Business Finance Exam #3

The degree of operating leverage is equal to:

1 + FC / OCF.

Last year, T-bills returned 2 percent while your investment in large-company stocks earned an average of 5 percent. Which one of the following terms refers to the difference between these two rates of return?

A. risk premium b. geometric return c. arithmetic d. standard deviation e. variance

Sensitivity analysis is based on:

A. varying a single variable and measuring the resulting change in the NPV of a project. b. applying differing discount rates to a project's cash flows and measuring the effect on the NPV. c. expanding and contracting the number of years for a project to determine the optimal project length. d. the best, worst, and most expected situations. e. various states of the economy and the probability of each state occurring.

Your portfolio is comprised of 40 percent of stock X, 15 percent of stock Y, and 45 percent of stock Z. Stock X has a beta of 1.16, stock Y has a beta of 1.47, and stock Z has a beta of 0.42. What is the beta of your portfolio?

BetaPortfolio = (0.40 × 1.16) + (0.15 × 1.47) + (0.45 × 0.42) = 0.87

When you assign the highest sales price and the lowest costs to a project, you are analyzing the project under the condition known as:

C. optimistic scenario analysis.

The Baltimore Co. would like to add a new product to complete their lineup. They want to know how many units they must sell to limit their potential loss to their initial investment. What is this quantity if their fixed costs are $14,000, the depreciation expense is $2,800, and the contribution margin is $1.25?

Cash break-even point = $14,000 / $1.25 = 11,200

The Handelcreek Co. is considering expanding their operations. Fixed costs are estimated at $86,000 a year. The variable cost per unit is estimated at $18.50. The estimated sales price is $34.00 per unit. What is the cash break-even point of this project?

Cash break-even point = $86,000 / ($34.00 $18.50) = 5,548.39 = 5,548

Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?

D. by using the capital asset pricing model

What is the variance of the returns on a portfolio that is invested 60 percent in stock S and 40 percent in stock T?

E(r)Boom = (0.60 × 0.17) + (0.40 × 0.07) = 0.13 E(r)Normal = (0.60 × 0.13) + (0.40 × 0.10) = 0.118 E(r)Portfolio = (0.20 × 0.13) + (0.80 × 0.118) = 0.1204 VarPortfolio = 0.20 (0.13 - 0.1204)2] + 0.80 (0.118 - 0.1204)2 = .000023

A company is considering a project with a cash break-even point of 14,500 units. The selling price is $14 a unit and the variable cost per unit is $8. What is the projected amount of fixed costs?

FC at the cash break-even point = 14,500 ($14 $8) = $87,000

Which of the following are characteristics of a project with sales set at the cash breakeven point? I. The project never pays back. II. The IRR equals the required rate of return. III. The NPV is negative and equal to the initial cash outlay. IV. The operating cash flow is equal to the depreciation expense.

I and III only

Which of the following statements are correct concerning the accounting break-even point? I. The net income is equal to zero. II. The net present value is equal to zero. III. The quantity sold is equal to the total fixed costs plus depreciation divided by the contribution margin. IV. The quantity sold is equal to the total fixed costs divided by the contribution margin.

I and III only

Which of the following statements concerning risk are correct? I. Nondiversifiable risk is measured by beta. II. The risk premium increases as diversifiable risk increases. III. Systematic risk is another name for nondiversifiable risk. IV. Diversifiable risks are market risks you cannot avoid.

I and III only

Tidewater Fishing has a current beta of 1.21. The market risk premium is 8.9 percent and the risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.50?

Increase in cost of equity = (1.50 - 1.21) × 0.089 = 2.58 percent

Boulder Furniture has bonds outstanding that mature in 15 years, have a 6 percent coupon, and pay interest annually. These bonds have a face value of $1,000 and a current market price of $1,075. What is the company's aftertax cost of debt if its tax rate is 32 percent?

N=15 iY= PV=-1075 PMT=60 FV= 1000 CPT IY = .0526446 Solve for Aftertax R(sub 4) =0526446 X (1-.32) = 3.58%

Wind Power Systems has 20-year, semi-annual bonds outstanding with a 5 percent coupon. The face amount of each bond is $1,000. These bonds are currently selling for 114 percent of face value. What is the company's pre-tax cost of debt?

N=20X2 iY=x/2 PV=-1140 PMT=50/2 FV= 1000 CPT IY = 3.98

Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 7.5 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $65 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital?

