EXAM STUDY GUIDE 4
Thornley Co. is considering a 3-year project with an initial cost of $587,000. The project will not directly produce any sales but will reduce operating costs by $265,000 a year. The equipment is classified as MACRS 7-year property. The MACRS table values are .1429, .2449, .1749, .1249, .0893, .0892, .0893, and .0446 for Years 1 to 8, respectively. At the end of the project, the equipment will be sold for an estimated $295,000. The tax rate is 34 percent and the required return is 9 percent. An extra $23,000 of inventory will be required for the life of the project. What is the total cash flow for Year 3? A. $491,782.87 B. $496,208.19 C. $514,782.87 D. $519,208.19 E. $523,008.24
C. $514,782.87 OCF3 = $265,000 (1 - .34) + ($587,000 × .1749)(.34) = $209,806.54 Book value3 = $587,000 × (1 - .1429 - .2449 - .1749) = $256,695.10 Aftertax salvage value = $295,000 - .34($295,000 - 256,695.10) = $281,976.33 C03 = $209,806.54 + 23,000 + 281,976.33 = $514,782.87
Margarite's Enterprises is considering a new project that will require $345,000 for new fixed assets, $160,000 for inventory, and $35,000 for accounts receivable. Short-term debt is expected to increase by $110,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to zero over the life of the project. At the end of the project, the fixed assets can be sold for 25 percent of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $550,000 and costs of $430,000. The tax rate is 35 percent and the required rate of return is 15 percent. What is the amount of the aftertax cash flow from the sale of the fixed assets at the end of this project? A. $30,187.50 B. $37,918.88 C. $56,062.50 D. $60,009.01 E. $86,250.00
C. $56,062.50 Aftertax salvage value = .25 × $345,000 × (1 - .35) = $56,062.50
Jeff opted to exercise his August option on August 10 and received $2,500 in exchange for his shares. Jeff must have owned a(an):
C. American put.
Which of the following statements are correct concerning option values?
C. I and II only (I. The value of a call increases as the price of the underlying stock increases. II. The value of a call decreases as the exercise price increases.)
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the: A. PI is less than 1. B. AAR is less than the required AAR. C. IRR exceeds the required return. D. payback period is less than the life of the project. E. discounted payback period is less than the life of the project.
C. IRR exceeds the required return.
In project analysis, which one of these is a common assumption regarding net working capital? A. Only changes in current assets are included in net working capital for project analysis purposes. B. The aftertax salvage value of an asset that is sold is included as a net working capital item. C. Net working capital will be returned to its pre-project level at the end of a project. D. Increases in net working capital will be treated as a cash inflow. E. Any change in net working capital will only occur when a project commences.
C. Net working capital will be returned to its pre-project level at the end of a project.
Which one of the following is the best example of two mutually exclusive projects? A. Planning to build a warehouse and a retail outlet side by side B. Buying sufficient equipment to manufacture both desks and chairs simultaneously C. Using an empty warehouse for storage or renting it entirely out to another firm D. Using the company sales force to promote sales of both shoes and socks E. Buying both inventory and fixed assets using funds from the same bond issue
C. Using an empty warehouse for storage or renting it entirely out to another firm
Webster's wants to introduce a new product that has a startup cost of $15,000. The product has a 2-year life and will provide cash flows of $12,700 in Year 1 and $6,300 in Year 2. The required rate of return is 10 percent. Should the product be introduced? Why or why not? A. Yes; The PI is 1.04. B. No; The PI is .90. C. Yes; The IRR is 19.74 percent. D. Yes; The NPV is $851.24. E. No; The IRR is 8.78 percent.
C. Yes; The IRR is 19.74 percent. NPV = -$15,000 + $12,700/1.1 + $6,300/1.12 = $1,752.07 PI = ($12,700/1.1 + $6,300/1.12)/$15,000 = 1.12 IRR = -$15,000 + $12,700/(1 + IRR) + $6,300/(1 + IRR)2 IRR = 19.74%
A project that will improve the manufacturing efficiency of a firm but will generate no additional sales is referred to as a(n) _____ project. A. sunk cost B. opportunity cost C. cost-cutting D. revenue-cutting E. revenue-generating
C. cost-cutting
If there is a conflict between mutually exclusive projects due to the IRR, one should: A. drop the two projects immediately. B. spend more money on gathering information. C. depend on the NPV as it will always provide the most value. D. depend on the AAR because it does not suffer from these same problems. E. None of the above
C. depend on the NPV as it will always provide the most value.
The cash flows of a new project that come at the expense of a firm's existing projects are called: A. opportunity costs. B. net working capital expenses. C. erosion costs. D. salvage value expenses. E. sunk costs.
C. erosion costs.
The present value of an investment's future cash flows divided by the initial cost of the investment is called the: A. average accounting return. B. internal rate of return. C. profitability index. D. profile period. E. net present value.
C. profitability index.
Accepting positive NPV projects benefits the stockholders because: A. it most easily understood valuation process. B. the value of the expected cashflows are equal to the cost. C. the value of the expected cashflows are greater than the cost. D. it is the most easily calculated
C. the value of the expected cashflows are greater than the cost
CF with leverage =
CF w/o leverage + interest tax shield
Riverton Sails currently produces boat sails and is considering expanding its operations to include awnings for homes and travel trailers. The company owns land beside its current manufacturing facility that could be used for the expansion. The company bought this land ten years ago at a cost of $89,000 and spent $26,000 on grading and excavation costs at that time. Today, the land is valued at $221,000. The company currently has some unused equipment that it currently owns with a current market value of $45,000. This equipment could be used for producing awnings if $9,000 is spent for equipment modifications. Other equipment costing $315,000 will be required. What is the amount of the initial cash flow for this expansion project?
CF0 = $221,000 + 45,000 + 9,000 + 315,000 = $590,000
DCF analysis is an application of the NPV formula we are familiar with: NPV = CF0 + (CF1 / (1+r)^1) + (CF2 / (1+r)^2) + ... The plan of attack: 1. Estimate cash flows 2. Discount cash flows (assess risk) 3. Accept or reject
CF0 = initial outlay or I0 (this is an expenditure represented by a negative number) CF1 = cash flow in year 1 CFt = cash flow in time t where t is usually the last year in which cash flows are received r = the discount rate (also notes as l, k, or y)
A _____ is a derivative security that gives the owner the right, but not the obligation, to buy an asset at a fixed price for a specified period of time.
Call Option
The essence of _________________ is determining whether a proposed investment or project will generate positive wealth for the owners of the firm once it is in place
Capital budgeting.
Chapter 9
Capital budgeting: discounted cash flow analysis
_____ refers to the changes in net capital assets.
Cash flow from investing
Futures contracts are regularly traded on the
Chicago Board of Trade
Net present value _____________.
Compares project cost to the present value of the project benefits
Which of the following is NOT a source of acquisition gains from revenue enhancement?
Complementary resources
The discounted payback period rule:
Considers the time value of money.
A project which has an initial cash outlay, with all future cash flows positive, is said to be:
Conventional.
An NPV of zero implies that an investment's ____________.
Cost is equal to the present value of its cash inflows
Sunk Cost
Costs incurred prior to deciding whether or not to produce a new product
fcf = free cash flow
Covers initial outlay, differential cash flows, but ignores a terminal cash flows which we will add in later
A firm should accept projects with positive net present values primarily because those projects will:
Create value for the firm's current stockholders
best justification for acquiring a firm?
Creating financial value by combining the bidder and target firms
Bloomfield's has some idle equipment that is debt-free and also fully depreciated. If the company decides to use this equipment for a new project, what cost, if any, should be included for this equipment in the project's start-up costs?
Current market value of the equipment
A trading opportunity that offers a riskless profit is called a(n): A. put option. B. call option. C. market equilibrium. D. arbitrage. E. cross-hedge.
D
All else held constant, the value of a call decreases when the: A. time to expiration increases. B. risk-free rate of return increases. C. stock price increases. D. exercise price increases. E. volatility of the price of the underlying stock increases.
D
An option that can only be exercised on the expiration date is referred to as A) an expired option. B) an American option. C) a struck option. D) a European option. E) an expiring option.
D
An option that grants the right, but not the obligation, to sell shares of the underlying asset on a particular date at a specified price is called: A. either an American or a European option. B. an American call. C. an American put. D. a European put. E. a European call.
D
Assume a firm in the extraction industry has major assets consisting solely of cash, equipment, and a closed facility but yet the firm appears to have extraordinary value. This value is least apt to be attributable to the: A. low exercise price held by the shareholders. B. option to open the facility when prices rise dramatically. C. option to keep the facility closed for an extended period of time. D. current operating cash flow. E. potential sale of the firm.
D
Assume a risky firm has both bondholders and stockholders. If the firm obtains a government loan guarantee on its existing debt, who will gain from this guarantee? A. existing stockholders only B. both existing bondholders and stockholders in proportion to the firm's debt-equity ratio C. existing bondholders and stockholders on an equal basis D. existing bondholders only E. future stockholders only
D
Assume you own both a June 20 put and a June 20 call on ALPO stock. Which one of the following statements is correct concerning your option positions? Ignore taxes and transaction costs. A) Both a May 20 put and a May 20 call on ALPO will have higher values than your June 20 options. B) An increase in the stock price will increase the value of your put and decrease the value of your call. C) A decrease in the stock price will decrease the value of both of your options. D) If put-call parity does not hold, you can profit from your positions even if ALPO stock sells for $20 a share. E) The time premium on your June 20 put is equal to the time premium on a July 20 put on ALPO.
D
Executive stock options generally have all of the following characteristics except: A. aligning executive goals with shareholder goals. B. linking executive compensation to performance. C. providing tax efficiency. D. increasing executive base salaries. E. putting executive pay at risk.
D
Hi-Tech announces a major expansion which causes the price of its stock to increase and also causes an increase in the volatility of the stock price. How will these two market reactions affect the value of put options on Hi-Tech stock? A. Both reactions decrease the value of the put options. B. Both reactions increase the value of the put options. C. Neither reaction will affect put option values. D. The reactions will have offsetting effects on put option prices. E. The change in volatility will not affect put option values while the increased stock price will decrease the put option values.
D
If a call has a positive intrinsic value at expiration the call is said to be: A. funded. B. unfunded. C. at the money. D. in the money. E. out of the money.
D
If an infinite number of intervals is applied to the binomial option pricing model, then the value of the call is equal to: A. the risk-free rate of return. B. zero. C. the exercise price. D. the Black Scholes model's call value. E. the stock price.
D
If you consider bondholders to be the owners of a firm, then those bondholders: A. own a call option on the firm with an exercise price equal to the firm's total equity. B. own a put option on the firm with an exercise price equal to the firm's total debt. C. have written a put option on the firm with an exercise price equal to the firm's total equity. D. have written a call option on the firm with an exercise price equal to the firm's total debt. E. own a put option on the firm with an exercise price equal to the firm's total assets.
D
If you consider the equity of a firm to be an option on the firm's assets then the act of paying off debt is comparable to _____ on the assets of the firm. A. purchasing a put option B. purchasing a call option C. exercising an in-the-money put option D. exercising an in-the-money call option E. selling a call option
D
In the binomial option pricing model the: A. number of intervals required for convergence is quite large. B. interval time span decreases as time moves forward. C. result based on infinitesimally small intervals will differ significantly from the value developed by the Black Scholes model. D. percentage increase in price in each interval can differ from the percentage decrease in price. E. value of u remains constant as the number of intervals increases.
D
Net present value analysis frequently ignores: A. project risk. B. cash flows after the first three years. C. the time value of money. D. some or all of a project's options. E. start-up costs.
D
Permanently rejecting an investment project today may not be a wise decision primarily because: A. the size of the firm will be less than it would be with the project. B. there are always errors in the estimation of NPVs. C. the management team may be replaced. D. the company is foregoing all future options. E. the firm may not have any other investment opportunities.
D
The Black-Scholes option pricing model is dependent on which five parameters? A. stock price, exercise price, risk-free rate, probability, and time to maturity B. stock price, risk-free rate, probability, time to maturity, and variance C. stock price, risk-free rate, probability, variance, and exercise price D. stock price, exercise price, risk-free rate, variance, and time to maturity E. exercise price, probability, stock price, variance, and time to maturity
D
The Consolidated Transfer Co. is an all-equity financed firm. The beta is .75, the market risk premium is 8% and the risk-free rate is 4%. What is the expected return of Consolidated? A. 7% B. 8% C. 9% D. 10% E. 13%
D
The Hold-n-Trade Co. is an all-equity financed firm. The beta is .9, the market risk premium is 7% and the risk-free rate is 5%. What is the expected return of Hold-n-Trade? A. 8% B. 8.5% C. 9% D. 11.3% E. 12%
D
The beta of a security provides an: A. estimate of the market risk premium. B. estimate of the slope of the Capital Market Line. C. estimate of the slope of the Security Market Line. D. estimate of the systematic risk of the security. E. None of the above.
D
The difference between an American call and a European call is that the American call A) has a fixed exercise price while the European exercise price can vary within a small range. B) is a right to buy while a European call is an obligation to buy. C) has an expiration date while the European call does not. D) can be exercised at any time up to and including the expiration date while the European call can only be exercised on the expiration date. E) is written on 100 shares of the underlying stock while the European call is based on 10 shares of the underlying stock.
D
The effect on an option's value of a small change in the value of the underlying asset is called the option: A. theta. B. vega. C. rho. D. delta. E. gamma.
D
The fixed price in an option contract at which the owner can buy or sell the underlying asset is called the option's A) opening price. B) intrinsic value. C) market price. D) strike price. E) time value.
D
The intrinsic value of a call equals the: A. exercise price minus the stock price. B. upper bound of the call's value. C. market price of the call option. D. lower bound of the call's value. E. premium paid to purchase the call.
D
The intrinsic value of a put is equal to the: a. lesser of the strike price or the stock price. b. lesser of the stock price minus the exercise price or zero. c. lesser of the stock price or zero. d. greater of the strike price minus the stock price or zero. e. greater of the stock price minus the exercise price or zero.
D
The intrinsic value of a put is equal to the: A. lesser of the strike price or the stock price. B. lesser of the stock price minus the exercise price or zero. C. lesser of the stock price or zero. D. greater of the strike price minus the stock price or zero. E. greater of the stock price minus the exercise price or zero.
D
The last day on which an owner of an option can elect to exercise is the _____ date. A. ex-payment B. ex-option C. opening D. expiration E. intrinsic
D
The maximum value of a call option is equal to the: A. strike price minus the initial cost of the option. B. exercise price plus the price of the underlying stock. C. strike price. D. price of the underlying stock. E. purchase price.
D
The maximum value of a call option is equal to: a. the strike price minus the initial cost of the option. b. the exercise price plus the price of the underlying stock. c. the strike price. d. the price of the underlying stock. e. the purchase price.
D
The value of a risky bond is equal to the value of A) a call option plus the value of a default-free bond. B) the put option plus the value of a default-free bond. C) a default-free bond minus the value of the call option. D) a default-free bond minus the value of the put option. E) a default-free bond minus the value of the put plus the value of the call.
D
Under risk neutrality, the expected return on an asset will equal: A. the market risk premium. B. the market rate of return. C. zero. D. the risk-free rate of interest. E. the asset beta times the market risk premium.
D
When valuing a project using the Black Scholes option pricing model, R is set equal to the: A. historical real market rate of return. B. annually compounded risk-free rate. C. expected future real market rate of return. D. continuously compounded risk-free rate. E. project's CAPM rate of return.
D
Which combination is referred to as a protective put? Assume all sales and purchases refer to ABC stock and its options. A. buying 100 shares of stock and writing one put B. selling a put and buying an offsetting call C. buying 300 shares and selling three call option contracts D. buying a put and buying 100 shares of stock E. buying a put and selling a call with the same strike price and expiration date
D
Which one of the Black-Scholes formula parameters must be estimated? A) Stock price B) Interest rate C) Time to expiration D) Variance of the return E) Exercise price
D
Which one of the following is not included as an input for the Black Scholes option pricing model? A. standard deviation B. time to maturity C. exercise price D. par value E. risk-free interest rate
D
Which one of the following will cause the value of a call to decrease? A. lowering the exercise price B. increasing the time to expiration C. increasing the risk-free rate D. lowering the risk level of the underlying security E. increasing the stock price
D
Which one of these is not a reason why executives place less value on employee stock options than their face value would indicate? A. The option's value depends on the stock price exceeding the exercise price. B. Options must be held beyond the freeze-out period. C. Options may create a highly undiversified portfolio for the executive. D. Options create taxable income for the executive when granted. E. Options could be out of the money.
