Finance Midterm 2

What is cumulative voting?

a procedure in which directors are elected all at once and a shareholder may cast all votes for one member of the board of directors

Debenture

-A long term bond or debt that is unsecured -Debenture bond holder receives lower interest rate

Secured Debt

-Debt backed or secured by collateral to reduce the risk associated with lending, such as a mortgage -Less risky because the security is used to pay it off

17. You want to be on the board of directors of a company that has three seats on the board. Since you are the only shareholder that will vote for you, you must own more than half of the outstanding shares of stock to be elected to the board. What is the type of voting that requires this level of stock ownership to be elected to the board? a. Straight b. Cumulative c. Democratic d. Deferred e. Proxy

A Straight

Subordinated debenture

A lower-ranked bond that is not secured by collateral or guarantees.

26. You are considering a project with an initial cost of $7,500. What is the payback period for this project if the cash inflows are $1,100, $1,640, $3,800, and $4,500 a year over the next four years, respectively? A. 3.21 years B. 3.28 years C. 3.36 years D. 4.21 years E. 4.29 years

A. 3.21 years 7500-1100 = 6400 6400-1640 = 4760 4760-3800 = 960 Roughly 3 years, but have to find the remaining time 960/4500 (remaining cash flow) = .21 3+.21 = 3.21

26. Motor City Productions sells original automotive art on a prepaid basis as each piece is uniquely designed to the customer's specifications. For one project, the cash flows are estimated as follows. Based on the internal rate of return (IRR), should this project be accepted if the required return is 9 percent? Year 0: 5,500 Year 1: -5,900 A. Accept the project. B. Reject the project. C. The IRR cannot be used to evaluate this type of project. D. The firm should be indifferent to either accepting or rejecting this project. E. Insufficient information is provided to make a decision based on IRR.

A. Accept the Project IRR = 7.27% IRR < R because this is a financing project, the initial cash flow is Positive.

27. Applying the discounted payback decision rule to all projects may cause: A. some positive net present value projects to be rejected. B. the most liquid projects to be rejected in favor of the less liquid projects. C. projects to be incorrectly accepted due to ignoring the time value of money. D. a firm to become more long-term focused. E. some projects to be accepted which would otherwise be rejected under the payback rule.

A. some positive net present value projects to be rejected. -discounted payback period will not consider the cash flows after the payback period, due to which positive net present value projects may be rejected. -most liquid projects will be accepted under discounted payback period. -discounted payback does consider time value of money. -discounted payback period would be longer because the CF > DCF, so adding up it takes more discounted cashflows to payback the money

27. (Slightly harder question) A conventional investment project has a discounted payback period that is equal to the required payback period. Given this, which of the following statements must be true? I. The project must also be acceptable under the payback rule. II. The project must have a profitability index that is equal to or greater than 1.0. III. The project must have a zero net present value. IV. The project's internal rate of return must equal the required return. A. I only B. I and II only C. II and III only D. I, III, and IV only E. I, II, III, and IV

B I TRUE -If the cash flows are bigger than the discounted cash flows, then the payback period will be shorter than the discounted payback period -- if we accept a projected based on its discounted payback period, we must accept it under the normal payback rule. II TRUE must be true because if the discounted payback period is equal to (or less than) the required payback period, then the sum of the discounted cash flows is equal (or greater than) the initial investment. As a result, the result from the PI formula will be greater than or equal to one. III false NPV is = or > 1 IV false IRR would only = 0 when NPV= 0 (it may be >0)

20. Douglass Gardens pays an annual dividend that is expected to increase by 3.6 percent per year. The stock commands a market rate of return of 12.6 percent and sells for $28.50 a share. What is the expected amount of the next dividend? A. $2.03 B. $2.57 C. $3.17 D. $2.20 E. $2.28

B. $2.57 R = (D1/P) + g 0.126 = (D1/28.50) + 0.036

10. The 7 percent, semi-annual coupon bonds offered by House Renovators are callable in 2 years at $1,054. What is the amount of the call premium on a $1,000 par value bond? A. $52 B. $54 C. $72 D. $84 E. $89