Re = 0.028 + 1.34 (0.112 - 0.028) = 0.14056 Rp = (0.07 × $100)/$65 = 0.10769 Debt: 80,000 X $1,000 = $80.00m Preferred: 750,000 X $65 = $48.75 Common: 2.5m X $42 = $105.00 Total: $233.75m WACC = ($105m/$233.75m) (0.14056) + ($48.75m/$233.75m) (0.10769) + ($80m/$233.75m) (0.075) (1 - 0.38) = 10.15 percent

A project has a projected IRR of negative 100 percent. Which one of the following statements must also be true concerning this project?

The estimated sales volume is equal to the cash break-even level of sales.

Morris Industries has a capital structure of 55 percent common stock, 10 percent preferred stock, and 45 percent debt. The firm has a 60 percent dividend payout ratio, a beta of 0.89, and a tax rate of 38 percent. Given this, which one of the following statements is correct?

The firm's cost of equity is unaffected by a change in the firm's tax rate.

Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure.

The model is dependent upon a reliable estimate of the market risk premium.

The company conducts a sensitivity analysis using a variable cost of $10. The total cost estimate, excluding depreciation, will be:

Total costs = ($10 3,500) + $15,500 = $50,500

A year ago, you purchased 300 shares of Stellar Wood Products, Inc. stock at a price of $8.62 per share. The stock pays an annual dividend of $0.10 per share. Today, you sold all of your shares for $4.80 per share. What is your total dollar return on this investment?

Total dollar return = ($4.80 - $8.62 + $0.10) × 300 = -$1,116

Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 14.3 percent, and a cost of preferred stock of 8.5 percent. The firm has 220,000 shares of common stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a market quote of 101.2. The company's tax rate is 37 percent. What is the firm's weighted average cost of capital?

WACC = ($5,940,000/$7,521,600) (0.143) + ($1,025,000/$7,521,600) (0.085) + ($556,600/$7,521,600) (0.076) (1 - 0.37) = 12.81 percent

Hard rationing is defined as the situation where:

a firm is unable to raise the funds needed for a project from any source.

All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.

a reduction in the risk-free rate

Which of the following variables will be at their highest expected level under a worst case scenario?

a. I only b. III only c. II and III only D. I and III only e. I, III, and IV only

Which one of the following statements is correct concerning a portfolio beta?

a. Portfolio betas range between -1.0 and +1.0. B. A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio. c. A portfolio beta cannot be computed from the betas of the individual securities comprising the portfolio because some risk is eliminated via diversification. d. A portfolio of U.S. Treasury bills will have a beta of +1.0. e. The beta of a market portfolio is equal to zero

Which one of the following statements concerning scenario analysis is correct?

a. The worst case scenario determines the maximum loss, in current dollars, that a firm could incur from a given project. b. Scenario analysis reflects the entire range of results that can be realized from a proposed investment project. c. Scenario analysis provides a clear signal to management to either accept or reject a proposed project. D. Scenario analysis provides management with a glimpse of the possible range of outcomes that could be realized from a project. e. When the base case scenario results in a positive net present value, management can be assured the proposed project will meet or exceed their expectations.

Assume you graph the changes in net present value against the changes in the value of a single variable used in a project. The steepness of the resulting function illustrates the:

a. degree of operating leverage within the project. b. trade-off of variable versus fixed costs utilized by the project. c. range of total outcomes possible from accepting a proposed project. d. contribution margin of the project at various levels of output. E. degree of sensitivity of the project's outcome to changes in the single variable.

Jennie is fairly cautious when considering new opportunities and therefore analyzes each project to determine the most optimistic, the most realistic, and the most pessimistic outcome that can reasonably be expected. Jennie is using:

a. forecast modeling. b. sensitivity analysis. c. break-even analysis. d. soft rationing. E. scenario analysis.

An analysis of what happens to the estimate of net present value when only one variable is changed is called _____ analysis.

a. forecasting b. scenario C. sensitivity d. simulation e. break-even

An analysis which combines scenario analysis with sensitivity analysis is called _____ analysis.

a. forecasting b. scenario c. sensitivity D. simulation e. break-even

Which one of the following will reduce the risk of a project by lowering the degree of operating leverage?

a. hiring temporary workers from an employment agency rather than hiring part-time employees B. subcontracting portions of the project rather than purchasing new equipment to do all the work in-house c. leasing equipment on a long-term basis rather than buying equipment d. lowering the projected selling price per unit e. changing the proposed production method to a more capital intensive method

Conducting scenario analysis on a proposed project helps managers determine the:

a. impact that an individual variable has on the outcome of the project. b. initial cost that will be required to implement the project. c. actual profitable life of the project. d. level of funding available for the project. E. potential range of reasonable outcomes that might be realized.