D
Which one of these will increase both the value of a call and the value of a put? A) Decrease in the exercise price B) Increase in the stock price C) Decrease in the interest rate D) Increase in stock volatility E) Decrease in time to expiration
D
Which variable within the Black-Scholes option pricing formula is the delta? A) S B) e−Rt C) N(d2) D) N(d1) E) E
D
Scotts currently has $1 billion in debt outstanding and plans to maintain that amount of debt forever. The average yield to maturity on Scotts debt is 5% and Scotts' tax rate is expected to continue to be 35%. What is the value of Scotts' interest tax shield?
D = $1B Tc = .35 .35 * $1B = $350 M
The distribution of shares in a subsidiary to existing parent company stockholders is called a(n): A. lockup transaction. B. bear hug C. equity carve-out. D. spin-off. E. split-up.
D. spin-off.
A mutually exclusive project is a project whose: A. acceptance or rejection has no effect on other projects. B. NPV is always negative. C. IRR is always negative. D. acceptance or rejection affects other projects. E. cash flow pattern exhibits more than one sign change.
D. acceptance or rejection affects other projects.
The increase you realize in buying power as a result of owning an investment is referred to as the _____ rate of return. A. inflated B. realized C. nominal D. real E. risk-free
D. real
How should a profitability index of zero be interpreted? A. The present value of the cash flows subsequent to the initial cash flow is equal to (−1 × Initial cash flow). B. The project has an internal rate of return equal to the discount rate. C. The project produces a net income of zero for every year of its life. D. The project's cash flows subsequent to the initial cash flow have a present value of zero. E. The project also has a net present value of zero.
D. The project's cash flows subsequent to the initial cash flow have a present value of zero.
Hi-Tech announces a major expansion which causes the price of its stock to increase and also causes an increase in the volatility of the stock price. How will these two market reactions affect the value of put options on Hi-Tech stock? A. Both reactions decrease the value of the put options. B. Both reactions increase the value of the put options. C. Neither reaction will affect put option values. D. The reactions will have offsetting effects on put option prices. E. The change in volatility will not affect put option values while the increased stock price will decrease the put option values.
D. The reactions will have offsetting effects on put option prices.
An option that grants the right, but not the obligation, to sell shares of the underlying asset on a particular date at a specified price is called: A. either an American or a European option. B. an American call. C. an American put. D. a European put. E. a European call.
D. a European put.
Firm A and Firm B join to create Firm AB. This is an example of: A. a tender offer. B. an acquisition of assets. C. an acquisition of stock. D. a consolidation. E. a merger.
D. a consolidation.
A financial device designed to make unfriendly takeover attempts financially unappealing, if not impossible, is called: A. a golden parachute. B. a standstill agreement. C. greenmail. D. a poison pill. E. a white knight.
D. a poison pill.
The discounted payback period of a project will decrease whenever the: A. discount rate applied to the project is increased. B. initial cash outlay of the project is increased. C. time period of the project is increased. D. amount of each project cash inflow is increased. E. costs of the fixed assets utilized in the project increase.
D. amount of each project cash inflow is increased.
The book value of an asset is primarily used to compute the: A. annual depreciation tax shield. B. amount of cash received from the sale of an asset. C. amount of tax saved annually due to the depreciation expense. D. amount of tax due on the sale of an asset. E. change in depreciation needed to reflect the market value of the asset.
D. amount of tax due on the sale of an asset.
If a project has a net present value equal to zero, then: A. the initial cost of the project exceeds the present value of the project's subsequent cash flows. B. the internal rate of return exceeds the discount rate. C. the project produces cash inflows that exceed the minimum required inflows. D. any delay in receiving the projected cash inflows will cause the project's NPV to be negative. E. the discount rate exceeds the internal rate of return.
D. any delay in receiving the projected cash inflows will cause the project's NPV to be negative.
The payback method: A. is the most frequently used method of capital budgeting analysis. B. is a more sophisticated method of analysis than the profitability index. C. considers the time value of money. D. applies mainly to projects where the actual results will be known relatively soon. E. generally results in decisions that conflict with the decision suggested by NPV analysis.
D. applies mainly to projects where the actual results will be known relatively soon.
A trading opportunity that offers a riskless profit is called a(n): A. put option. B. call option. C. market equilibrium. D. arbitrage. E. cross-hedge.
D. arbitrage.
Which combination is referred to as a protective put? Assume all sales and purchases refer to ABC stock and its options. A. buying 100 shares of stock and writing one put B. selling a put and buying an offsetting call C. buying 300 shares and selling three call option contracts D. buying a put and buying 100 shares of stock E. buying a put and selling a call with the same strike price and expiration date
D. buying a put and buying 100 shares of stock
A project will have more than one IRR if, any only if, the: A. primary IRR is positive. B. primary IRR is negative. C. NPV is zero. D. cash flow pattern exhibits more than one sign change. E. cash flow pattern exhibits exactly one sign change.
D. cash flow pattern exhibits more than one sign change.
All else equal, the payback period for a project will decrease whenever the: A. initial cost increases. B. required return for a project increases. C. assigned discount rate decreases. D. cash inflows are moved earlier in time. E. duration of a project is lengthened.
D. cash inflows are moved earlier in time.
Suppose that General Motors makes an offer to acquire General Mills. Ignoring potential antitrust problems, this merger would be classified as a: A. monopolistic merger. B. horizontal merger. C. vertical merger. D. conglomerate merger. E. equity carve-out merger.
D. conglomerate merger.
A key reason for acquisitions is synergy. Synergy includes all of the following except: A. revenue enhancements. B. cost reductions. C. decreased taxes. D. decreased cash flows. E. increased efficiency.
D. decreased cash flows.
The effect on an option's value of a small change in the value of the underlying asset is called the option: A. theta. B. vega. C. rho. D. delta. E. gamma.
D. delta.
For a profitable firm, an increase in which one of the following will increase the operating cash flow? A. employee salaries B. office rent C. building maintenance D. depreciation E. equipment rental
D. depreciation
All else held constant, the value of a call decreases when the: A. time to expiration increases. B. risk-free rate of return increases. C. stock price increases. D. exercise price increases. E. volatility of the price of the underlying stock increases.
D. exercise price increases.
If you consider the equity of a firm to be an option on the firm's assets then the act of paying off debt is comparable to _____ on the assets of the firm. A. purchasing a put option B. purchasing a call option C. exercising an in-the-money put option D. exercising an in-the-money call option E. selling a call option
D. exercising an in-the-money call option
Assume a risky firm has both bondholders and stockholders. If the firm obtains a government loan guarantee on its existing debt, who will gain from this guarantee? A. existing stockholders only B. both existing bondholders and stockholders in proportion to the firm's debt-equity ratio C. existing bondholders and stockholders on an equal basis D. existing bondholders only E. future stockholders only
D. existing bondholders only
The last day on which an owner of an option can elect to exercise is the _____ date. A. ex-payment B. ex-option C. opening D. expiration E. intrinsic
D. expiration
When the officers of a firm purchase all of the equity shares and the shares of the firm are delisted and no longer publicly available, this action is known as a(n): A. consolidation. B. vertical acquisition. C. proxy contest. D. going-private transaction. E. equity carve-out.
D. going-private transaction.
The intrinsic value of a put is equal to the: A. lesser of the strike price or the stock price. B. lesser of the stock price minus the exercise price or zero. C. lesser of the stock price or zero. D. greater of the strike price minus the stock price or zero. E. greater of the stock price minus the exercise price or zero.
D. greater of the strike price minus the stock price or zero.
If you consider bondholders to be the owners of a firm, then those bondholders: A. own a call option on the firm with an exercise price equal to the firm's total equity. B. own a put option on the firm with an exercise price equal to the firm's total debt. C. have written a put option on the firm with an exercise price equal to the firm's total equity. D. have written a call option on the firm with an exercise price equal to the firm's total debt. E. own a put option on the firm with an exercise price equal to the firm's total assets.
D. have written a call option on the firm with an exercise price equal to the firm's total debt.
The acquisition of a firm in the same industry as the bidder is called a _____ acquisition. A. conglomerate B. forward C. backward D. horizontal E. vertical
D. horizontal
If a call has a positive intrinsic value at expiration the call is said to be: A. funded. B. unfunded. C. at the money. D. in the money. E. out of the money.
D. in the money.
The modified internal rate of return: A. is used as the discount rate for all NPV calculations. B. applies only to profitability calculations. C. is used to make accept/reject decisions when no discount rate can be assigned. D. is computed by combining cash flows until only one change in sign remains. E. assumes all projects are financing projects.
D. is computed by combining cash flows until only one change in sign remains.
Net working capital: A. can be ignored in project analysis because any expenditure is normally recouped by the end of the project. B. requirements generally, but not always, create a cash inflow at the beginning of a project. C. expenditures commonly occur at the end of a project. D. is frequently affected by the additional sales generated by a new project. E. is the only expenditure where at least a partial recovery can be made at the end of a project.
D. is frequently affected by the additional sales generated by a new project.
Net working capital: A. can be ignored in project analysis because any expenditure is normally recouped by the end of the project. B. requirements generally, but not always, create a cash inflow at the beginning of a project. C. expenditures commonly occur at the end of a project. D. is frequently affected by the additional sales generated by a new project. E. is the only expenditure where at least a partial recovery can be made at the end of a project.
D. is frequently affected by the additional sales generated by a new project.
The discounted payback rule states that you should accept an investment project if its discounted payback period: A. exceeds some pre-specified period of time. B. is positive and rejected if it is negative. C. is less than the payback period. D. is less than some pre-specified period of time. E. exceeds the life of the investment.
D. is less than some pre-specified period of time.
A financing project is acceptable if its IRR is: A. exactly equal to its net present value (NPV). B. exactly equal to zero. C. greater than the discount rate. D. less than the discount rate. E. negative.
D. less than the discount rate.
A going-private transaction in which a large percentage of the money used to buy the outstanding stock is borrowed is called a: A. tender offer. B. proxy contest. C. merger. D. leveraged buyout. E. consolidation.
D. leveraged buyout.
The intrinsic value of a call equals the: A. exercise price minus the stock price. B. upper bound of the call's value. C. market price of the call option. D. lower bound of the call's value. E. premium paid to purchase the call.
D. lower bound of the call's value.
Which one of the following will cause the value of a call to decrease? A. lowering the exercise price B. increasing the time to expiration C. increasing the risk-free rate D. lowering the risk level of the underlying security E. increasing the stock price
D. lowering the risk level of the underlying security
Project A is opening a bakery at 10 Center Street. Project B is opening a specialty coffee shop at the same address. Both projects have unconventional cash flows, that is, both projects have positive and negative cash flows that occur following the initial investment. When trying to decide which project to accept, given sufficient funding to accept either, you should rely most heavily on the _____ method of analysis. A. profitability index B. internal rate of return C. payback D. net present value E. discounted payback
D. net present value
The most valuable investment given up if an alternative investment is chosen is a(n): A. salvage value expense. B. net working capital expense. C. sunk cost. D. opportunity cost. E. erosion cost.
D. opportunity cost.
If a firm is more concerned about the quick return of its initial investment than it is about the amount of value created, then the firm is most apt to evaluate a capital project using the _____ method of analysis. A. internal rate of return B. net present value C. modified internal rate of return D. payback E. profitability index
D. payback
The maximum value of a call option is equal to the: A. strike price minus the initial cost of the option. B. exercise price plus the price of the underlying stock. C. strike price. D. price of the underlying stock. E. purchase price.
D. price of the underlying stock.
he present value of an investment's future cash flows divided by the initial cost of the investment is called the: A. net present value. B. internal rate of return. C. average accounting return. D. profitability index. E. profile period.
D. profitability index.
A proposed acquisition may create synergy by doing all of the following except: A. increasing the market power of the combined firm. B. improving the distribution network of the acquiring firm. C. reducing the acquiring firm's distribution costs. D. reducing the utilization of the acquiring firm's assets. E. providing the combined firm with a strategic advantage.
D. reducing the utilization of the acquiring firm's assets.
The Black-Scholes option pricing model is dependent on which five parameters? A. stock price, exercise price, risk-free rate, probability, and time to maturity B. stock price, risk-free rate, probability, time to maturity, and variance C. stock price, risk-free rate, probability, variance, and exercise price D. stock price, exercise price, risk-free rate, variance, and time to maturity E. exercise price, probability, stock price, variance, and time to maturity
D. stock price, exercise price, risk-free rate, variance, and time to maturity
The cash flow from a project is computed as the: A. net operating cash flow generated by the project, less any sunk costs and erosion costs. B. sum of the incremental operating cash flow and aftertax salvage value of the project. C. net income generated by the project, plus the annual depreciation expense. D. sum of the incremental operating cash flow, capital spending, and net working capital cash flows incurred by the project. E. sum of the sunk costs, opportunity costs, and erosion costs of the project.
D. sum of the incremental operating cash flow, capital spending, and net working capital cash flows incurred by the project.
The cash flow from a project is computed as the: A. net operating cash flow generated by the project, less any sunk costs and erosion costs. B. sum of the incremental operating cash flow and aftertax salvage value of the project. C. net income generated by the project, plus the annual depreciation expense. D. sum of the incremental operating cash flow, capital spending, and net working capital cash flows incurred by the project. E. sum of the sunk costs, opportunity costs, and erosion costs of the project.
D. sum of the incremental operating cash flow, capital spending, and net working capital cash flows incurred by the project.
You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost. A. opportunity B. fixed C. incremental D. sunk E. relevant
D. sunk
Which one of the following should be excluded from the analysis of a project? A. erosion costs B. incremental fixed costs C. incremental variable costs D. sunk costs E. opportunity costs
D. sunk costs
The purchase accounting method for mergers requires that: A. the excess of the purchase price over the fair market value of the target firm be recorded as a one-time expense on the income statement of the acquiring firm B. goodwill be amortized on a yearly basis. C. the equity of the acquiring firm be reduced by the excess of the purchase price over the fair market value of the target firm. D. the assets of the acquired firm be recorded at their fair market value on the balance sheet of the acquiring firm. E. the excess amount paid for the target firm be recorded as a tangible asset on the books of the acquiring firm.
D. the assets of the acquired firm be recorded at their fair market value on the balance sheet of the acquiring firm.
All else constant, the net present value of a typical investment project increases when: A. the discount rate increases. B. each cash inflow is delayed by one year. C. the initial cost of a project increases. D. the rate of return decreases. E. all cash inflows occur during the last year instead of periodically throughout a project's life.
D. the rate of return decreases.
When a building supply store acquires a lumber mill it is making a ______ acquisition. A. horizontal B. longitudinal C. conglomerate D. vertical E. complementary resources
D. vertical
A company which uses the MACRS system of depreciation: A. will have equal depreciation costs each year of an asset's life. B. will expense the largest percentage of the cost during an asset's first year of life. C. can depreciate the cost of land, if it so desires. D. will write off the entire cost of an asset over the asset's class life. E. cannot expense any of the cost of a new asset during the first year of the asset's life.