B. $54 1054-1000

5. Which one of the following bonds is the least sensitive to interest rate risk? A. 3-year; 4 percent coupon B. 3-year; 6 percent coupon C. 5-year; 6 percent coupon D. 7-year; 6 percent coupon E. 7-year; 4 percent coupon

B. 3-year; 6 percent coupon LEAST sensitive most sensitive = 7 year, 4%

Which one of the following represents the dividend yield as used in the dividend growth model? A. D1 B. D1/P0 C. P0 D. g E. g/P0

B. D1/P0 Dividend yield

5. Which one of the following risks would a floating-rate bond tend to have less of as compared to a fixed-rate coupon bond? A. Real rate risk B. Interest rate risk C. Default risk D. Reinvestment risk E. Taxability risk

B. Interest rate risk

1. Atlas Entertainment has 15-year bonds outstanding. The interest payments on these bonds are sent directly to each of the individual bondholders. These direct payments are a clear indication that the bonds can accurately be defined as being issued: A. at par. B. in registered form. C. in street form. D. as debentures. E. as callable.

B. in registered form A registered bond is a bond whose owner is registered with the bond issuer—the company/government who issued the bond. The bond issuer records the bond owner's name and contact information to ensure coupon payments are delivered to the correct person. In the US, it is much more common to see bonds issued in registered form rather than bearer form.

6. As a bond's time to maturity increases, the bond's sensitivity to interest rate risk: A. increases at an increasing rate. B. increases at a decreasing rate. C. increases at a constant rate. D. decreases at an increasing rate. E. decreases at a decreasing rate.

B. increases at a decreasing rate.

Which Bond will have the highest coupon rate all else equal? A Bond with sinking fund or without

Bond without sinking fund -company has to come up with substantial cash at maturity to retire debt and this is riskier than having systematic debt through time -sinking debt yields less because it has low risk

Senior Debt

Borrowed money that a company must repay first if it goes out of business.

19. Roy's Welding common stock sells for $58.49 a share and pays an annual dividend that increases by 1.3 percent annually. The market rate of return on this stock is 12.6 percent. What is the amount of the last dividend paid? A. $6.60 B. $5.86 C. $6.52 D. $6.98 E. $5.64

C. $6.52

18. How much are you willing to pay for one share of Jumbo Trout stock if the company just paid a $0.70 annual dividend, the dividends increase by 2.5 percent annually, and you require a 10 percent rate of return? A. $9.29 B. $9.33 C. $9.57 D. $9.53 E. $9.59

C. $9.57 P0 = .70(1.025)/(0.10-0.025) P0 = $9.57

23. You are considering an investment project with conventional cash flows and the following characteristics: IRR 11.63% Profitability Index 1.04 NPV $987 Payback period 2.98 years Which of the following statements is correct given this information? I. The discount rate used in computing the net present value was less than 11.63 percent. II. The discounted payback period must be more than 2.98 years. III. The discount rate used in the computation of the profitability index was 11.63 percent. IV. This project should be accepted as the internal rate of return exceeds the required return. A. I and II only B. III and IV only C. I, II, and IV only D. II, III, and IV only E. I, II, III, and IV

C. I, II, and IV only I. If NPV > 0, IRR > R II Always CF > Discounted CF 100 v 100/1.12= 89 IV If NPV > 0 IRR > R and the project should be accepted R= discount rate

4. You expect interest rates to decline in the near future even though the bond market is not indicating any sign of this change. Which one of the following bonds should you purchase now to maximize your gains if the rate decline does occur? A. Short-term; low coupon B. Short-term; high coupon C. Long-term; zero coupon D. Long-term; low coupon E. Long-term; high coupon

C. Long-term; zero coupon

15. You want to be on the board of directors of Wisely Foods. Since you are the only shareholder that will vote for you, you will need to own more than half of the outstanding shares of stock if you are to be elected to the board. What is the type of voting called that requires this level of stock ownership to be successfully elected under these conditions? A. democratic B. cumulative C. straight D. deferred E. proxy

C. Straight

6. Which one of the following statements is false concerning the term structure of interest rates? A. Expectations of lower inflation rates in the future tend to lower the slope of the term structure of interest rates. B. The term structure of interest rates includes both an inflation premium and an interest rate risk premium. C. The term structure of interest rates and the time to maturity are always positively related. D. The real rates of return can influence the slope of the term structure of interest rates. E. The interest rate risk premium increases as the time to maturity increases.