As the degree of sensitivity of a project to a single variable rises, the:

a. less important the variable to the final outcome of the project. b. less volatile the project's net present value to that variable. C. greater the importance of accurately predicting the value of that variable. d. greater the profit margin of the project. e. less volatile the project's outcome.

To ascertain whether the accuracy of a variable cost estimate for a project will have much effect on the final outcome of that project, you should conduct _____ analysis.

a. leverage b. scenario c. break-even D. sensitivity e. cash flow

The procedure of allocating a fixed amount of funds for capital spending to each business unit is called

a. marginal spending. b. average spending. C. soft rationing. d. hard rationing. e. marginal rationing.

The sales level that results in a project's operating cash flow exactly equaling zero is called the _____ break-even.

a. operational b. leveraged c. accounting D. cash e. financial

The base case values used in scenario analysis are the ones considered the most:

a. optimistic. b. desired by management. c. pessimistic. d. conducive to creating a positive net present value. E. likely to occur.

Sensitivity analysis determines the:

a. range of possible outcomes given that most variables can assume a range of values. B. degree to which the net present value reacts to changes in a single variable. c. extent of the range of net present values that can be realized from a proposed project. d. degree to which a project is reliant upon the fixed costs. e. ideal ratio of variable costs to fixed costs for profit maximization.

Scenario analysis is defined as:

a. the determination of the most likely outcome for a project. B. analyzing the changes in NPV estimates when what-if questions are posed. c. isolating the effect that one variable has on the NPV of a project. d. comparing the NPV of a project both with and without considering the effects of erosion. e. determining the acceptability of a project based solely on the project's operating cash flows.

When conducting a best case scenario analysis, you should assume that:

a. the number of units sold and the variable cost per unit are at the high end of their potential ranges. B. the salvage value will be at the high end of its possible range. c. sales quantity will be at the low end of its range while the sales price is the highest price possible. d. the variable costs per unit are at the high end of potential cost range. e. fixed costs will become variable and decrease in dollar amount.

The sales level that results in a project's net income exactly equaling zero is called the _____ break-even

accounting

Systematic risk is measured by: A. the mean. B. beta. C. the geometric average. D. the standard deviation. E. the arithmetic average.

beta

Which one of the following measures the amount of systematic risk present in a particular risky asset relative to the systematic risk present in an average risky asset?

beta

Unsystematic risk A. can be effectively eliminated by portfolio diversification. B. is compensated for by the risk premium. C. is measured by beta. D. is measured by standard deviation. E. is related to the overall economy.

can be effectively eliminated by portfolio diversification.

Which one of the following is the formula that explains the relationship between the expected return on a security and the level of that security's systematic risk? A. capital asset pricing model B. time value of money equation C. unsystematic risk equation D. market performance equation E. expected risk formula

capital asset pricing model

Roger just completed analyzing a project. His analysis indicates that the project will have a 5-year life and require an initial cash outlay of $225,000. Annual sales are estimated at $685,000 and the tax rate is 35 percent. The net present value is a negative $225,000. Based on this analysis, the project is expected to operate at the:

cash break-even point.

When the operating cash flow of a project is equal to zero, the project is operating at the:

cash break-even point.

The percentage change in operating cash flow relative to the percentage change in quantity sold is called the:

degree of operating leverage.

Operating leverage is the:

degree to which a firm relies on fixed costs.

Assume that the market prices of the securities that trade in a particular market fairly reflect the available information related to those securities. Which one of the following terms best defines that market?

efficient capital market

The primary purpose of portfolio diversification is to: A. increase returns and risks. B. eliminate all risks. C. eliminate asset-specific risk. D. eliminate systematic risk. E. lower both returns and risks.

eliminate asset-specific risk.

The sales level that results in a project's net present value exactly equaling zero is called the _____ break-even.

financial

At the accounting breakeven point, the contribution margin must equal:

fixed costs plus depreciation.

Which one of the following characteristics best describes a project that has a low degree of operating leverage?

high variable costs relative to the fixed costs

A firm's overall cost of equity is:

highly dependent upon the growth rate and risk level of the firm.

A firm's overall cost of equity is: A. is generally less that the firm's WACC given a leveraged firm. B. unaffected by changes in the market risk premium. C. highly dependent upon the growth rate and risk level of the firm. D. generally less than the firm's aftertax cost of debt. E. inversely related to changes in the firm's tax rate

highly dependent upon the growth rate and risk level of the firm.

When a firm has flotation costs equal to 7 percent of the funding need, project analysts should:

increase the initial project cost by dividing that cost by (1 - 0.07).