D. will write off the entire cost of an asset over the asset's class life.
Kurt's Kabinets is looking at a project that will require $80,000 in fixed assets and another $20,000 in net working capital. The project is expected to produce sales of $138,000 with associated costs of $74,000. The project has a 4-year life. The company uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 34 percent. What is the operating cash flow for this project? A. $42,240 B. $62,240 C. $35,440 D. $49,040 E. $69,040
D. $49,040 OCF = ($138,000 - 74,000)(1 - .34) + ($80,000/4)(.34) = $49,040
A new product has startup costs of $338,200 and projected cash flows of $102,000, $187,500, and $245,000 for Years 1 to 3, respectively. What is the profitability index given a 9 percent required return? A. 0.71 B. 0.77 C. 1.16 D. 1.30 E. 1.41
D. 1.30 PI = ($102,000/1.09 + $187,500/1.092 + $245,000/1.093)/$338,200 = 1.30
You are considering a project with an initial cost of $4,600. What is the payback period for this project if the cash inflows are $450, $970, $2,800, and $500 a year for Years 1 to 4, respectively? A. 1.03 years B. 2.36 years C. 2.89 years D. 3.76 years E. 3.81 years
D. 3.76 years Payback period = 3 + ($4,600 - 450 - 970 - 2,800)/$500 = 3.76 years
Projects A and B require an initial investment of $48,000 and $98,000, respectively. The projects are mutually exclusive and both have positive net present values. Which of these methods is probably the best method to use to determine which project to accept? A. Payback B. Modified IRR C. AAR D. Incremental IRR E. IRR
D. Incremental IRR
Which one of these statements is correct? A. Operating cash flow is equal to net income plus depreciation plus taxes. B. Sunk costs should be included in the initial cost of a project. C. Synergy occurs when a new product reduces the sales of a current product. D. The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost. E. Real cash flows must be discounted at the nominal rate.
D. The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
Bloomfield's has some equipment sitting idle in a warehouse. The equipment is fully paid for and also fully depreciated. If the firm decides to use this equipment for a new project, what cost, if any, should the firm include in its startup costs for the project? A. There is no cost to the project for this equipment. B. The original purchase price of the equipment should be included in the startup costs. C. The original purchase price minus any tax savings realized to date on the depreciation should be included in the startup costs. D. The current market value of the equipment should be included in the startup costs. E. The annual storage cost for the equipment should be included as a cash inflow in the startup costs.
D. The current market value of the equipment should be included in the startup costs
The last day on which an owner of an option can elect to exercise is the _____ date.
D. expiration
The intrinsic value of a put is equal to the:
D. greater of the strike price minus the stock price or zero.
Net working capital: A. can be ignored in project analysis because any expenditure is normally recouped by the end of the project. B. requirements generally, but not always, create a cash inflow at the beginning of a project. C. expenditures commonly occur at the end of a project. D. is frequently affected by the additional sales generated by a new project. E. is the only expenditure where at least a partial recovery can be made at the end of a project
D. is frequently affected by the additional sales generated by a new project.
Which one of the following will cause the value of a call to decrease?
D. lowering the risk level of the underlying security
28. The profitability index is closely related to: A. payback. B. discounted payback. C. average accounting return. D. net present value. E. internal rate of return
D. net present value.
The problem of multiple IRRs can occur when: A. there is only one sign change in the cash flows. B. the first cash flow is always positive. C. the cash flows decline over the life of the project. D. there is more than one sign change in the cash flows. E. None of the above
D. there is more than one sign change in the cash flows.
The discounted cash flow approach to valuation
DCF analysis is an application of the NPV formula we are familiar with: NPV = CF0 + (CF1 / (1+r)^1) + (CF2 / (1+r)^2) + ... The plan of attack: 1. Estimate cash flows 2. Discount cash flows (assess risk) 3. Accept or reject
Record Date
Date on which company determines existing shareholders.
Ex-Dividend Date
Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend.
NPV ______ as the discount rate rises
Declines
If there is a conflict between mutually exclusive projects due to the IRR, one should:
Depend on the NPV as it will always provide the most value.
Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and aftertax income of $74,200?
Depreciation in a non-cash expense that increases the firm's cash flows.
Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and aftertax income of $74,200? -Depreciation increases the net book value of the firm's assets. -Depreciation in a non-cash expense that increases the firm's cash flows. -Depreciation lowers the firm's net income but does not affect its cash flows. -Depreciation has no effect on either the firm's net income or its cash flows. -Depreciation decreases both the firm's net income and its cash flows.
Depreciation in a non-cash expense that increases the firm's cash flows.
Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and after-tax income of $74,200?
Depreciation is a noncash expense that increases the firm's cash flows.
The process of valuing an investment by determining the present value of its future cash flows is called (the):
Discounted cash flow valuation.
For which capital investment evaluation technique is the following a complete list of its disadvantages when compared to NPV analysis? (1) Ignores cash flows beyond the cutoff date; (2) Requires an arbitrary cutoff point; (3) Biased against long-term projects; (4) May reject positive NPV projects
Discounted payback
Which of the following is a correct statement?
Discounted payback analysis requires use of a discount rate.
The length of time needed to recover the initial investment once time value of money is considered is called the:
Discounted payback period.
The length of time required for an investment's discounted cash flows to equal its initial cost is the:
Discounted payback period.
A branching tree depicting the binomial model of a projected investment: A. should capture all possible futures paths the investment could take. B. will have more up-branches than down-branches if there are two or more time intervals. C. can only have one final point that has an option value of zero. D. only depicts paths that will lead to acceptable project decisions. E. should lead to the same result if you take an up-branch followed by a down-branch or a down-branch followed by an up-branch.
E
A put option on ABC stock with E = $35 expires today. The current price of ABC stock is $36. The put is: a. funded. b. unfunded. c. at the money. d. in the money. e. out of the money.
E
A put option with a $35 exercise price on ABC stock expires today. The current price of ABC stock is $36. The put is: A. funded. B. unfunded. C. at the money. D. in the money. E. out of the money.
E
An increase in which one of these will decrease the value of a call option and increase the value of a put option? A) Stock price B) Time to expiration C) Stock volatility D) Interest rate E) Exercise price
E
An option that may be exercised at any time up to and including its expiration date is called a(n) _____ option. A. futures B. Asian C. Bermudan D. European E. American
E
Assuming all else equal, the value of an in-the-money call increases when the I. time to expiration increases. II. stock price increases. III. risk-free rate of return increases. IV. volatility of the price of the underlying stock increases. A) I and III only B) II, III, and IV only C) I, III, and IV only D) I, II, and III only E) I, II, III, and IV
E
Given an exercise price, time to maturity, and European put-call parity, the present value of the strike price plus the call option is equal to: A. the current market value of the stock. B. the present value of the stock minus a put option. C. a put option minus the market value of the share of stock. D. the value of a U.S. Treasury bill. E. the share of stock plus the put option.
E
In the Black-Scholes option pricing formula, N(d1) is the probability that a standardized, normally distributed random variable is: A. less than or equal to N(d2). B. less than one. C. equal to one. D. equal to d1. E. less than or equal to d1.
E
Selling a covered call is equivalent to A) selling a put and buying the underlying stock. B) buying a put and selling a zero coupon bond. C) selling a put and selling the underlying stock. D) buying the underlying stock and selling a put. E) buying a zero coupon bond and selling a put.
E
Stock option quotes are A) quoted as the price for each 100-share contract. B) quoted on a per-share basis with each contract covering 1,000 shares. C) quoted on a per-share basis with each contract covering a single share. D) based on a 1,000-share contract and quoted as a price per contract. E) based on a 100-share contract with the quote stated on a per-share basis.
E
Suppose that the Simmons Corporation's common stock has a beta of 1.6. If the risk-free rate is 5% and the market risk premium is 4%, the expected return on Simmons' common stock is: A. 4.0%. B. 5.0%. C. 5.6%. D. 10.6%. E. 11.4%.
E
The difference between an American call and a European call is that the American call: a. has a fixed exercise price while the European exercise price can vary within a small range. b. is a right to buy while a European call is an obligation to buy. c. has an expiration date while the European call does not. d. is written on 100 shares of the underlying security while the European call covers 1,000 shares. e. can be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.
E
The difference between an American call and a European call is that the American call: A. has a fixed exercise price while the European exercise price can vary within a small range. B. is a right to buy while a European call is an obligation to buy. C. has an expiration date while the European call does not. D. is written on 100 shares of the underlying security while the European call covers 1,000 shares. E. can be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.
E
The intrinsic value of a call is I. the value of the call if it were to expire today. II. equal to the lower bound of a call's value. III. another name for the market price of a call. IV. always equal to zero if the call is currently out of the money. A) I and III only B) II and IV only C) I and II only D) II, III, and IV only E) I, II, and IV only
E
The opportunity to defer investing in a project until a later date may have value primarily because: A. the cost of capital may increase. B. project cash flows may be lower in the future. C. investment costs tend to increase over time. D. the option to abandon may disappear. E. market conditions may improve.
E
The relationship between a change in the price of a stock and the related change in the price of the call on that stock is referred to as the option A) vega. B) theta. C) rho. D) gamma. E) delta.
E
The value of an option if it were to immediately expire, that is, its lower pricing bound, is called an option's _____ value. A. strike B. market C. volatility D. time E. intrinsic
E
Which one of the following statements correctly describes your situation as the owner of an American call option? A) You are obligated to buy at a set price at any time up to and including the expiration date. B) You have the right to sell at a set price at any time up to and including the expiration date. C) You have the right to buy at a set price only on the expiration date. D) You are obligated to sell at a set price if the option is exercised. E) You have the right to buy at a set price at any time up to and including the expiration date.
E
Which one of the following statements correctly describes your situation as the owner of an American call option? A. You are obligated to buy at a set price at any time up to and including the expiration date. B. You have the right to sell at a set price at any time up to and including the expiration date. C. You have the right to buy at a set price only on the expiration date. D. You are obligated to sell at a set price if the option is exercised. E. You have the right to buy at a set price at any time up to and including the expiration date.
E
Which one of these statements is true? A. If virtually all projects have embedded options, then ignoring these options does not affect the value of the projects. B. Every business will benefit if it exercises its expansion option. C. Abandoning a project will lower the project's value. D. Start-up businesses do not have any options until they have succeeded for one year. E. Every business idea has at least two possible outcomes.
E
Which one of these statements is true? A. The Black Scholes model is most applicable to complex situations. B. The binomial model is limited to a two-period time sequence. C. The binomial model is limited to ten time intervals for any single analysis. D. The binomial model is basically equivalent to the Black Scholes model when there is a single time interval. E. The Black Scholes model is simpler to use, but for complex situations, the binomial model is preferred.
E
An option that may be exercised at any time up to and including its expiration date is called a(n) _____ option. A. futures B. Asian C. Bermudan D. European E. American
E. American
Assume a firm has no interest expense or extraordinary items. Given this, the operating cash flow can be computed as: A. EBIT - Taxes. B. EBIT × (1 - Tax rate) + Depreciation × Tax rate. C. (Sales - Costs) × (1 - Tax rate). D. EBIT - Depreciation + Taxes. E. Net income + Depreciation.
E. Net income + Depreciation.
You are considering a project with the following data: Internal rate of return 8.7% Profitability ratio .98 Net present value −$393 Payback period 2.44 years Required return 9.5% Which one of the following is correct given this information? A. The discount rate used in computing the net present value must have been less than 8.7%. B. The discounted payback period will have to be less than 2.44 years. C. The discount rate used to compute the profitability ratio was equal to the internal rate of return. D. This project should be accepted based on the profitability ratio. E. This project should be rejected based on the internal rate of return.
E. This project should be rejected based on the internal rate of return.
Which one of the following statements correctly describes your situation as the owner of an American call option? A. You are obligated to buy at a set price at any time up to and including the expiration date. B. You have the right to sell at a set price at any time up to and including the expiration date. C. You have the right to buy at a set price only on the expiration date. D. You are obligated to sell at a set price if the option is exercised. E. You have the right to buy at a set price at any time up to and including the expiration date.
E. You have the right to buy at a set price at any time up to and including the expiration date.
You own stock in a firm that has a pure discount loan due in six months. The loan has a face value of $50,000. The assets of the firm are currently worth $62,000. The stockholders in this firm basically own a _____ option on the assets of the firm with a strike price of ______ A. put; $62,000. B. put; $50,000. C. warrant; $62,000. D. call; $62,000. E. call; $50,000.
E. call; $50,000.
The lower bound of a call option: A. can be a negative value regardless of the stock or exercise prices. B. can be a negative value but only when the exercise price exceeds the stock price. C. can be a negative value but only when the stock price exceeds the exercise price. D. must be greater than zero. E. can be equal to zero.
E. can be equal to zero.
The difference between an American call and a European call is that the American call: A. has a fixed exercise price while the European exercise price can vary within a small range. B. is a right to buy while a European call is an obligation to buy. C. has an expiration date while the European call does not. D. is written on 100 shares of the underlying security while the European call covers 1,000 shares. E. can be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.
E. can be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.
A firm may want to divest itself of some of its assets for all of these reasons except to: A. raise cash. B. eliminate unprofitable operations. C. eliminate some recently acquired assets. D. cash in on profitable operations. E. eliminate some synergy.
E. eliminate some synergy.
The annual annuity stream of payments with the same present value as a project's costs is called the project's _____ cost. A. incremental B. sunk C. opportunity D. erosion E. equivalent annual
E. equivalent annual
A decrease in a firm's current cash flows resulting from the implementation of a new project is referred to as: A. salvage value expenses. B. net working capital expenses. C. sunk costs. D. opportunity costs. E. erosion costs.
E. erosion costs.
The two fatal flaws of the internal rate of return decision rule are the: A. arbitrary determination of a discount rate and the failure to consider initial expenditures. B. arbitrary determination of a discount rate and the failure to correctly analyze mutually exclusive investment projects. C. arbitrary determination of a discount rate and the multiple rate of return problem. D. failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment projects. E. failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem.
E. failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem.
The payback method of analysis: A. discounts cash flows. B. ignores the initial cost. C. always uses all project cash flows. D. applies an industry-standard recoupment period. E. has a timing bias.
E. has a timing bias.
Accepting a positive net present value (NPV) project: A. indicates the project will pay back within the required period of time. B. means the present value of the expected cash flows is equal to the project's cost. C. ignores the inherent risks within the project. D. guarantees all cash flow assumptions will be realized. E. is expected to increase the stockholders' value by the amount of the NPV.
E. is expected to increase the stockholders' value by the amount of the NPV.
The pretax salvage value of an asset is equal to the: A. book value if straight-line depreciation is used. B. book value if MACRS depreciation is used. C. market value minus the book value. D. book value minus the market value. E. market value.
E. market value.
The possibility that more than one discount rate will make the NPV of an investment equal to zero presents the problem referred to as: A. net present value profiling. B. operational ambiguity. C. the mutually exclusive investment decision. D. issues of scale. E. multiple rates of return.
E. multiple rates of return.
A put option with a $35 exercise price on ABC stock expires today. The current price of ABC stock is $36. The put is: A. funded. B. unfunded. C. at the money. D. in the money. E. out of the money.
E. out of the money.
The profitability index of an investment project is the ratio of the: A. average net income to the average investment. B. internal rate of return to the current market rate of interest. C. net present value of the project's cash outflows divided by the net present value of its inflows. D. net present value of every project cash flow to the initial cost. E. present value of the Time 1 and subsequent cash flows to the initial cost.
E. present value of the Time 1 and subsequent cash flows to the initial cost.
The net present value method of capital budgeting analysis does all of the following except: A. incorporate risk into the analysis. B. consider all relevant cash flow information. C. use all of a project's cash flows. D. discount all future cash flows. E. provide a specific anticipated rate of return.
E. provide a specific anticipated rate of return.
The positive incremental net gain associated with the combination of two firms through a merger or acquisition is called: A. the agency conflict. B. goodwill. C. the merger cost. D. the consolidation effect. E. synergy.
E. synergy.
Given an exercise price, time to maturity, and European put-call parity, the present value of the strike price plus the call option is equal to: A. the current market value of the stock. B. the present value of the stock minus a put option. C. a put option minus the market value of the share of stock. D. the value of a U.S. Treasury bill. E. the share of stock plus the put option.