C. The term structure of interest rates and the time to maturity are always positively related. The term structure of interest rates depend on inflation expectation and also the future expectation of interest rates. Moreover the real return has minimal impact. A lower inflation expectation lowers the slope of the term structure.

Which Bond will have the highest coupon rate all else equal? Callable Bond vs Noncallable Bond

Callable Bonds -The bondholders have the risk of having the bond be called earlier than the maturity date, usually with lower interest rates. The bondholders don't receive all the coupon payments and have to reinvest at lower interest rates.

19. Winter Time Adventures is going to pay an annual dividend of $2.86 a share on its common stock next year. This year, the company paid a dividend of $2.75 a share. The company adheres to a constant rate of growth dividend policy. What will one share of this common stock be worth five years from now if the applicable discount rate is 11.7 percent? A. $43.45 B. $43.87 C. $44.15 D. $45.19 E. $47.00

D. $45.19 g = (2.86-2.75)/2.75 = 4% D5= 2.86(1.04^5) = 3.48/(.117-.04) = $45.19

4. Which one of the following relationships is stated correctly? A. The coupon rate exceeds the current yield when a bond sells at a discount. B. The call price must equal the par value. C. An increase in market rates increases the market price of a bond. D. Decreasing the time to maturity increases the price of a discount bond, all else constant. E. Increasing the coupon rate decreases the current yield, all else constant.

D. Decreasing the time to maturity, increase the price of a discount bond. Think about how there is less time to maturity

16. An increase in which of the following will increase the current value of a stock according to the dividend growth model? I. dividend amount II. number of future dividends, provided the current number is less than infinite III. discount rate IV. dividend growth rate A. I and II only B. III and IV only C. I, II, and III only D. I, II, and IV only E. I, II, III, and IV

D. I, II, and IV only

27. A project has a required (ordinary) payback period of three years. Which one of the following statements is correct concerning the (ordinary) payback analysis of this project? A. The cash flows in each of the three years must exceed one-third of the project's initial cost if the project is to be accepted. B. The cash flow in Year 3 is ignored. C. The project's cash flow in Year 3 is discounted by a factor of (1 + R)3. D. The cash flow in Year 2 is valued just as highly as the cash flow in Year 1. E. The project is acceptable whenever the payback period exceeds three years.

D. The cash flow in Year 2 is valued just as highly as the cash flow in Year 1. This is not discounted paybacks, you don't know to consider the time value of money

14. Which one of following is the rate at which a stock's price is expected to appreciate? A. current yield B. total return C. dividend yield D. capital gains yield E. coupon rate

D. capital gains yield percentage price appreciation on an investment. (P1-P0) / P0

17. Which one of the following represents the capital gains yield as used in the dividend growth model? A. D1 B. D1/P0 C. P0 D. g E. g/P0

D. g (aka dividend growth rate) Get R by itself. P0 = D1 / (R-g) R = (D1 / P0) + g D1/P0 = dividend yield g= capital gains yield

4. A newly issued bond has a 7 percent coupon with semiannual interest payments. The bonds are currently priced at par value. The effective annual rate provided by these bonds must be: A. 3.5 percent. B. greater than 3.5 percent but less than 7 percent. C. 7 percent. D. greater than 7 percent. E. Answer cannot be determined from the information provided.

