock B is expected to earn 18 percent. What is the expected return on a portfolio that is equally divided among stock A, stock B, and a risk-free asset? The expected return on the risk-free asset is 4 percent regardless of the state of the economy. A) 8.97 percent B) 9.00 percent C) 10.11 percent D) 11.82 percent E) 13.88 percent

B

When calculating your return on investment you should ignore: A) paper gains. B) losses you avoided by not buying a stock that has since decreased in price. C) dividends that have been declared on a stock you own if you have not yet received the dividend. D) paper capital losses. E) fees you are charged in the process of purchasing a security.

B

You hold four stocks (A, B, C, and D) in your portfolio. The portfolio beta is 1.20. Stock C constitutes 40 percent of the dollar value of your holdings and has a beta of 1.60. If you sell all of your holdings in stock C, and replace them with an equal investment in stock E (which has a beta of 1.25), your new portfolio beta will be: A) 1.00. B) 1.06. C) 1.12. D) 1.25. E) 1.32.

B

Your company just bought a new distillation unit for $175,000 to be used for research and development. Such equipment has a 3-year MACRS classification. The MACRS percentages are 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent, respectively. What is the book value of the distillation unit at the end of year 2? A) $12,968.00 B) $38,902.50 C) $49,833.50 D) $77,770.00 E) $116,673.50

B

It is important to identify and use only incremental cash flows in capital investment decisions: A) because they are the simplest to identify. B) only when the stand-alone principle fails to hold. C) because ultimately it is the change in a firm's overall future cash flows that matter. D) in order to accommodate unforeseen changes that might occur. E) whenever sunk costs are involved.

C

Suppose that two firms, A and B, are considering the same project. The project is in the same risk class as firm A's overall operations. The project has an IRR of 13.0 percent. Firm A has a beta of 1.2, while firm B's beta is 0.9. The risk-free rate is 4.5 percent and the market risk premium is 7.0 percent. Which firm(s) should accept the project? A) firm A only B) firm B only C) both firms A and B D) neither firm A nor B E) The answer cannot be determined without more information.

C

Suppose you purchased 500 shares of Jet-Electro Corporation stock at a price of $22.50 per share. One year later, the shares are selling for $21 each. In addition, a dividend of $1.50 per share was paid at the end of the period. What is the percentage return on the investment? A) -7.1 percent B) -6.7 percent C) 0.0 percent D) 6.7 percent E) 7.1 percent

C

The lessons from capital market history tell us that: I. there is a reward for bearing risk. II. the greater the potential reward from a risky asset, the greater is the risk. III. the NYSE stock exchange is an inefficient market. A) I only B) II only C) I and II only D) I and III only E) I, II, and III

C

There are two expected states of the economy. The probability of a normal economy is 70 percent and the probability of a recession is 30 percent. If the economy is normal, Security A is expected to earn 20 percent and Security B is expected to earn 6 percent. If the economy goes into a recession, Security A is expected to earn 4 percent and Security B is expected to earn 24 percent. What is the expected return on a portfolio that is invested 60 percent in A and 40 percent in B? A) 10.89 percent B) 11.07 percent C) 13.68 percent D) 14.28 percent E) 14.79 percent

C

Which one of the following asset classes has displayed the flattest and widest distribution of returns over the 1926-2004 period? Assume that annual security returns are normally distributed. A) large company stocks B) long-term corporate bonds C) small company stocks D) long-term government bonds E) U.S. Treasury bills

C

You are advising Peter who is attempting to decide whether or not to drop one of the college courses he is currently enrolled in. If he drops the course, he will forfeit half of the money spent on tuition. If he stays in the class, he will have to give up his part-time job. His textbook is being replaced by a new edition, so is worthless at this time. Which of the following conclusions is consistent with capital budgeting principles? I. Remaining in the class incurs an opportunity cost. II. The entire tuition is irrelevant because it is a sunk cost. III. The cost of the book is a sunk cost. A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III