E. the share of stock plus the put option.
The acquisition of a firm involved with a different production process stage than the bidder is called a _____ acquisition. A. conglomerate B. forward C. backward D. horizontal E. vertical
E. vertical
The equivalent annual cost method is useful in determining: A. the annual operating cost of a machine if the annual maintenance is performed versus when the maintenance is not performed as recommended. B. the tax shield benefits of depreciation given the purchase of new assets for a project. C. operating cash flows for cost-cutting projects of equal duration. D. which one of two machines to acquire given equal machine lives but unequal machine costs. E. which one of two machines to purchase when the machines are mutually exclusive, have different machine lives, and will be replaced once they are worn out.
E. which one of two machines to purchase when the machines are mutually exclusive, have different machine lives, and will be replaced once they are worn out.
Sway's Market is considering a project that will require the purchase of $1.4 million in new equipment. The equipment will be depreciated straight-line to zero over the 5-year life of the project. The firm expects to sell the equipment at the end of the project for 20 percent of its original cost. New net working capital equal to 10 percent of sales will be required to support the project. All of the new net working capital will be recouped at the end of the project. Annual sales are estimated at $750,000 with costs of $338,000. The required rate of return is 12 percent and the tax rate is 34 percent. What is the amount of the aftertax salvage value of the equipment? A. $68,800 B. $74,000 C. $95,200 D. $280,000 E. $184,800
E. $184,800 Aftertax salvage value = ($1,400,000 × .20) × (1 - .34) = $184,800
Riverton Sails currently produces boat sails and is considering expanding its operations to include awnings for homes and travel trailers. The company owns land beside its current manufacturing facility that could be used for the expansion. The company bought this land ten years ago at a cost of $89,000 and spent $26,000 on grading and excavation costs at that time. Today, the land is valued at $221,000. The company currently has some unused equipment that it currently owns with a current market value of $45,000. This equipment could be used for producing awnings if $9,000 is spent for equipment modifications. Other equipment costing $315,000 will be required. What is the amount of the initial cash flow for this expansion project? A. $484,000 B. $545,000 C. $324,000 D. $439,000 E. $590,000
E. $590,000 CF0 = $221,000 + 45,000 + 9,000 + 315,000 = $590,000
What is the internal rate of return on an investment that has an initial cost of $38,400 and projected cash inflows of $11,200, $19,600, and $18,100 for Years 1 to 3, respectively? A. 11.86% B. 12.37% C. 11.08% D. 13.92% E. 12.15%
E. 12.15% NPV = $0 = -$38,400 + $11,200/(1 + IRR) + $19,600/(1 + IRR)2 + $18,100/(1 + IRR)3 IRR = 12.15%
A project has an initial cost of $32,000 and a 4-year life. The company uses straightline depreciation to a book value of zero over the life of the project. The projected net income from the project is $1,200, $2,200, $3,500, and $2,700 a year for Years 1 to 4, respectively. What is the average accounting return? A. 3.55% B. 14.13% C. 4.28% D. 7.11% E. 15.00%
E. 15.00% Average net income = ($1,200 + 2,200 + 3,500 + 2,700)/4 = $2,400 Average book value = ($32,000 + 24,000 + 16,000 + 8,000 + 0)/5 = $16,000 AAR = $2,400/$16,000 = .1500, or 15.00%
Which one of the following will decrease a firm's net working capital? A. A decrease in fixed assets B. An increase in inventory C. An increase in the firm's checking account balance D. A decrease in accounts payable E. A decrease in accounts receivable
E. A decrease in accounts receivable
An option that may be exercised at any time up to its expiration date is called a(n) _____ option.
E. American
The value of a call increases when:
E. I, II, III, and IV I. the time to expiration increases. II. the stock price increases. III. the risk-free rate of return increases. IV. the volatility of the price of the underlying stock increases.
Miller's is considering a 2-year expansion project that will require $410,000 up front. The project will produce cash flows of $358,000 and $98,000 for Years 1 and 2, respectively. Based on the profitability index (PI) rule, should the project be accepted if the discount rate is 12 percent? Why or why not? A. Yes; because the PI is 1.03 B. Yes; because the PI is .97 C. Yes; because the PI is .94 D. No; because the PI is 1.03 E. No; because the PI is .97
E. No; because the PI is .97 PI = ($358,000/1.12 + $98,000/1.122)/$410,000 = .97
Project I has an initial cash outflow of $18,300 and annual cash flows of $8,700 for Years 1 to 3. Project II has an initial cash outflow of $25,400 and annual cash flows of $10,500 for Years 1 to 3. These projects are mutually exclusive. The required rate of return is 11 percent. Based on the incremental NPV(II - I), which project(s) should be accepted and why? A. Project II; because the incremental NPV(II - I) is negative B. Project I; because both the incremental NPV(II - I) and NPVI are positive C. Both Project I and II; because both project NPVs are positive D. Project II; because it has the larger NPV E. Project I; because the incremental NPV(II - I) is negative and NPVI is positive
E. Project I; because the incremental NPV(II - I) is negative and NPVI is positive Incremental cash flows: Time 0: -$25,400 - (-$18,300) = -$7,100 Years 1 to 3: $10,500 - 8,700 = $1,800 Incremental NPV(II - I) = -$7,100 + $1,800/1.11 + $1,800/1.112 + $1,800/1.113 = -$2,701.31 NPVI = -$18,300 + $8,700/1.11 + $8,700/1.112 + $8,700/1.113 = $2,960.32
If you want to review a project from a benefit-cost perspective, you should use the _______ method of analysis. A. net present value B. payback C. internal rate of return D. average accounting return E. profitability index
E. profitability index
Elton International is considering the installation of a new computer system that will cut annual operating costs by $12,000. The system will cost $48,000 to purchase and install. This system is expected to have a 5-year life and will be depreciated to zero using straight-line depreciation. What is the amount of the earnings before interest and taxes?
Earnings before interest and taxes = $12,000 - ($48,000/5) = $2,400
NASDAQ
Electronic exchange
The Bet-r-Bilt Company has a six-year bond outstanding with a 5 percent coupon. Interest payments are paid semi-annually. The face amount of the bond is $1,000 and it is currently selling for 98 percent of its face value. The firm must pay 2 percent to float its debt. The tax rate is 40 percent. What is the company's after-tax cost of debt?
Enter N = 6 * 2 pv = -980 * (1 - 0.02) PMT = 50 / 2 FV = 1000 Solve for semiannual I/Y = Take 2.9 * 2 to get the annual YTM and you get 5.8 percent. Now you have to take out taxes. Annual YTM * (1 - tax rate) = 5.8 * (1 - 0.4) = 3.47 percent
What is one possible difference between corporate and entrepreneurial finance mentioned in the text?
Entrepreneurial finance often maximizes utility function, not wealth function.
All else equal, an increase in which one of the following will increase the operating cash flow?
Equipment depreciation
loss of current sales due to a new project being implemented.
Erosion
The cash flows of a new project that come at the expense of a firm's existing projects are called:
Erosion Costs
Turkey Hill Motor Homes currently sells 1,200 Class A motor homes, 2,600 Class C motor homes, and 4,000 pop-up trailers each year. It is considering adding a mid-range camper and expects that if it does so the firm can sell 1,500 of them. However, if the new camper is added, the firm expects its Class A sales to decline by 10 percent while the Class C camper sales decline to 2,100 units. The sales of pop-ups will not be affected. Class A motor homes sell for an average of $162,000 each. Class C homes are priced at $59,500 and the pop-ups sell for $5,500 each. The new mid-range camper will sell for $32,900. What is the erosion cost?
Erosion cost = [.10 × 1,200 × $162,000] + [(2,600 - 2,100) × $59,500] = $49,190,000
The act where an owner of an option buys or sells the underlying asset, as is his right, is called ______ the option.
Exercising
Out-of-the-Money
Exercising the option would result in a negative payoff.
At-the-Money
Exercising the option would result in a zero payoff (i.e., exercise price equal to spot price).
The last day on which an owner of an option can elect to exercise is the _____ date.
Expiration
The formula for free cash flow
FCF = EBIT * (1-t) + depr. - CAPX - Change in NWC where EBIT = earnings before interest and taxes t = tax rate CAPX = capital expenditures change NWC = change in net working capital (Changes in NWC usually occur in year 0 and the terminal year) Depr = annual depreciation
(Calculating free cash flows) Bikez is introducing a new product and has an expected change in EBIT of $475,000. This project will also produce $100,000 of depreciation per year. In addition, the project will cause changes to the following accounts: - Increase of $18,000 in A/R - Increase of $15,000 in Inventory - Increase of $24,000 in A/P Assuming a tax rate of 34%, calculate the project's free cash flows.
FCF = EBIT(1-T) + Dep - Change in NWC Change in NWC: 18,000 + 15,000 - 24,000 = 9,000 Operating Cash Flow: 475,000 x (1 - 0.34) + 100,000= 413,500 Free Cash Flow: 413,500 - 9,000 = 404,500 Note: in many multi-year projects, we assume that NWC only changes at time 0 and at the end of the life of the project
Estimating k in the DCF
FCFF - must use firm-wide discount rate WACC FCFE - must use an equity discount rate CAPM; build-up
FCFF vs FCFE
FCFF: all capital providers (debt and equity) FCFE: CF for the equity providers only (be careful to match CF with discount rate) FCFF = EBIT - Tax + depr - change in CAPX - change in NWC FCFE = NI + depr - change in CAPX - Change in NWC + change in net debt
PV =
FV / (1 + R)^n
When buying a home, what specific tip will save you thousands of dollars on your mortgage purchase?
Finance your house with a fifteen-year mortgage as opposed to a thirty-year mortgage. In the section "Strategies for Car and House Buying," on page 15-2, the text gives key advice: use a fifteen-year mortgage, not a thirty-year mortgage. The three reasons that they give as support are the following: 1) You will buy within your means. 2) You will pay more towards principal faster; that is, you will pay the debt off faster, and save tens of thousands of dollars. This will help you to invest in your future since you will have, on average, $100,000 dollars left over that you would have paid with the thirty-year mortgage. 3) You will almost always get a lower interest rate (i/y on the calculator. With your TVM skills you can see this will further save you money compared to a thirty-year loan).
The value of firm B to firm A is equal to the value of:
Firm B as a stand-alone firm plus the synergy value.
Proposition I (with taxes)
Firm value increases with leverage Vl = Vu + tcB
Jake's Sound Systems has 210,000 shares of common stock outstanding at a market price of $36 a share. Last month, Jake's paid an annual dividend in the amount of $1.593 per share. The dividend growth rate is 4 percent. Jake's also has 6,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7 percent coupon, pay interest annually, and mature in 4.89 years. The bonds are selling at 99 percent of face value. The company's tax rate is 34 percent. What is Jake's weighted average cost of capital?
First do the weights: Debt: 6,000 * $1,000 * 0.99 = $5,940,000 Common: 210,000 * $36 = $7,560,000 Total = $5,940,000 + $7,560,000 = $13,500,000 Next do the cost of equity: Ke = [($1.593 * 1.04) / $36] + 0.04 = 0.08602 Next do the cost of debt: Enter 4.89 -990 70 1000 N I/Y PV PMT FV Solve for 7.250 = 6.9 percent Finally, combine into WACC: WACC = (7,560,000/13,500,000 * 0.08602) + (5,940,000 / 13,500,000 * 0.0725 * (1 - 0.34)) = 6.92 percent
Firm RST is considering a $2,000 a year investment (paid now) that will produce a $1,500 cash inflow in year 1 and a $500 cash inflow in year 2. (Assumed discount rate = 10%) year 1 year 2 cash inflow $1,500 $500 less depreciation $1,000 $1,000 accounting income $500 $(500)
"accounting" npv = 500 / 1.1 - 500 / (1.1)^2 = $41.32 But cash flow NPV is clearly negative When calculating NPV, recognize investment expenditures when they occur, not later when they show up as depreciation. Projects generate cash (to distribute or reinvest), therefore the focus must be on cash flow, not profits.
Kelly's Corner Bakery purchased a lot in Oil City five years ago at a cost of $580,000. Today, that lot has a market value of $830,000. At the time of the purchase, the company spent $41,000 to level the lot and another $4,900 to install storm drains. The company now wants to build a new facility on that site. The building cost is estimated at $1,000,000. What amount should be used as the initial cash flow for this project?
$-1,830,000 CF0 = -$830,000 - $1,000,000 = -$1,830,000
Champion Bakers uses specialized ovens to bake its bread. One oven costs $850,000 and lasts about 3 years before it needs to be replaced. The annual operating cost per oven is $10,000. What is the equivalent annual cost of an oven if the required rate of return is 8 percent? (Round your answer to whole dollars)
$-339,828 1 - 1 NPV = - $850,000 - $10,000 × (1+ 0.08)3 = $-875,771 0.08 1 - 1 $-875,771 = EAC × (1+ 0.08)3 ; EAC = $-339,828
A firm has a total debt ratio of .47. This means the firm has 47 cents in debt for every
$.53 in total equity.
Roy's Welding Supplies common stock sells for $22 a share and pays an annual dividend that increases by 6 percent annually. The market rate of return on this stock is 9 percent. What is the amount of the last dividend paid?
$0.62 22= D0 x (1.06)/ .09-.03
An investment cost $10,000 with expected cash flows of $3,000 for 5 years. The discount rate is 15.2382%. The NPV is _____ and the IRR is ________ for the project.
$0; 15.2382%
An investment cost $10,000 with expected cash flows of $3,000 for 5 years. The discount rate is 15.2382%. The NPV is ___ and the IRR is ___ for the project.
$0; 15.2382% NPV = $-10,000 + (3,000 x PVIFA 5, .152382 ) = $0
A bond with a coupon rate of 6 percent that pays interest semiannually and is priced at par will have a market price of _____ and interest payments in the amount of _____ each.
$1,000; $30
Grand Adventure Properties offers a 8 percent coupon bond with annual payments. The yield to maturity is 6.85 percent and the maturity date is 8 years from today. What is the market price of this bond if the face value is $1,000?
$1,069.07 Enter 8 6.85 80 1,000 N I/Y PV PMT FV Solve for -1,069.07
Jamestown Ltd. currently produces boat sails and is considering expanding its operations to include awnings for homes and travel trailers. The company owns land beside its current manufacturing facility that could be used for the expansion. The company bought this land ten years ago at a cost of $250,000. Today, the land is valued at $425,000. The grading and excavation work necessary to build on the land will cost $15,000. The company currently owns some unused equipment, valued at $60,000, which could be used for producing awnings if $5,000 is spent for equipment modifications. Other equipment, costing $780,000, will also be required. What is the amount of the initial cash flow for this expansion project?
$1,285,000 CF0 = $425,000 + $15,000 + $60,000 + $5,000 + $780,000 = $1,285,000
A firm has net working capital of $452, net fixed assets of $2,209, sales of $6,000, and current liabilities of $800. How many dollars worth of sales are generated from every $1 in total assets?
$1.73 Total asset turnover = $6,000/($452 + $2,209 + $800) = 1.73
Camille's Café is considering a project that will not produce any sales but will decrease cash expenses by $12,000. If the project is implemented, taxes will increase from $23,000 to $24,500 and depreciation will increase from $4,000 to $5,500. What is the amount of the operating cash flow using the top-down approach?
$10,500 OCF = $0 ?(?$12,000) - ($24,500 ?23,000) = $10,500
Samoa's Tools has sales of $760,000 and a profit margin of 8 percent. The annual depreciation expense is $50,000. What is the amount of the operating cash flow if the company has no long-term debt?
$110,800 OCF = ($760,000 �.08) + $50,000 = $110,800
Peter's Boats has sales of $760,000 and a profit margin of 5 percent. The annual depreciation expense is $80,000. What is the amount of the operating cash flow if the company has no long-term debt?
$118,000 OCF = ($760,000 �.05) + $80,000 = $118,000
Winter Time Adventures is going to pay an annual dividend of $3.22 a share on its common stock next week. This year, the company paid a dividend of $3.10 a share. The company adheres to a constant rate of growth dividend policy. What will one share of this common stock be worth 11 years from now if the applicable discount rate is 8.0 percent?
$118.43 G= (3.33-3.2)/3.1 g=.03871 P11= 3.22 x (1.03871)^11 / .08=.03871= 118.43
The Beach House has sales of $780,000 and a profit margin of 6 percent. The annual depreciation expense is $80,000. What is the amount of the operating cash flow if the company has no long-term debt?