D. greater than 7 percent. YTM = Coupon Rate YTM is quoted like an APR EAR = (1 + 7/2)^2 + 1 EAR > 7

Which Bond will have the highest coupon rate all else equal? Secured debt versus a debenture

Debenture

20. Marshall Arts Studios just paid an annual dividend of $1.36 a share. The firm plans to pay annual dividends of $1.50, $1.55, and $1.58 over the next 3 years, respectively. After that time, the dividends will be held constant at $1.70 per share. What is this stock worth today at a 9 percent discount rate? A. $14.08 B. $14.30 C. $16.67 D. $16.79 E. $18.49

E. $18.49 Price= 1.7/.09 = 18.89 18.89/(1.09^3) =14.58 1.5/1.09 +1.55/(1.09^2) + (1.58+18.89)/(1.09^3) =3.90 =14.58+3.90 =18.49

21. Home Products common stock sells for $36.84 a share and has a market rate of return of 15.8 percent. The company just paid an annual dividend of $1.61 per share. What is the dividend growth rate? A. 11.43 percent B. 11.06 percent C. 10.87 percent D. 11.18 percent E. 10.95 percent

E. 10.95 percent

11. Northern Warehouses wants to raise $11.4 million to expand its business. To accomplish this, it plans to sell 40-year, $1,000 face value, zero-coupon bonds. The bonds will be priced to yield 8.75 percent with semi-annual compounding. What is the minimum number of bonds it must sell to raise the $11.4 million it needs? A. 210,411 B. 239,800 C. 254,907 D. 326,029 E. 350,448

E. 350,448 FV = 1000 N = 40x2 = 80 1/y= 8.75/2 = 4.375 PMT= 0 PV = -32.5 11,400,000 / 32.50 =350,448

3. Which of the following are characteristics of a premium bond? I. coupon rate < yield-to-maturity II. coupon rate > yield-to-maturity III. coupon rate < current yield IV. coupon rate > current yield A. I only B. I and III only C. I and IV only D. II and III only E. II and IV only

E. II and IV only Coupon rate = annual coupon / face value Current yield = annual coupon / price of bond We know price of bond > face value for premium bonds. Current yield gives a smaller value so. Coupon rate > Current Yield

What are deferred shares?

Founder Shares -Not entitled to assets of company -Have preferential right to get dividend before preference shares and equity shares

The higher the risk the ___ the coupon

HIGHER

What condition is used for NPV to accept a project?

NPV >= 0

What condition does the Profitability Index have to follow to accept project?

PI > 1 accept PI < 1 reject PI = 1 indifferent

What is a sinking fund?

Saving money over time for a large purchase

Which Bond will have the highest coupon rate all else equal? Subordinated debenture versus senior debt

Subordinated debenture -receives higher rate of return than senior debt due to the extra risk

11. If the yield curve is upward sloping, what can you conclude? a. Longer maturity bonds have higher yields than short maturity bonds b. Default risk is larger for short maturity bonds c. Default risk is larger for long maturity bonds d. The taxability premium is greater for short maturity bonds e. The liquidity premium is lower for long maturity bonds

a. Longer maturity bonds have higher yields than short maturity bonds

Which of the following statements is CORRECT? a. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk. b. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk. c. Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds. d. Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds. e. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sol

a. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk.

13. You are considering buying a bond without a sinking fund that is classified as junior debt, and pays a coupon rate of 9%. All else equal, which of the following bonds would offer a coupon rate above 9%? a. Senior debt without a sinking fund b. Subordinated debt without a sinking fund c. Senior debt with a sinking fund d. Junior debt with a sinking fund e. Cannot be determined from the information given

b. Subordinated debt without a sinking fund Senior Debt and the junior debt holders have to be paid off first during liquidation. The coupon rate would be highest for subordinated debt without a sinking fund because it has higher risk

1. If the EAR of a bond that makes annual coupon payments decreases from 2.3% to 1.2%, which of the following is true? a. The bond's YTM will increase b. The bond's price will increase c. The annual coupon payment will increase d. Coupons will now be paid semiannually e. The bond's price will decrease

b. The bond's price will increase The EAR is the interest rate compounded. It makes annual coupon payments to the bond holders.