C

You own a stock which has produced annual returns of 11 percent, 3 percent, 8 percent, and 14 percent over the past four years, respectively. The arithmetic rate of return is _____ percent and the geometric rate of return is _____ percent. A) 8.50; 8.92 B) 8.50; 18.92 C) 9.00; 8.92 D) 9.00; 9.92 E) 9.00; 18.92

C

A firm has 1 million shares of common stock outstanding with a market price of $5.00 each. It has 2,500 bonds outstanding, each with a market value of $1,100. The bonds mature in 13 years, have a coupon rate of 10 percent, and pay coupons annually. The firm's beta is 1.3, the risk-free rate is 4.5 percent, the market risk premium is 7 percent, and the tax rate is 34 percent. What is the weighted average cost of capital (WACC)? A) 5.45 percent B) 6.53 percent C) 9.49 percent D) 10.81 percent E) 11.65 percent

D

Diversification works because: I. unsystematic risk exists. II. combining stocks into a portfolio reduces the standard deviation of each stock in the portfolio. III. firm-specific risk can be dramatically reduced if not eliminated. A) I only B) III only C) I and II only D) I and III only E) I, II, and III

D

Given the following information and assuming straight-line depreciation to zero, what is the payback period for this project? The project requires an initial investment of $900,000; has a life of 6 years; produces cost savings of $190,000 per year; has a tax rate of 35 percent; and a discount rate of 9 percent. The fixed assets will be sold for $50,000 at the end of year 6. A) 2.54 years B) 3.67 years C) 3.93 years D) 5.10 years E) The project never pays back.

D

Suppose a firm uses a constant weighted average cost of capital (WACC) in determining the value of capital budgeting projects rather than using the security market line. The firm will tend to: A) accept profitable, low-risk projects and reject unprofitable, high-risk projects. B) accept profitable, low-risk projects and accept unprofitable, high-risk projects. C) reject unprofitable, high-risk projects. D) become more risky over time due to the continual acceptance of high-risk projects. E) accept profitable, low-risk projects

D

The appropriate discount rate to use when analyzing an investment project is: A) the rate of return that will result in the highest net present value (NPV). B) the internal rate of return (IRR) on that investment. C) equal to the cost of capital based on the firm's existing assets. D) the rate of return relevant to the risk level of the project. E) the rate of interest the firm would pay if it sold bonds.

D

Which of the following can be a problem when estimating the cost of equity? I. a beta based on historical information II. dividend growth rate III. market risk premium IV. risk-free rate of interest A) I and II only B) I and IV only C) II and III only D) I, II, and III only E) I, II, III, and IV

D

Which of the following is (are) true? I. Systematic risk is all that matters to a well-diversified investor. II. The amount of systematic risk in an asset relative to an average risky asset is measured by beta. III. Spreading a portfolio across a number of assets will eliminate all of the risk. IV. On average, the standard deviation of a portfolio declines as the number of assets in the portfolio is increased but it can not decline to zero. A) II and III only B) I and II only C) I, II, and III only D) I, II, and IV only E) I, III, and IV only

D

Which of the following statements are accurate concerning the security market line (SML) approach? I. The SML applies only to firms with stable dividend growth rates. II. Like the dividend growth model, the SML generally relies on using the past to predict the future. III. Unlike the dividend growth model, the SML estimate is adjusted for risk. IV. The quality of the estimate from the SML approach is sensitive to the quality of the estimates of the variables in the model. A) I and III only B) II and IV only C) II and III only D) II, III, and IV only E) I, II, III, and IV

D

Your firm needs a computerized line-boring machine that costs $90,000 and requires $16,000 in maintenance costs for each year of its 3-year life. After 3 years, this machine will be replaced. The machine falls into the MACRS 3-year class life category. The MACRS percentages for each year are 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent, respectively. Assume a tax rate of 35 percent and a discount rate of 10 percent. Assume the machine can be sold for $12,000 at the end of year 3. What is the aftertax salvage value of the machine? A) $5,633 B) $7,800 C) $7,920 D) $10,134 E) $10,678