$126,800 OCF = ($780,000 x 0.06) + $80,000 = $126,800
Global Enterprises has spent $134,000 on research developing a new type of shoe. For this shoe to now be manufactured, the firm will need to expand into an empty building that it currently owns. The firm was offered $229,000 last week for that building. An additional $342, 000 will be required for new equipment and building improvements. Labor and material costs are estimated at $4.98 per pair of shoes. Interest expense on the loan needed to finance the production of this new shoe will be $17,800 a year. Which one of these correctly identifies the sunk costs?
$134,000 for research
The By-Way has sales of $435,000, costs of $254,000, depreciation of $35,000, interest expense of $22,000, and taxes of $43,400. What is the amount of the operating cash flow?
$137,600 OCF = $435,000 - 254,000 - 43,400 = $137,600
A zero coupon bond with a face value of $1,000 is issued with an initial price of $475.00. The bond matures in 25 years. What is the implicit interest, in dollars, for the first year of the bond's life?
$14.36 475= 1000/ (1+ r/2)^25x2 = 3% PV1= 1000/ (1 +.03/2)^24x2= 489.36 Implicit interest = $489.36 − $475 = $14.36
Valentine Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for each of the next three years. Calculate the NPV for the project if the cost of capital is 15%.
$169,935.
The Java House is considering a project that will produce sales of $47,500 and increase cash expenses by $22,500. If the project is implemented, taxes will increase by $7,600. The additional depreciation expense will be $10,100. An initial cash outlay of $7,300 is required for net working capital. What is the amount of the operating cash flow using the top-down approach?
$17,400
Aaron's Paint paid $320,000, in cash, for a piece of equipment three years ago. Last year, the company spent $34,000 to update the equipment with the latest technology. The equipment is being depreciated using the straight-line method over seven years. The company no longer uses this equipment in its current operations and has received an offer of $175,000 from a firm that would like to purchase it. Aaron's is debating whether to sell the equipment or to expand its operations such that the equipment can be used. When evaluating the expansion option, what value, if any, should be assigned to this equipment as an initial cost of the expansion project?
$175,000
Aaron's Paint paid $320,000, in cash, for a piece of equipment three years ago. Last year, the company spent $34,000 to update the equipment with the latest technology. The equipment is being depreciated using the straight-line method over seven years. The company no longer uses this equipment in its current operations and has received an offer of $175,000 from a firm that would like to purchase it. Aaron's is debating whether to sell the equipment or to expand its operations such that the equipment can be used. When evaluating the expansion option, what value, if any, should be assigned to this equipment as an initial cost of the expansion project?
$175,000 - Explanation CF0 = $175,000, which is the opportunity cost.
Walks Softly, Inc. sells customized shoes. Currently, it sells 10,000 pairs of shoes annually at an average price of $68 a pair. It is considering adding a lower-priced line of shoes which sell for $49 a pair. Walks Softly estimates it can sell 5,000 pairs of the lower-priced shoes but will sell 1,000 less pairs of the higher-priced shoes by doing so. What is the amount of the sales that should be used when evaluating the addition of the lower-priced shoes?
$177,000
Ernie's Electrical is evaluating a project which will increase sales by $50,000 and costs by $30,000. The project will cost $150,000 and be depreciated straight-line to a zero book value over the 10 year life of the project. The applicable tax rate is 34 percent. What is the operating cash flow for this project?
$18,300 Tax = 0.34 * [$50,000 - 30,000 - ($150,000 / 10)] = $1,700 Operating Cash Flow = $50,000 - $30,000 - $1,700 = $18,300
. Ernie's Electrical is evaluating a project which will increase sales by $50,000 and costs by $30,000. The project will cost $150,000 and will be depreciated straight-line to a zero book value over the 10-year life of the project. The applicable tax rate is 34 percent. What is the operating cash flow for this project?
$18,300 OCF = ($50,000 - 30,000) � (1 ?.34) + ($150,000 / 10) � .34 = $18,300
Bernie's Beverages purchased some fixed assets classified as 5-year property for MACRS. The assets cost $26,000. What will the accumulated depreciation be at the end of year three? MACRS 5-year property Year Rate 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76%
$18,512 Depreciation = $26,000 x (0.20 + 0.32 + 0.192) = $18,512
Edward's Manufactured Homes purchased some machinery 2 years ago for $51,000. The assets are classified as 5-year property for MACRS. The company is replacing this machinery today with newer machines that utilize the latest in technology. The old machines are being sold for $16,000 to a foreign firm for use in its production facility in South America. What is the aftertax salvage value from this sale if the tax rate is 34 percent? MACRS 5-year property Year Rate 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76%
$18,883.20 Book value2 = $51,000 x (1 - 0.20 - 0.32) = $24,480.00 Tax on sale = ($16,000 - $24,480.00) x .34 = -$2,883.20 Aftertax cash flow = $16,000 + $2,883.20 = $18,883.20
Kustom Cars purchased a fixed asset two years ago for $39,000 and sold it today for $19,000. The assets are classified as 5-year property for MACRS. The MACRS table values are .2000, .3200, .1920, .1152, .1152, and .0576 for Years 1 to 6, respectively. What is the net cash flow from the salvage value if the tax rate is 35 percent?
$18,902
Ronnie's Custom Cars purchased some fixed assets two years ago for $39,000. The assets are classified as 5-year property for MACRS. Ronnie is considering selling these assets now so he can buy some newer fixed assets which utilize the latest in technology. Ronnie has been offered $19,000 for his old assets. What is the after-tax salvage value if the tax rate is 34%? MACRS 5-year property Year Rate 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76%
$18,904.80
You just purchased some equipment that is classified as 5-year property for MACRS. The equipment cost $67,600. What will the book value of this equipment be at the end of three years should you decide to resell the equipment at that point in time? MACRS 5-year property Year Rate 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76%
$19,468.80
Marshall's & Co. purchased a corner lot in Eglon City five years ago at a cost of $640,000. The lot was recently appraised at $810,000. At the time of the purchase, the company spent $50,000 to grade the lot and another $4,000 to build a small building on the lot to house a parking lot attendant who has overseen the use of the lot for daily commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.2 million. What amount should be used as the initial cash flow for this building project?
$2,010,000
Marshall's & Co. purchased a corner lot in Eglon City five years ago at a cost of $640,000. The lot was recently appraised at $810,000. At the time of the purchase, the company spent $50,000 to grade the lot and another $4,000 to build a small building on the lot to house a parking lot attendant who has overseen the use of the lot for daily commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.2 million. What amount should be used as the initial cash flow for this building project?
$2,010,000 CF0 = $810,000 + $1,200,000 = $2,010,000. The historical cost is irrelevant. The grading and small building expenses are not incremental; they are in the past so they do not count.
Ronnie's Coffee House is considering a project which will produce sales of $6,000 and increase cash expenses by $2,500. If the project is implemented, taxes will increase by $1,300. The additional depreciation expense will be $1,000. An initial cash outlay of $2,000 is required for net working capital. What is the amount of the operating cash flow using the top-down approach?
$2,200 OCF = $6,000 ?2,500 ?1,300 = $2,200
A project costing $6,200 initially should produce cash inflows of $2,860 a year for three years. After the three years, the project will be shut down and will be sold at the end of Year 4 for an estimated net cash amount of $3,300. What is the net present value of this project of the required rate of return is 11.3 percent?
$2,903.19
Langley Enterprises pays a constant dividend of $1.40 a share. The company announced today that it will continue to do this for another 2 years after which time it will discontinue paying dividends permanently. What is one share of this stock worth today if the required rate of return is 8 percent?
$2.50 P0= 1.4/(1.08) + (1.4)/(1.08)^2
What is the net present value of a project that has an initial cash outflow of $12,670 and the following cash inflows? The required return is 11.5%. Year Cash Inflows 1 $4,375 2 $0 3 $8,750 4 $4,100
$218.68
Miller Mfg. is analyzing a proposed project. The company expects to sell 11,000 units, give or take 3 percent. The expected variable cost per unit is $6.00 and the expected fixed cost is $35,000. The fixed and variable cost estimates are considered accurate within a plus or minus 6 percent range. The depreciation expense is $29,000. The tax rate is 34 percent. The sale price is estimated at $14.00 a unit, give or take 4 percent. What is the earnings before interest and taxes under the base case scenario?
$24,000 EBIT for base case = [11,000 x ($14.00 - $6.00)] - $35,000 - $29,000 = $24,000
Miller Brothers Hardware paid an annual dividend of $1.45 per share last month. Today, the company announced that future dividends will be increasing by 3.20 percent annually. If you require a 9.2 percent rate of return, how much are you willing to pay to purchase one share of this stock today?
$24.94 P0= 1.45x(1.032)/(.092-.032)
Walks Softly sells customized shoes. Currently, it sells 14,800 pairs of shoes annually at an average price of $59 a pair. It is considering adding a lower-priced line of shoes that will be priced at $39 a pair. Walks Softly estimates it can sell 6,000 pairs of the lower-priced shoes but will sell 3,500 less pairs of the higher-priced shoes by doing so. What annual sales revenue should be used when evaluating the addition of the lower-priced shoes?
$27,500 Sales = (6,000 �$39) + (?3,500 � $59) = $27,500
You are interested in valuing your firm. You have sales of $2 million, NI (earnings) of $200,000, and a tax rate of 40 percent. You have researched your industry and the average PE ratio is 15. What is your firm worth, according to the comparable multiples approach?
$3 million PE * earnings = price, so, 15 * $200,000 = $3 million
Data, Inc. purchased some fixed assets four years ago at a cost of $19,800. It no longer needs these assets, so it is going to sell them today at a price of $3,500. The assets are classified as 5-year property for MACRS. The MACRS table values .2000, .3200, .1920, .1152, .1152, and .0576 for Years 1 to 6, respectively. What is the current book value of these assets?
$3,421.44
RP&A, Inc. purchased some fixed assets four years ago at a cost of $19,800. They no longer need these assets, so they are going to sell them today at a price of $3,500. The assets are classified as five-year property for MACRS. What is the current book value of these assets? MACRS five-year property Year Rate 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76%
$3,421.44 Book value at the end of year three = $19,800 - [$19,800 * (0.20 + 0.32 + 0.192 + 0.1152)] = $3,421.44
Last week, Hansen Delivery paid its annual dividend of $1.20 per share. The company has been reducing the dividends by 12 percent each year. How much are you willing to pay to purchase stock in this company if your required rate of return is 15 percent?
$3.91 P0= 1.2 x (1+(-.12)/(.15-(-.12)
Kurt's Cabinets is looking at a project that will require $80,000 in fixed assets and another $20,000 in net working capital. The project is expected to produce sales of $110,000 with associated costs of $70,000. The project has a 4-year life. The company uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 35 percent. What is the operating cash flow for this project?
$33,000 OCF = ($110,000 - 70,000) � (1 ?.35) + ($80,000 / 4) � .35 = $33,000
Tool Makers, Inc. uses tool and die machines to produce equipment for other firms. The initial cost of one customized tool and die machine is $850,000. This machine costs $10,000 a year to operate. Each machine has a life of 3 years before it is replaced. What is the equivalent annual cost of this machine if the required return is 9%? (Round your answer to whole dollars.)
$345,797
Ben's Border Café is considering a project which will produce sales of $16,000 and increase cash expenses by $10,000. If the project is implemented, taxes will increase from $23,000 to $24,500 and depreciation will increase from $4,000 to $5,500. What is the amount of the operating cash flow?
$4,500
Ben's Border Café is considering a project that will produce sales of $16,000 and increase cash expenses by $10,000. If the project is implemented, taxes will increase from $23,000 to $24,500 and depreciation will increase from $4,000 to $5,500. What is the amount of the operating cash flow using the top-down approach?
$4,500 OCF = $16,000 ?10,000 ?($24,500 ?23,000) = $4,500
A firm has total debt of $1,060 and a debt-equity ratio of .27. What is the value of the total assets?
$4,986 Total equity = $1,060 / .27 = $3,926 Total assets = $1,060 + $3,926= $4,986
Margarite's Enterprises is considering a new project. The project will require $325,000 for new fixed assets, $160,000 for additional inventory and $35,000 for additional accounts receivable. Short-term debt is expected to increase by $100,000 and long-term debt is expected to increase by $300,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to a zero book value over the life of the project. At the end of the project, the fixed assets can be sold for 25% of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $554,000 and costs of $430,000. The tax rate is 35% and the required rate of return is 15%. What is the initial cost of this project?
$420,000
Margarite's Enterprises is considering a new project that will require $345,000 for new fixed assets, $160,000 for inventory, and $35,000 for accounts receivable. Short-term debt is expected to increase by $110,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to zero over the life of the project. At the end of the project, the fixed assets can be sold for 25 percent of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $550,000 and costs of $430,000. The tax rate is 35 percent and the required rate of return is 15 percent.
$430,000
Jamie's Motor Home Sales currently sells 1,100 Class A motor homes, 2,200 Class C motor homes, and 2,800 pop-up trailers each year. Jamie is considering adding a mid-range camper and expects that if she does so she can sell 1,500 of them. However, if the new camper is added, Jamie expects that her Class A sales will decline to 850 units while the Class C camper sales decline to 2,000. The sales of pop-ups will not be affected. Class A motor homes sell for an average of $140,000 each. Class C homes are priced at $59,500 and the pop-ups sell for $5,000 each. The new mid-range camper will sell for $42,900. What is the erosion cost of adding the mid-range camper?
$46,900,000 Erosion cost = [(1,100 ?850) �$140,000] + [(2,200 ?2,000) �$59,500] = $46,900,000
Farris Industrial purchased a machine five years ago at a cost of $164,900. The machine is being depreciated using the straight-line method over eight years. The tax rate is 35 percent and the discount rate is 14 percent. If the machine is sold today for $42,500, what will the aftertax salvage value be?
$49,268.13
A project is expected to create operating cash flows of $22,500 a year for three years. The initial cost of the fixed assets is $50,000. These assets will be worthless at the end of the project. An additional $3,000 of net working capital will be required for the project, while the net working capital will be completely recovered at the end of the project. What is the project's net present value if the required rate of return is 10%?
$5,208.11
Margarite's Enterprises is considering a new project. The project will require $325,000 for new fixed assets, $160,000 for additional inventory and $35,000 for additional accounts receivable. Short-term debt is expected to increase by $100,000 and long-term debt is expected to increase by $300,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to a zero book value over the life of the project. At the end of the project, the fixed assets can be sold for 25% of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $554,000 and costs of $430,000. The tax rate is 35% and the required rate of return is 15% What is the amount of the after-tax salvage value of the fixed assets at the end of this project? (Round your answer to whole dollars.)
$52,813
Wexter's purchased a warehouse for $499,000 six years ago. Four years ago, repairs costing $132,000 were made to the building. The annual property taxes are $41,000. The warehouse has a current book value of $268,000 and a market value of $529,000. The warehouse is debt-free. If the company decides to assign this warehouse to a new project, what value, if any, should be included in the initial cash flow of the project for this building?
$529,000
Stellar Plastics is analyzing a proposed project. The company expects to sell 11,000 units, give or take 4 percent. The expected variable cost per unit is $7.00 and the expected fixed cost is $36,000. The fixed and variable cost estimates are considered accurate within a plus or minus 4 percent range. The depreciation expense is $33,000. The tax rate is 34 percent. The sale price is estimated at $16.00 a unit, give or take 3 percent. What is the operating cash flow for a sensitivity analysis using total fixed costs of $32,000?
$55,440.00 OCF = [(11,000 x ($16.00 - $7.00)] - $32,000][1- .34] +($33,000 x .34) = $55,440.00
Margarite's Enterprises is considering a new project. The project will require $325,000 for new fixed assets, $160,000 for additional inventory and $35,000 for additional accounts receivable. Short-term debt is expected to increase by $100,000 and long-term debt is expected to increase by $300,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to a zero book value over the life of the project. At the end of the project, the fixed assets can be sold for 25% of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $554,000 and costs of $430,000. The tax rate is 35% and the required rate of return is 15%. What is the amount of the earnings before interest and taxes for the first year of this project?