As coupon rates ____ and interest rates ____ reinvestment risk increases.

coupon rates increase, interest rates decrease

3. Bond A and Bond B are identical in every respect except they have different maturities. Suppose interest rates fall and the percentage price change of Bond A exceeds that of Bond B. What can you conclude? a. Both bonds must have been trading at par before interest rates fell b. Bond A must have been trading at a discount before interest rates fell c. The maturity of Bond B must be less than 10 years d. The maturity of Bond A is longer than the maturity of Bond B e. Both bonds will now trade at a discount

d. The maturity of Bond A is longer than the maturity of bond B

21. NBC Inc. pays dividends annually and follows a constant rate of growth dividend policy, with the growth rate being 2 percent. The company just paid a dividend of $1.20 per share today. What will be the stock price in five years if the applicable annual discount rate is 11 percent? a. $12.89 b. $13.60 c. $14.13 d. $14.78 e. $15.02

e. $15.02 = 1.20(1.02) / (0.11-0.02) = 13.60 FV = 13.06(1.02)^5 =15.02

9. Which of the following is true about a call provision on a bond? a. When the issuer exercises a call provision, the bond holder can choose not to sell the bond back to the issuer b. The issuer typically prefers to exercise the call provision when interest rates are high c. A call provision favors the bond holder d. The issuer must exercise the call provision at some point before the bond matures e. Call provisions will typically increase the coupon rate on a bond

e. Call provisions will typically increase the coupon rate on a bond (you don't have to exercise a call provision) Callable bonds are more risky

18. Which of the following is true? a. A corporation can deduct both interest payments to bondholders and dividend payments to stockholders from its taxable income b. A bondholder can vote during the board of directors election c. In the event that a company liquidates all its assets, preferred stockholders will receive assets ahead of subordinated debt holders d. A firm that issues too much equity compared to debt has a high risk of bankruptcy e. Creditors have legal recourse if interest payments are missed

e. Creditors have legal recourse if interest payments are missed All debt holders are paid off before the company pays off equity

8. A bond has 3% coupon rate with annual interest payments. The bond is currently trading at a discount. The effective annual rate provided by this bond is: a. 1.5% b. 2% c. 2.5% d. 3% e. Greater than 3%

e. Greater than 3% 3% = Coupon Rate YTM > Coupon Rate EAR = (1+YTM/m)^m -1 Interest Rate > Coupon Rate EAR is interest rate compounded,

19. The dividend growth model: I. Assumes that dividends increase at a constant rate forever. II. Can be used to compute a stock price at any point in time. III. Can be used to value stocks with zero dividend growth IV. Requires the growth rate to be less than the required return a. I and II only b. II and IV only c. I, III, and IV only d. I, II, and IV only e. I, II, III, and IV

e. I, II, III, and IV

27. You are considering an investment with the following cash flows. If the required rate of return for this investment is 15.5%, should you accept the investment based solely on the IRR rule? Why or why not? Year 0: -152,000 Year 1: 98,200 Year 2: 102,300 Year 3: -4,900 a. Yes; the IRR exceeds the required return b. Yes; the IRR is less than the required return c. No; the IRR exceeds the required return d. No; the IRR is less than the required return e. No; you should use a different rule

e. No; you should use a different rule

25. A project has a net present value of zero. Which one of the following best describes this project? a. The project has a zero percent rate of return b. The project requires no initial cash investment c. The project has no cash flows d. The sum of all the project's cash inflows equals zero e. The present value of the cash inflows equals the present value of the cash outlflows

e. The present value of the cash inflows equals the present value of the cash outlflows

The_____ the maturity the more impact interest rates have on percentage price change.

longer [ 1/(1+r)^30 ] vs [ 1 / (1+r)^5]

_____ maturity and _____ coupon rates increase interest rate risk

longer maturity, lower coupon rates

The price grows at the____ rate as the dividends

same !

What is proxy voting?

the grant of authority by shareholders to someone else to vote his or her shares.

What is straight voting?

voting for directors where shareholders must vote for each director separately, with each shareholder having as many votes as shares held