As additional fixed assets are purchased for a project, the project's level of fixed costs _____ and the degree of operating leverage _____.

increases; increases

Which one of the following is an example of systematic risk? A. investors panic causing security prices around the globe to fall precipitously B. a flood washes away a firm's warehouse C. a city imposes an additional one percent sales tax on all products D. a toymaker has to recall its top-selling toy E. corn prices increase due to increased demand for alternative fuels

investors panic causing security prices around the globe to fall precipitously

The pre-tax cost of debt: A. is based on the current yield to maturity of the firm's outstanding bonds. B. is equal to the coupon rate on the latest bonds issued by a firm. C. is equivalent to the average current yield on all of a firm's outstanding bonds. D. is based on the original yield to maturity on the latest bonds issued by a firm. E. has to be estimated as it cannot be directly observed in the market.

is based on the current yield to maturity of the firm's outstanding bonds.

The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the:

is the return investors require on the total assets of the firm.

The market rate of return is 11 percent and the risk-free rate of return is 3 percent. Lexant stock has 3 percent less systematic risk than the market and has an actual return of 12 percent. This stock: A. is underpriced. B. is correctly priced. C. will plot below the security market line. D. will plot on the security market line. E. will plot to the right of the overall market on a security market line graph.

is underpriced.

You are considering a project that you believe is quite risky. To reduce any potentially harmful results from accepting this project, you could:

lower the degree of operating leverage.

The change in revenue that occurs when one more unit of output is sold is called the _____ revenue

marginal

Which one of the following is represented by the slope of the security market line? A. reward-to-risk ratio B. market standard deviation C. beta coefficient D. risk-free interest rate E. market risk premium

market risk premium

Forecasting risk is defined as the:

possibility that errors in projected cash flows will lead to incorrect decisions.

The weighted average cost of capital for a firm is the:

rate of return a firm must earn on its existing assets to maintain the current value of its stock.

The expected risk premium on a stock is equal to the expected return on the stock minus the:

risk-free rate.

Which one of the following is a positively sloped linear function that is created when expected returns are graphed against security betas? A. reward-to-risk matrix B. portfolio weight graph C. normal distribution D. security market line E. market real returns

security market line

The type of analysis that is most dependent upon the use of a computer is _____ analysis.

simulation

Merkel Enterprises has three divisions. As part of the planning process, the CFO requested that each division submit their capital budgeting proposals for next year. These proposals all have positive net present values and fall within the long-range plans of the firm. The requests from the divisions are $6.2 million, $4.8 million, and $3.7 million, respectively. For the firm as a whole, Merkel Enterprises has a maximum of $12 million which can be spent for new projects next year. This is an example of:

soft rationing.

Treynor United has received requests for capital investment funds from each of their five divisions for next year. Senior management has decided to allocate the available funds based on the profitability index of each project since the company has insufficient funds to fulfill all of the requests. Management is following a practice known as:

soft rationing.

Total risk is measured by _____ and systematic risk is measured by _____. A. beta; alpha B. beta; standard deviation C. alpha; beta D. standard deviation; beta E. standard deviation; variance

standard deviation; beta

The market risk premium is computed by: A. adding the risk-free rate of return to the inflation rate. B. adding the risk-free rate of return to the market rate of return. C. subtracting the risk-free rate of return from the inflation rate. D. subtracting the risk-free rate of return from the market rate of return. E. multiplying the risk-free rate of return by a beta of 1.0.

subtracting the risk-free rate of return from the market rate of return.

The _____ tells us that the expected return on a risky asset depends only on that asset's nondiversifiable risk.

systematic risk principle

The principle of diversification tells us that:

that spreading an investment across many diverse assets will eliminate some of the total risk

The flotation cost for a firm is computed as: A. the arithmetic average of the flotation costs of both debt and equity. B. the weighted average of the flotation costs associated with each form of financing. C. the geometric average of the flotation costs associated with each form of financing. D. one-half of the flotation cost of debt plus one-half of the flotation cost of equity. E. a weighted average based on the book values of the firm's debt and equity.

the weighted average of the flotation costs associated with each form of financing.

Standard deviation measures which type of risk? A. total B. nondiversifiable C. unsystematic D. systematic E. economic

total

A news flash just appeared that caused about a dozen stocks to suddenly drop in value by about 20 percent. What type of risk does this news flash represent?

unsystematic

The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the: A. reward to risk ratio. B. weighted capital gains rate. C. structured cost of capital. D. subjective cost of capital. E. weighted average cost of capital.

weighted average cost of capital.

Simulation analysis is based on assigning a _____ and analyzing the results.

wide range of values to multiple variables simultaneously