$59,000
A project will increase annual sales by $144,000 and cash expenses by $95,000 for four years. The project has an initial cost of $102,000 for equipment that will be depreciated using MACRS depreciation. The applicable MACRS table values are .1429, .2449, .1749, and .1249 for Years 1 to 4, respectively. The company has a marginal tax rate of 34 percent. What is the depreciation tax shield for Year 3?
$6,065.53
Combined Communications is a new firm in a rapidly growing industry. The company is planning on increasing its annual dividend by 23 percent a year for the next 4 years and then decreasing the growth rate to 5 percent per year. The company just paid its annual dividend in the amount of $1.30 per share. What is the current value of one share of this stock if the required rate of return is 9.00 percent?
$62.43 P4= 1.3 x (1.023)^4 x (1.05) / .09-.05 = 78.11 CF0= 0 CF1= 1.3x(1.023) CF2= 1.3x(1.023)^2 CF3= 1.3x(1.023)^3 CF4= 1.3x(1.023)^4 + 78.11
Pete's Garage just purchased some equipment at a cost of $650,000. What is the proper methodology for computing the depreciation expense for Year 3 if the equipment is classified as 5-year property for MACRS? The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6, respectively.
$650,000 ×.192
You are analyzing a project and have prepared the following data: CF0: -$169,000 CF1: $46,200 CF2: $87,300 CF3: $41,000 CF4: $39,000 Based on the net present value of _____ for this project, you should _____ the project.
$7,978.72; accept (You should accept because the NPV is positive.)
CATO, Inc. just purchased some fixed assets at a total cost of $62,118 that are classified as 3-year property for MACRS. The MACRS table values are .3333, .4445, .1481, and .0741 for Years 1 to 4, respectively. What is the amount of the depreciation expense for Year 3?
$9,199.68
A project will increase sales by $60,000 and cash expenses by $51,000. The project will cost $40,000 and will be depreciated using straight-line depreciation to a zero book value over the 4-year life of the project. The company has a marginal tax rate of 35 percent. What is the operating cash flow of the project using the tax shield approach?
$9,350 OCF = ($60,000 - 51,000) �(1 ?.35) + ($40,000 / 4) �.35 = $9,350
Kay's Quilts is considering a project that will require additional inventory of $138,000, increase accounts payable by $55,000 and increase accounts receivables by 10 percent. Accounts receivable is currently $80,000. What is the net working capital requirement?
$91,000
Oil Well Supply offers a 8 percent coupon bond with semiannual payments and a yield to maturity of 8.73 percent. The bonds mature in 9 years. What is the market price per bond if the face value is $1,000?
$955.13 Enter 9 × 2 8.73/2 80/2 1,000 N I/Y PV PMT FV Solve for -955.13
replacement cost approach: left side of the balance sheet
(asset side) tangibles - appraised / estimated value intangibles - patents, customer list, reputation (much harder)
Procedure for Cash Dividend
- Declaration Date: The Board of Directors declares a payment of dividends. - Cum-Dividend Date: Buyer of stock still receives the dividend. - Ex-Dividend Date: Seller of the stock retains the dividend. - Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November.
In-the-Money
- Exercising the option would result in a positive payoff. - Call is in-the-money if stock price is greater than strike price (opposite for a put). - If a call has a positive intrinsic value at expiration
Usually, spin-offs are motivated by agency-related reasons.
- For instance, when a firm with multiple divisions becomes large, it becomes difficult for the CEO to govern all of the divisions together, or difficult for shareholders to monitor them. • As non-cash dividends, spin-offs are not subject to immediate taxation. • Capital gains tax is only imposed when shareholders sell the original firm's shares.
MM Proposition II (No taxes)
- No Taxes - Leverage increases the risk and return to stockholders Return on (levered) equity (cost of equity, Rs) = Return on unlevered equity (cost of capital, Ro) + (Value of debt,B/value of equity,S)(Ro - interest rate(cost of debt,Rb))
Expected vs. Unexpected Returns
- Realized returns are generally not equal to expected returns. - There is the expected component and the unexpected component. - At any point in time, the unexpected return can be either positive or negative. - Over time, the average of the unexpected component is zero. Total return = Expected return + unexpected return
Expected Return
- Return that an individual expects a stock to earn over the next period. - May be higher or lower, or simply the average return per period a security has earned in the past
Correlation
- Returns on individual securities are related to one another - Alternatively to covariance, restated in terms of correlation between the two securities
Covariance
- Returns on individual securities are related to one another - Measures the interrelationship between two securities
Systematic Risk
- Risk factors that affect a large number of assets - Also known as non-diversifiable risk or market risk - Includes such things as changes in GDP, inflation, interest rates, etc.
Unsystematic Risk
- Risk factors that affect a limited number of assets - Also known as unique risk and asset-specific risk - Includes such things as labor strikes, part shortages, etc.
Free cash flow hypothesis
- an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities - argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.
A project will produce cash inflows of $1,750 a year for four years. The project initially costs $10,600 to get started. In year five, the project will be closed and as a result should produce a cash inflow of $8,500. What is the net present value of this project if the required rate of return is 13.75%?
-$1,011.40
PI Advantages
-Closely related to NPV, generally leading to identical decisions -Easy to understand and communicate -May be useful when available investment funds are limited
Disadvantages of Payback Period
-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects
Advantages of Discounted Payback Period
-Includes time value of money -Easy to understand -Does not accept negative estimated NPV investments when all future cash flows are positive -Biased towards liquidity
Disadvantages of Discounted Payback Period
-May reject positive NPV investments -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff point -Biased against long-term projects, such as R&D and new products
Shortcomings IRR
-Non conventional(cash flow sign changes more than once) cash flows -Mutually Exclusive
Advantages of Payback Period
-easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity
In the text, an academic study showed how many entrepreneurs lost their liability protection even when they had incorporated. How did they do this?
...
A firm has a debt-equity ratio of .44. What is the total debt ratio?
.31 The debt-equity ratio is 0.44. If total debt is $44 and total equity is $100, then total assets are $144. Total debt ratio = $44/$144 = 0.31.
What is the debt-equity ratio for 2009?
.38 Debt-equity ratio = ($1,240 + $500)/($3,356 + $1,224) = 0.38
A banker considering loaning money to a firm for ten years would most likely prefer the firm have a debt ratio of _______ and a times interest earned ratio of _______.
.40 (lowest) ; 1.75 (highest)
hil's Carvings, Inc. wants to have a weighted average cost of capital of 9%. The firm has an after-tax cost of debt of 5 % and a cost of equity of 11%. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? Multiple Choice .33 .40 .50 .60 .67
.5 9 = 5 (D/V) + 11(E/V) 9 = 5 (D/V) + 11((V-D)/V) 9V = 5D + 11V - 11D-2V = -6D 6(D/V) = 2 D/V = 2/6 If D = 2, and V = 6 then E must equal 4 →(6-2) D/E = 2/4, or 0.5
Jessica's Boutique has cash of $54, accounts receivable of $64, accounts payable of $200, and inventory of $160. What is the value of the quick ratio?
.59 Quick ratio = ($54 + $64)/$200 = 0.59
What is the quick ratio for 2009?
.80 Quick ratio for 2009 = ($2,450 - $1,530)/$1,150 = 0.8
A bond that pays interest annually yielded 6.75 percent last year. The inflation rate for the same period was 5.80 percent. What was the actual real rate of return on this bond for last year?
.90 percent (1.0675)/1.058 -1 = .9%
If the economy booms, RTF, Inc. stock is expected to return 10 percent. If the economy goes into a recessionary period, then RTF is expected to return only 4 percent. The probability of a boom is 60 percent while the probability of a recession is 40 percent. What is the variance of the returns on RTF, Inc. stock?
0.000864 E(r) = (0.60 * 0.10) + (0.40 * 0.04) = 0.06 + 0.016 = 0.076 Variance = 0.60 * (0.10 - 0.076)2 + .40 * (0.04 - .076)2 = 0.0003456 + 0.0005184 = 0.000864 Remember that variance is the square of the standard deviation. See the section "Risk" on page 8-2 for the equation for standard deviation.
Slippery Slope Roof Contracting has an equity beta of 1.2, capital structure with 2/3 debt, and a zero tax rate. What is its asset beta?
0.40
Slippery Slope Roof Contracting has an equity beta of 1.2, capital structure with 2/3 debt, and a zero tax rate. What is its asset beta? Multiple Choice 0.40 0.72 1.20 1.80 None of the above
0.40 A = (E/(D+E.) β E =(1/3)(1.2) = .4
The cost of equity for Ryan Corporation is 8.4%. If the expected return on the market is 10% and the risk-free rate is 5%, then the equity beta is ___.
0.68
he cost of equity for Ryan Corporation is 8.4%. If the expected return on the market is 10% and the risk-free rate is 5%, then the equity beta is __. Multiple Choice 0.48 0.68 1.25 1.68 Impossible to calculate with information given.
0.68 R s = R f + β (R m- R f ); .084 = .05 + β (.10-.05); β = .68
Which of the following entity structures typically has unlimited liability? -all of the above -1 and 2 only -partnership -sole proprietorship -LLC
1 and 2 only
A "Perfect Capital Market" is one in which:
1) Securities are fairly priced, trading at competitive prices equal to PV(Future CF). 2) There are no taxes nor costs of issuing and trading securities. 3) Investment cash flows are independent of financing choices.
Two key factors determine the present value of financial distress costs:
1) The probability of financial distress. 2) The magnitude of the bankruptcy costs, if the firm defaults ("loss given default").
payback period criticisms:
1) ignores the time value of money. does not discount projects future cashflows 2) ignores cashflows occurring after the payback period 3) project payback period is arbitrarily set
Internal Rate of Return (IRR) criticisms
1) nonconventional cashflows 2) mutually exclusive projects
Wexford Industrial Supply is considering a new project with estimated depreciation of $33,000, fixed costs of $35,000, and total sales of $75,000. The variable costs per unit are estimated at $5.00. What is the accounting break-even level of production?
1,400 units Qaccounting break even = $35,000 + $33,000 = $75,000 - ($5.00 × Q)
Three steps to calculating cost of capital
1. calculate the value of each security as a proportion of the firm's market value. 2. determine the required rate of return on each security. 3. calculate a weighted average of these required returns
Alphabet Inc. (GOOG) is currently unlevered and the market's expectation is that it will remain unlevered forever. GOOG has 750 million shares outstanding and its stock price is $800. GOOG's marginal tax rate is 20%. This afternoon, in a surprise press release, Alphabet announces that tomorrow morning, it will issue $200 billion of debt, using the proceeds to repurchase shares of equity, and that it will maintain this level of debt going forward. What is the effect of this announcement on the price of GOOG stock?
1. find tax shield .2*200B = 40B 2. divide by shares outstanding is change in stock mkt price 40B/.75B = $53.3 change in share price 3. calc price 800+53 = $853 share price after announcement
putting DCF in perspective: 5 steps
1. forecase op. results for 3-5 years 2. Calculate FCF for each year 3. Estimate a terminal value in the last year V(terminal( = CFt (1+G) / (kcf - g) 4. compute the discount rate CAPM, WACC 5. Use TVM calculations to get value
The Template Corporation has an equity beta of 1.2 and a debt beta of .8. The firm's market value debt to equity ratio is .6. Template has a zero tax rate. What is the asset beta?
1.05
You are analyzing a project and have prepared the following data: CF0: -$169,000 CF1: $46,200 CF2: $87,300 CF3: $41,000 CF4: $39,000 Required Payback Period 2.5 years; Required return 8.5% Based on the profitability index of _____ for this project, you should _____ the project.
1.05; accept
Suppose the Barges Corporation's common stock has an expected return of 12%. Assume that the risk-free rate is 5%, and the market risk premium is 6%. If no unsystematic influence affected Barges' return, the beta for Barges is ______.
1.17
Calculate the Profitability Index (PI) for the project with the following cash flows. The firm's cost of capital is 10%. Time Cash Flow 0 -$2,800 1 200 2 500 3 800 4 1,300 5 1,970
1.181
If the dollar appreciates from 0.8 euros per dollar to 1.2 euros per dollar, the euro depreciates from ________ dollars to ________ dollars per euro.
1.25; 0.83
Assuming the CAPM or one-factor model holds, what is the cost of equity for a firm if the firm's equity has a beta of 1.2, the risk-free rate of return is 2%, the expected return on the market is 9%, and the return to the company's debt is 7%?
10.4%
Assuming the CAPM or one-factor model holds, what is the cost of equity for a firm if the firm's equity has a beta of 1.2, the risk-free rate of return is 2%, the expected return on the market is 9%, and the return to the company's debt is 7%? Multiple Choice 10.4% 10.8% 12.8% 14.4% None of the above.
10.4% R s = R f + β (R m- R f ) = .02 + 1.2(.09 - .02) = .104 = 10.4%
You are analyzing a project and have prepared the following data: CF0: -$169,000 CF1: $46,200 CF2: $87,300 CF3: $41,000 CF4: $39,000 Based on the internal rate of return of _____ for this project, you should _____ the project.
10.75%; accept (You should accept because the IRR of 10.75% exceeds the required return of 8.50%.)
A project produces annual net income of $11,500, $13,700, and $16,900 over the three years of its life, respectively. The initial cost of the project is $257,000. This cost is depreciated straight-line to a zero book value over three years. What is the average accounting rate of return if the required discount rate is 6.75 percent?
10.92 percent
A project has an initial cost of $32,000 and a 4-year life. The company uses straightline depreciation to a book value of zero over the life of the project. The projected net income from the project is $1,200, $2,200, $3,500, and $2,700 a year for Years 1 to 4, respectively. What is the average accounting return? 3.55% 14.13% 4.28% 7.11% 15.00%
15.00%
You are analyzing two mutually exclusive projects and have developed the following information. What is the incremental IRR? Project A: CF0: -$84,500 CF1: $29,000 CF2: $40,000 CF3: $27,000 Project B: CF0: -$76,900 CF1: $25,000 CF2: $35,000 CF3: $26,000
17.90%
Ernie's Electrical is evaluating a project which will increase sales by $50,000 and costs by $30,000. The project will cost $150,000 and be depreciated straight-line to a zero book value over the 10 year life of the project. The applicable tax rate is 34%. What is the operating cash flow for this project?
18,300
What is the internal rate of return on an investment that has an initial cost of $63,100 and projected cash inflows of $18,700, $38,600, and $34,100 for Years 1 to 3, respectively?
19.10% NPV = $0 = -$63,100 + $18,700 / (1 + IRR) + $38,600 / (1 + IRR)2 + $34,100 / (1 + IRR)3 IRR = 19.10%
An investment with an initial cost of $15,000 produces cash flows of $5,000 annually for 5 years. If the cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback period is ______ years.
3.75
You are considering a project with an initial cost of $4,600. What is the payback period for this project if the cash inflows are $450, $970, $2,800, and $500 a year for Years 1 to 4, respectively? 1.03 years 2.36 years 2.89 years 3.76 years 3.81 years
3.76 years
Consider an investment with an initial cost of $20,000 and is that expected to last for 5 years. The expected cash flows in years 1 and 2 are $5,500 and in year 5 is $1,000. The total cash inflow is expected to be $22,000 or an average of $4,400 per year. Compute the payback period in years.
3.82 years
Consider an investment with an initial cost of $20,000 and is that expected to last for 5 years. The expected cash flows in years 1 and 2 are $5,000, in years 3 and 4 are $5,500 and in year 5 is $1,000. The total cash inflow is expected to be $22,000 or an average of $4,400 per year. Compute the payback period in years.
3.82 years Payback Period = ($5,000 + $5,000 + $5,500 = $15,500 for 3 years; remainder $20,000 - $15,500 = 4,500. $4,500/$5,500 = .81818 = .82) = Payback Period = 3.82 years
Baxter's Market is considering opening a new location with an initial cost of $139,200. This location is expected to generate cash flows of $22,400, $61,500, $37,800, and $21,000 in Years 1 to 4, respectively. What is the payback period?