D

Given the following information, what is the market value of XYZ Corporation? Common stock 13.6 million shares outstanding, selling at $31 per share Bond issue 1 $600 million total face value, selling at 98 percent of par Bond issue 2 $150 million total face value, selling at $950 per bond A) $697.52 million B) $874.82 million C) $987.24 million D) $1,049.43 million E) $1,152.10 million

E

Suppose you have a portfolio comprised of two securities. You have 60 shares of the stock X valued at $10 per share and 40 shares of stock Y valued at $3 per share. What is the weight of stock X in the portfolio? A) 23 percent B) 40 percent C) 60 percent D) 77 percent E) 83 percent

E

The expected return on a risky asset depends only on that asset's _____ risk. A) diversifiable B) asset-specific C) surprise D) unique E) systematic

E

Which one of the following is true about risk and return? A) Riskier assets will, on average, earn lower returns. B) The reward for bearing risk is known as the standard deviation. C) Based on historical data, there is no reward for bearing risk. D) An increase in the risk of an investment will result in a decreased risk premium. E) In general, the higher the expected return, the higher the risk.

E

Which one of the following portfolios would have the least systematic risk? A) a portfolio of the common stocks of 100 different companies B) a market portfolio C) a portfolio half invested in the market portfolio and half invested in Treasury bills D) a portfolio half invested in the market portfolio and half invested in stocks with betas of 1.50 E) a portfolio made up entirely of Treasury bills

E

You are looking at two different stocks. Stock A has a beta of 1.25 and stock B has a beta of 1.30. Which one of the following statements is true about these investments? A) Stock A is a better addition to your portfolio. B) Stock B is a better addition to your portfolio. C) The expected return on stock A will exceed that of stock B. D) Stock B has a higher standard deviation than stock A. E) Stock A should have the same reward-to-risk ratio as stock B.

E

Assume a project requires additions to net working capital in each year of its life, all of which will be recovered at the end of the project. In this case, the present value of the net working capital recovery will equal the total dollar outlays for net working capital.

False

For a cost cutting project, the net present value will generally be negative, but the project should still be accepted.

False

For a profitable firm, an increase in the marginal tax rate increases the cost of debt.

False

If insiders were allowed to profit on their inside information without penalty, financial markets would be more efficient.

False

If the total risk of firm X is greater than that of firm Y, then the beta of firm X must be greater than that of firm Y.

False

Investors shouldn't count capital gains as a part of their total return until a security is sold, since the capital gain is really only a "paper gain" up to that point.

False

No matter how much total risk an asset has, only the unsystematic portion is relevant in determining the expected return on that asset.

False

Sunk costs and opportunity costs are often the same thing.

False

Suppose that new information regarding future inflation in the U.S. causes investors to become less risk averse. The security market line (SML) approach indicates that, all else equal, most firms will see their cost of capital increase.

False

The projected risk premium is defined as the sum of the expected return on a risky investment and the return on a risk-free investment.

False

Your classmate just made $10,000 in a single day by trading in the stock market. It is reasonable to conclude, therefore, that the efficient market hypothesis cannot be true.

False

A firm that uses its weighted average cost of capital (WACC) to evaluate all projects, regardless of their risk level, will tend to become riskier over time.

True

A normal distribution is a symmetric, bell-shaped frequency distribution that is completely defined by its average and standard deviation.

True

For the purpose of estimating a firm's cost of debt for a project, you can observe the yield-to-maturity on recently issued bonds with a similar rating and term-to-maturity.

True

If net working capital grows from $1,000 to $1,500 as a result of taking on a new project, the $500 increase should be included in the initial outlay for the new project.

True

If world events cause investors to become more risk-averse, you would expect the market risk premium to increase.

True

In general, the greater the potential reward, the greater the risk.

True

The security market line is based on the principle that the reward-to-risk ratio must be constant for all assets in the market.

True

To accurately reflect the costs associated with a project, you should exclude interest expenses in the computation of operating cash flows.

True