3.83 years Payback period = 3 + ($139,200 - $22,400 - $61,500 - $37,800) / $21,000 = 3.83 years
The yield to maturity on a bond is currently 7.75 percent. The real rate of return is 3.70 percent. What is the rate of inflation?
3.91 percent r= 1.0775/1.037 -1 = 3.91%
Supposed we issue 50,000 in debt, what is the cost?
33,000 = 50,000 * (1 - 0.34)
What is the days' sales in receivables? (use 2009 values)
33.1 Accounts receivable turnover for 2009 = $8,500/$770 = 11.04 Days' sales in receivables for 2009 = 365/11.04 = 33.06
Kurt s Toy Co. has had total annual returns for the past five years of -5 percent, 8 percent, -3 percent, 20 percent, and 12 percent. What is the 5-year holding period return?
33.76%
What is the cost of five November 25 call option contracts on KNF stock given the following price quote of 6.6? (Note that Nov 25 call option is call option that matures in Nov with E = $25)
3300
Given the following net cash flows, determine the internal rate of return (IRR) of the project: Time Net Cash Flow 0 -$2,000 1 500 2 1,500 3 2,000
35.19%.
An investment with an initial cost of $14,000 produces cash flows of $4,000 annually for 5 years. If the cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback period is _____ years.
4.53
The outstanding bonds of Winter Time Products provide a real rate of return of 3.30 percent. The current rate of inflation is 2.30 percent. What is the nominal rate of return on these bonds?
5.68 percent (1 + 0.033) x (1 + 0.023) - 1 = 5.68 percent
Northern Warehouses wants to raise $12 million to expand its business. To accomplish this, it plans to sell 35-year, $1,000 face value zero-coupon bonds. The bonds will be priced to yield 5 percent. What is the minimum number of bonds it must sell to raise the $12 million it needs?
67,585 PV= 1000/(1+ (.05/2))^35x2= 177.553576 Number 12000000/177.553576= 67585
What are the arithmetic and geometric average returns for a stock with annual returns of 11 percent, 14 percent, -2 percent and 6 percent?
7.25%; 7.08%
You recently purchased a stock that is expected to earn 12 percent in a booming economy, 8 percent in a normal economy and lose 5 percent in a recessionary economy. There is a 15 percent probability of a boom, a 75 percent chance of a normal economy, and a 10 percent chance of a recession. What is your expected rate of return on this stock?
7.30% E(r) = (0.15 * 0.12) + (0.75 * 0.08) + (0.10 * -0.05) = 0.018 + 0.06 - 0.005 = 0.073 = 7.3 percent
The Purple Martin has annual sales of $4,500, total debt of $1,240, total equity of $2,400, and a profit margin of 6 percent. What is the return on assets?
7.42 percent Return on assets = (0.06 x $4,500)/($1,240 + $2,400) = 7.42 percent
Hotchow is issuing a $1000 face value bond that pays 10% annual interest, and matures in 20 years. The bond will be sold at par ($1000) and flotation costs will be 15% of the market value. The company is in the 25% tax bracket. What is the firm's after-tax cost of debt on the bond?
9.0% FV = 1000 PV after flotation costs = -1000 * (1 - 0.15) = -850 PMT = 1000 * 0.10 = 100 n = 20 Use calculator to solve for I/Y. Before tax YTM = 12.01 percent Tax rate = 25 percent After tax YTM = 12.01 * (1 - 0.25) = 9.0 percent
A ________ is a derivative security that grants the owner the right, but not the obligation, to buy an asset at a fixed price during a specified period of time. A) call option B) futures contract C) put option D) swap E) forward contract
A
A financial contract that gives its owner the right, but not the obligation, to buy or sell a specified asset at an agreed-upon price on or before a given future date is called a(n) _____ contract. A. option B. futures C. forward D. swap E. straddle
A
A government guarantee of a firm's existing debt A) has a cost equal to that of a put option. B) benefits shareholders at the expense of current bondholders. C) converts risk-free debt into risky debt. D) is costless to taxpayers. E) is essentially exercising a call option on the firm.
A
An in-the-money put option is one that: A. has an exercise price greater than the underlying stock price. B. has an exercise price less than the underlying stock price. C. expires today. D. should not be exercised at expiration. E. should not be exercised at any time.
A
Assume you purchase one share of a stock and sell a call on a single share of that same stock with an exercise price of $25. What is the maximum payoff you can realize on this combination? A. the exercise price of $25 B. an amount equal to the stock price on the option expiration date C. an amount equal to $25 minus the stock price on the option expiration date D. an amount equal to the stock price on the expiration date plus $25 E. an amount equal to the sum of the exercise price and the stock price on the option expiration date
A
Assuming the CAPM or one-factor model holds, what is the cost of equity for a firm if the firm's equity has a beta of 1.2, the risk-free rate of return is 2%, the expected return on the market is 9%, and the return to the company's debt is 7%? A. 10.4% B. 10.8% C. 12.8% D. 14.4% E. None of the above.
A
At expiration, the maximum price of a ____ is the greater of the: A. call; stock price minus the exercise price, or 0. B. call; the exercise price or 0. C. put; stock price minus the exercise price, or 0. D. put; stock price or 0. E. put; exercise price or the stock price.
A
Eduardo owns an option that gives him the right to purchase shares of ABC stock at a price of $18 a share. Currently, the stock is selling for $21.60. He would like to profit on this stock but is not permitted to exercise his option for another 2 weeks. Contrary to other investors, he believes the stock price will decline significantly over the next 2 weeks. Given this situation, he should A) sell his option today. B) buy call options today that expire in 2 weeks. C) wait for 2 weeks and then immediately exercise his option. D) purchase shares of ABC today and then sell his option in 2 weeks. E) just forget about it because he cannot profit from this situation.
A
For every positive net present value project that a firm undertakes, the equity in the firm will increase the most if the delta of the call option on the firm's assets is: A. equal to one. B. between zero and one. C. equal to zero. D. between zero and minus one. E. equal to minus one.
A
Given an exercise price, E, time to maturity, t, and European put-call parity, the present value of the strike price plus the value of the call option on the stock is equal to the A) price of the stock plus the price of the put option. B) present value of the stock minus the put option. C) price of the put option minus the market value of the stock. D) value of risk-free security, such as a U.S. Treasury bill. E) current market value of the stock.
A
If a firm has low fixed costs relative to all other firms in the same industry, a large change in sales volume (either up or down) would have: A. a smaller change in EBIT for the firm versus the other firms. B. no effect in any way on the firms as volume does not effect fixed costs. C. a decreasing effect on the cyclical nature of the business. D. a larger change in EBIT for the firm versus the other firms. E. None of the above.
A
If a project has both expansion and abandonment options, then the: A. shorter the available life of the project the less valuable the project is. B. longer the available life of the project the less valuable the project is. C. options will offset each other and therefore add no value to the project. D. project life becomes irrelevant. E. project should always be accepted.
A
Investing in a negative NPV project today may be a feasible choice if: A. there are future option alternatives. B. all of the future options were included in the NPV analysis. C. the current discount rate is low. D. all future options will be ignored by decision makers. E. the discount rate is expected to increase over time.
A
Jillian owns an option which gives her the right to purchase shares of WAN stock at a price of $20 a share. Currently, WAN stock is selling for $24.50. Jillian would like to profit on this option but is not permitted to exercise it for another two weeks. She believes the stock will decline in value before the two weeks is up. What should she do? A. sell her option today B. put in an order to exercise her option on its expiration date C. convert her European option into an American option D. put in an order to exercise her option as soon as she is permitted to do so E. convert her American option into a European option
A
Selling a covered call is equivalent to: A. buying a zero coupon bond and selling a put. B. selling a put and buying an offsetting call. C. buying the stock and selling the call. D. selling a zero coupon bond and buying a put. E. buying a zero coupon bond and buying a call.
A
Shareholders in a levered firm might wish to accept a negative net present value project if it: A. increases the standard deviation of the returns on the firm's assets. B. lowers the variance of the returns on the firm's assets. C. lowers the firm's volatility. D. diversifies the cash flows of the firm. E. decreases the risk that a firm will default on its debt.
A
The lower bound on a call's value is the: A) stock price minus the exercise price or zero, whichever is greater. B) strike price or zero, whichever is greater. C) strike price or zero, whichever is lower. D) strike price or the stock price, whichever is lower. E) stock price minus the exercise price or zero, whichever is lower.
A
The maximum payoff to the seller of a call is A) zero. B) equal to the stock price. C) equal to the exercise price. D) not quantifiable. E) unlimited.
A
The option to abandon is: A. a real option. B. usually of little value because of the costs associated with abandonment. C. irrelevant in capital budgeting analysis. D. nearly always less relevant the option to expand. E. of no value to a project.
A
The owner of a European call option has the: A. right but not the obligation to buy a stock at a specified price on a specified date. B. right but not the obligation to buy a stock at a specified price during a specified period of time. C. obligation to buy a stock on a specified date but only at the specified price. D. obligation to buy a stock sometime during a specified period of time at the specified price. E. obligation to buy a stock at the lower of the exercise price or the market price on the expiration date.
A
The relationship between the prices of the underlying stock, a call option, a put option, and a riskless asset is referred to as the _____ relationship. A. put-call parity B. covered call C. protective put D. straddle E. strangle
A
The seller of a European call option has the A) obligation to sell the underlying stock at the strike price if the option is exercised. B) right but not the obligation to exercise the option on the expiration date. C) obligation to buy a stock on a specified date but only at the specified price. D) obligation to buy a stock sometime during a specified period of time at the specified price. E) obligation to buy a stock at the lower of the exercise price or the market price on the expiration date.
A
Which one of the following will cause the value of a call to decrease? A) Lowering the risk level of the underlying security B) Increasing the time to expiration C) Increasing the risk-free rate D) Lowering the exercise price E) Increasing the stock price
A
Which term applies to the purchase or sale of an underlying asset via an option contract? A) Exercising the option B) Striking the price C) Opening the bid D) Splitting the security E) Expiring the option
A
What value should you assign as the flotation cost of internally generated equity financing?
A cost of zero
Which of the following causes a depreciation of the domestic currency?
A decline in the domestic real interest rate
Which one of the following will decrease a firm's net working capital?
A decrease in accounts receivable
Which one of the following will decrease a firm's net working capital? -A decrease in fixed assets -An increase in inventory -An increase in the firm's checking account balance -A decrease in accounts payable -A decrease in accounts receivable
A decrease in accounts receivable
C) create value for the firm's current stockholders.
A firm should accept projects with positive net present values primarily because those projects will A) produce cash inflows that exceed the cash outflows. B) return the firm's initial cash outlay within 1 year. C) create value for the firm's current stockholders. D) produce only positive cash flows after the initial investment period. E) increase the current liquidity of the firm.
high fixed costs relative to variable costs.
A firm with high operating leverage is best defined as a firm that has:
Which one of the following combinations of firms would benefit the most through the use of complementary resources?
A golf resort and a ski resort
Which is NOT a problem of forward contracts?
A lack of flexibility
0.8875
A levered firm has a debt-to-equity ratio of .6 and an equity beta of 1.42. What would be the beta of the firm if it switched to an all-equity financial structure?
Net present value can be defined as
A measure of the value created or added today by undertaking a project
A consolidation is the combining of firms such that:
A new firm is created and both the acquired and the acquiring firms cease to exist.
Yes; The CAPM rate is 11.21 percent.
A project has an internal rate of return of 11.76 percent and a beta of 1.22. The market rate of return is 9.8 percent, the tax rate is 35 percent, and the risk-free rate is 3.4 percent. Should this project be accepted according to the CAPM if the firm is all-equity financed? Why or why not?
initial outlay example
A project will require an up-front expenditure of $20 million for equipment, and the equipment will be depreciated using MACRS. An initial commitment of $5 million in net working capital will also be required. What are the initial (year 0) cash flows to be included? FCF = EBIT * (1-t) + Depr. - CAPX - change NWC
Which one of the following statements is correct?
A spin-off frequently follows an equity carve-out.
Which one of the following is most likely a good candidate for an acquisition that could benefit from the use of complementary resources?
A sports arena that is home only to an indoor hockey team
In the financial world, the term poison pill refers to:
A tactic to make unfriendly takeover attempts unappealing
Which of the following can cause a project to have multiple IRRs?
A ten-year project has a negative cash flow in the last year of the project's life.
nondiversifiable risk example
A well respected chairman of the Federal Reserve suddenly resigns
The changes in the firm's future cash flows that are a direct consequence of accepting a project are called: A) Incremental cash flows. B) Stand-alone cash flows. C) Aftertax cash flows. D) Net present value cash flows. E) Erosion cash flows.
A) Incremental cash flows.
The discounted payback method: A. considers the time value of money. B. discounts the cutoff point. C. discounts the initial cost. D. is preferred to the NPV method. E. ignores project risks.
A. considers the time value of money.
The changes in a firm's future cash flows that are a direct consequence of accepting a project are called _____ cash flows. A. incremental B. stand-alone C. opportunity D. net present value E. erosion
A. incremental
Interest rates or rates of return on investments that have been adjusted for the effects of inflation are called _____ rates. A. real B. nominal C. effective D. stripped E. coupon
A. real
Which one of the following statements is correct? A. An equity carve-out generates cash for the parent firm. B. A split-up frequently follows a spin-off. C. An equity carve-out is a specific type of acquisition. D. A spin-off involves an initial public offering. E. A divestiture means that the original firm ceases to exist.
A. An equity carve-out generates cash for the parent firm.
An option that may be exercised only on the expiration date is called a(n) _____ option. A. European B. American C. Bermudan D. futures E. Asian
A. European
Which one of the following statements concerning mergers and acquisitions is correct? A. Generally, two-thirds of the shareholders in each firm must approve a merger. B. Acquisitions always result in at least one firm being dissolved. C. The net present value of an acquisition should have no bearing on whether or not the acquisition occurs. D. Acquisitions of assets are generally quite simple and inexpensive from a legal and accounting perspective. E. At least one-half of the shareholders must vote to approve an acquisition of stock.
A. Generally, two-thirds of the shareholders in each firm must approve a merger.
Which one of these is an example of erosion that should be included in project analysis? A. The anticipated loss of current sales when a new product is launched. B. The expected decline in sales as a new product ages. C. The reduction in your sales that occurs when a competitor introduces a new product. D. The sudden loss of sales due to a major employer in your community implementing massive layoffs. E. The reduction in sales price that will most likely be required to sell inventory that has aged.
A. The anticipated loss of current sales when a new product is launched.
Which one of the following statements is true? A. You must know the discount rate to compute the NPV but you can compute the IRR without having a discount rate. B. You must have a discount rate to compute, NPV, IRR, PI, and discounted payback. C. Payback uses the same discount rate as that applied in the NPV calculation. D. Financing projects can only ever have one IRR. E. Discounted payback is a better method than payback and is more frequently used in practice.
A. You must know the discount rate to compute the NPV but you can compute the IRR without having a discount rate.
Which one of the following is most likely a good candidate for an acquisition that could benefit from the use of complementary resources? A. a sports arena that is home only to an indoor hockey team B. a hotel in a busy downtown business district of a major city C. a day care center located near a major route into the main business district of a large city D. an amusement park located in a centralized Florida location E. a fast food restaurant located near a major transportation hub
A. a sports arena that is home only to an indoor hockey team
The shareholders of a target firm benefit the most when: A. an acquiring firm has the better management team and replaces the target firm's managers. B. the management of the target firm is more efficient than the management of the acquiring firm which replaces them. C. the management of both the acquiring firm and the target firm are as equivalent as possible. D. their current management team is kept in place even though the managers of the acquiring firm are more suited to manage the target firm's situation. E. their management team is technologically knowledgeable yet ineffective.
A. an acquiring firm has the better management team and replaces the target firm's managers.
Selling a covered call is equivalent to: A. buying a zero coupon bond and selling a put. B. selling a put and buying an offsetting call. C. buying the stock and selling the call. D. selling a zero coupon bond and buying a put. E. buying a zero coupon bond and buying a call.
A. buying a zero coupon bond and selling a put.
At expiration, the maximum price of a ____ is the greater of the: A. call; stock price minus the exercise price, or 0. B. call; the exercise price or 0. C. put; stock price minus the exercise price, or 0. D. put; stock price or 0. E. put; exercise price or the stock price.
A. call; stock price minus the exercise price, or 0.
Changes in the net working capital: A. can affect the cash flows of a project every year of the project's life. B. only affect the initial cash flows of a project. C. are included in project analysis only if they represent cash outflows. D. are generally excluded from project analysis due to their irrelevance to the total project. E. affect the initial and the final cash flows of a project but not the cash flows of the middle years.
A. can affect the cash flows of a project every year of the project's life.
Changes in the net working capital: A. can affect the cash flows of a project every year of the project's life. B. only affect the initial cash flows of a project. C. are included in project analysis only if they represent cash outflows. D. are generally excluded from project analysis due to their irrelevance to the total project. E. affect the initial and the final cash flows of a project but not the cash flows of the middle years.
A. can affect the cash flows of a project every year of the project's life.
The acquisition of a firm whose business is not related to that of the bidder is called a _____ acquisition. A. conglomerate B. forward C. backward D. horizontal E. vertical
A. conglomerate
A project's operating cash flow will increase when the: A. depreciation expense increases. B. sales projections are lowered. C. interest expense is lowered. D. net working capital requirement increases. E. earnings before interest and taxes decreases.
A. depreciation expense increases
A project's operating cash flow will increase when the: A. depreciation expense increases. B. sales projections are lowered. C. interest expense is lowered. D. net working capital requirement increases. E. earnings before interest and taxes decreases.
A. depreciation expense increases.
The internal rate of return for an investment project is best defined as the: A. discount rate that causes the NPV to equal zero. B. difference between the market rate of interest and the discount rate. C. market rate of interest less the risk-free rate. D. minimum project acceptance rate set by management. E. maximum rate that can be earned for a project to be accepted.
A. discount rate that causes the NPV to equal zero.
The internal rate of return tends to be: A. easier for managers to comprehend than the net present value. B. extremely accurate even when cash flow estimates are faulty. C. ignored by most financial managers. D. used primarily to differentiate between mutually exclusive projects. E. utilized in project analysis only when multiple net present values apply.
A. easier for managers to comprehend than the net present value.
For every positive net present value project that a firm undertakes, the equity in the firm will increase the most if the delta of the call option on the firm's assets is: A. equal to one. B. between zero and one. C. equal to zero. D. between zero and minus one. E. equal to minus one.
A. equal to one.
In a merger or acquisition, an asset should be acquired if it: A. generates a positive net present value to the shareholders of the acquiring firm. B. is a firm in the same line of business in which the acquirer has expertise. C. is a firm in a totally different line of business which will diversify the firm. D. pays a large dividend which will provide a cash pass through to the acquirer. E. increases the firm's market share.
A. generates a positive net present value to the shareholders of the acquiring firm.
An independent investment is acceptable if the profitability index (PI) of the investment is: A. greater than one. B. less than one. C. greater than the internal rate of return. D. less than the internal rate of return. E. greater than a pre-specified rate of return.
A. greater than one.
An in-the-money put option is one that: A. has an exercise price greater than the underlying stock price. B. has an exercise price less than the underlying stock price. C. expires today. D. should not be exercised at expiration. E. should not be exercised at any time.
A. has an exercise price greater than the underlying stock price.
Suppose that Ford and General Motors were to merge. Ignoring potential antitrust problems, this merger would be classified as a(n): A. horizontal merger. B. vertical merger. C. conglomerate merger. D. tax inversion merger. E. equity carve-out merger.
A. horizontal merger.
The top-down approach to computing the operating cash flow: A. ignores all noncash items. B. applies only if a project produces sales. C. can only be used if the entire cash flows of a firm are included. D. is equal to Sales −Costs −Taxes + Depreciation. E. includes the interest expense related to a project.
A. ignores all noncash items.
Shareholders in a levered firm might wish to accept a negative net present value project if it: A. increases the standard deviation of the returns on the firm's assets. B. lowers the variance of the returns on the firm's assets. C. lowers the firm's volatility. D. diversifies the cash flows of the firm. E. decreases the risk that a firm will default on its debt.
A. increases the standard deviation of the returns on the firm's assets.
An investment is acceptable if the payback period: A. is less than some pre-specified period of time. B. exceeds the life of the investment. C. is negative. D. is equal to or greater than some pre-specified period of time. E. is equal to, and only if it is equal to, the investment's life.
A. is less than some pre-specified period of time.
The complete absorption of one company by another, wherein the acquiring firm retains its identity and the acquired firm ceases to exist as a separate entity, is called a: A. merger. B. consolidation. C. tender offer. D. spinoff. E. divestiture.
A. merger.
The difference between the present value of an investment's future cash flows and its initial cost is the: A. net present value. B. internal rate of return. C. payback period. D. profitability index. E. discounted payback period.
A. net present value.
A financial contract that gives its owner the right, but not the obligation, to buy or sell a specified asset at an agreed-upon price on or before a given future date is called a(n) _____ contract. A. option B. futures C. forward D. swap E. straddle
A. option
The relationship between the prices of the underlying stock, a call option, a put option, and a riskless asset is referred to as the _____ relationship. A. put-call parity B. covered call C. protective put D. straddle E. strangle
A. put-call parity
The owner of a European call option has the: A. right but not the obligation to buy a stock at a specified price on a specified date. B. right but not the obligation to buy a stock at a specified price during a specified period of time. C. obligation to buy a stock on a specified date but only at the specified price. D. obligation to buy a stock sometime during a specified period of time at the specified price. E. obligation to buy a stock at the lower of the exercise price or the market price on the expiration date.
A. right but not the obligation to buy a stock at a specified price on a specified date.
Jillian owns an option which gives her the right to purchase shares of WAN stock at a price of $20 a share. Currently, WAN stock is selling for $24.50. Jillian would like to profit on this option but is not permitted to exercise it for another two weeks. She believes the stock will decline in value before the two weeks is up. What should she do? A. sell her option today B. put in an order to exercise her option on its expiration date C. convert her European option into an American option D. put in an order to exercise her option as soon as she is permitted to do so E. convert her American option into a European option
A. sell her option today
A change in the corporate charter making it more difficult for the firm to be acquired by increasing the percentage of shareholders that must approve a merger offer is called a: A. supermajority amendment. B. standstill agreement. C. greenmail provision. D. poison pill amendment. E. white knight provision.
A. supermajority amendment.
No matter how many forms of investment analysis you employ: A. the actual results from a project may vary significantly from the expected results. B. the internal rate of return will always produce the most reliable results. C. a project will never be accepted unless the payback period is met. D. the initial costs will generally vary considerably from the estimated costs. E. only the first three years of a project ever affect its final outcome.
A. the actual results from a project may vary significantly from the expected results.
Assume you purchase one share of a stock and sell a call on a single share of that same stock with an exercise price of $25. What is the maximum payoff you can realize on this combination? A. the exercise price of $25 B. an amount equal to the stock price on the option expiration date C. an amount equal to $25 minus the stock price on the option expiration date D. an amount equal to the stock price on the expiration date plus $25 E. an amount equal to the sum of the exercise price and the stock price on the option expiration date
A. the exercise price of $25
The internal rate of return for a project will increase if: A. the initial cost of the project can be reduced. B. the total amount of the cash inflows is reduced. C. each cash inflow is moved such that it occurs one year later than originally projected. D. the required rate of return is reduced. E. the discount rate is increased.
A. the initial cost of the project can be reduced.
The internal rate of return for a project will increase if: A. the initial cost of the project can be reduced. B. the total amount of the cash inflows is reduced. C. each cash inflow is moved such that it occurs one year later than originally projected. D. the required rate of return is reduced. E. the discount rate is increased.
A. the initial cost of the project can be reduced. *(IRR increase if initial outlay decreases)*
If a project is assigned a required rate of return of zero, then: A. the timing of the project's cash flows has no bearing on the value of the project. B. the project will always be accepted. C. the project will always be rejected. D. whether the project is accepted or rejected will depend on the timing of the cash flows. E. the project can never add value for the shareholders.
A. the timing of the project's cash flows has no bearing on the value of the project.
The primary reason that company projects with positive net present values are considered acceptable is that: A. they create value for the owners of the firm. B. the project's rate of return exceeds the rate of inflation. C. they return the initial cash outlay within three years or less. D. the required cash inflows exceed the actual cash inflows. E. the investment's cost exceeds the present value of the cash inflows.
A. they create value for the owners of the firm
The primary reason that company projects with positive net present values are considered acceptable is that: A. they create value for the owners of the firm. B. the project's rate of return exceeds the rate of inflation. C. they return the initial cash outlay within three years or less. D. the required cash inflows exceed the actual cash inflows. E. the investment's cost exceeds the present value of the cash inflows.
A. they create value for the owners of the firm.
The value of a target firm to the acquiring firm is equal to the: A. value of the target firm as a separate entity plus the synergy derived from the acquisition. B. purchase cost of the target firm. C. value of the merged firm minus the value of the target firm as a separate entity. D. purchase cost plus the incremental value derived from the acquisition. E. incremental value derived from the acquisition.
A. value of the target firm as a separate entity plus the synergy derived from the acquisition.
Lefty's just purchased some equipment that is classified as 7-year property for MACRS. The equipment cost $67,600. The MACRS table values are .1429, .2449, .1749, .1249, and .0893, for Years 1 to 5, respectively. What will the book value of this equipment be at the end of four years? A. $21,118.24 B. $6,036.68 C. $7,040.00 D. $15,081.56 E. $8,443.24
A. $21,118.24 Book value Year 4 = $67,600 * (1 - .1429 - .2449 - .1749 - .1249)] = $21,118.24
A project will produce an operating cash flow of $7,300 a year for three years. The initial cash outlay for equipment will be $11,600. The net aftertax salvage value of $3,500 will be received at the end of the project. The project requires $800 of net working capital that will be fully recovered. What is the net present value of the project if the required rate of return is 11 percent? A. $8,583.24 B. $9,896.87 C. $8,368.19 D. $9,353.41 E. $7,398.29
A. $8,583.24 NPV = -$11,600 - 800 + $7,300[(1 - 1/1.113)/.11] + ($3,500 + 800)/1.113 = $8,583.24
A project has an initial cash inflow of $95,500 and cash flows of -$48,700 in Year 1 and -$57,200 in Year 2. The discount rate is 9 percent. Should this project be accepted or rejected based on IRR? Why? A. Accepted: because the IRR of 6.98 percent is less than the discount rate B. Accepted: because the IRR of 8.21 percent is less than the discount rate C. Accepted: because the IRR of 8.78 percent is less than the discount rate D. Rejected: because the IRR of 8.21 percent is less than the discount rate E. Rejected: because the IRR of 6.98 percent is less than the discount rate
A. Accepted: because the IRR of 6.98 percent is less than the discount rate IRR = $95,500 + (-$48,700)/(1 + IRR) + (-$57,200)/(1 + IRR)2 IRR = 6.98% NPV = $95,500 - $48,700/1.09 - $57,200/1.092 NPV = $2,677.01 Because this is a financing type project, the project should be accepted since the IRR of 6.98 percent is less than the discount rate of 9 percent. This is verified by the positive NPV at the 9 percent rate.
Which of the following statement is true? A. One must know the discount rate to compute the NPV of a project but one can compute the IRR without referring to the discount rate. B. One must know the discount rate to compute the IRR of a project but one can compute the NPV without referring to the discount rate. C. Payback accounts for time value of money D. There will always be one IRR regardless of cash flows
A. One must know the discount rate to compute the NPV of a project but one can compute the IRR without referring to the discount rate.
What is the key reason why a positive NPV project should be accepted? A. The project is expected to increase shareholder value. B. The present value of the expected cash flows equal the project's cost. C. The firm will earn a return equal to the NPV value at the end of the project. D. The project will have a payback period equal to its life. E. The project's PI will be less than 1, which also indicates acceptance.
A. The project is expected to increase shareholder value.
Given that the net present value (NPV) is generally considered to be the best method of analysis, why should you still use the other methods?
A. You need to use other methods because the net present value method is unreliable when a project has unconventional cash flows
The payback method is a convenient and useful tool because: A. it provides a quick estimate of how rapidly an initial investment will be recouped. B. it considers all of a project's relevant cash flows. C. it considers the time value of money. D. the required payback period for all of a firm's projects must be identical. E. it only considers the cash flows within the current period of 12 months.
A. it provides a quick estimate of how rapidly an initial investment will be recouped.
A financial contract that gives its owner the right, but not the obligation, to buy or sell a specified asset at an agreed-upon price on or before a given future date is called a(n) _____ contract.
A. option
No matter how many forms of investment analysis you perform: A. the actual results from a project may vary significantly from the expected results. B. the internal rate of return will always produce the most reliable results. C. a project will never be accepted unless the payback period is met. D. only the first three years of a project ever affect its final outcome. E. the initial costs will generally vary considerably from the estimated costs.
A. the actual results from a project may vary significantly from the expected results.
If a project is assigned a required rate of return equal to zero, then: A. the timing of the project's cash flows has no bearing on the value of the project. B. the project will always be accepted. C. the project will always be rejected. D. whether the project is accepted or rejected will depend on the timing of the cash flows. E. the project can never add value for the shareholders
A. the timing of the project's cash flows has no bearing on the value of the project
Which capital investment evaluation technique offers the following advantages? (1) Easy to calculate; (2) Needed information will usually be available
AAR
You are considering two independent projects. The required rate of return is 13.75 percent for Project A and 14.25 percent for Project B. Project A has an initial cost of $51,400 and cash inflows of $21,400, $24,900, and $22,200 for Years 1 to 3, respectively. Project B has an initial cost of $38,300 and cash inflows of $23,000 a year for 2 years. Which project(s), if either, should you accept?
Accept A and reject B NPVA = -$51,400 + ($21,400 / 1.1375) + ($24,900 / 1.13752) + ($22,200 / 1.13753) = $1,740.62; Accept NPVB = -$38,300 + ($23,000 / 1.1425) + ($23,000 / 1.14252) = -$548.32; Reject
Isaac has analyzed two mutually exclusive projects that have 3-year lives. Project A has an NPV of $81,406, a payback period of 2.48 years, and an AAR of 9.31 percent. Project B has an NPV of $82,909, a payback period of 2.57 years, and an AAR of 9.22 percent. The required return for Project A is 11.5 percent while it is 12 percent for Project B. Both projects have a required AAR of 9.25 percent. Isaac must make a recommendation and justify it in 15 words or less. What should his recommendation be?
Accept Project B and reject Project A because Project B has a higher NPV
Payback period Decision Criteria
Accept if the payback period is less than the policy payback time
You know that two mutually exclusive projects are of different sizes. The smaller project is known to have a positive NPV. Which one of these accurately describes a method of properly determining which one, if either, project should be accepted?
Accept the larger project if the incremental IRR exceeds the discount rate
Discounted Payback Period Decision Criteria
Accept the project if it pays back on a discounted basis within the specified time
IRR decision criteria
Accept the project if the IRR is greater than the required return
A mutually exclusive project is a project whose:
Acceptance or rejection affects other projects.
When the present value of the cash inflows exceeds the initial cost of a project, then the project should be:
Accepted because the profitability index is greater than 1.
A project has an initial cash inflow of $95,500 and cash flows of -$48,700 in Year 1 and -$57,200 in Year 2. The discount rate is 9 percent. Should this project be accepted or rejected based on IRR? Why? Accepted: because the IRR of 6.98 percent is less than the discount rate Accepted: because the IRR of 8.21 percent is less than the discount rate Accepted: because the IRR of 8.78 percent is less than the discount rate Rejected: because the IRR of 8.21 percent is less than the discount rate Rejected: because the IRR of 6.98 percent is less than the discount rate
Accepted: because the IRR of 6.98 percent is less than the discount rate
Benji's has an opportunity with an initial cash flow of $48,900 and future cash flows of -$31,300 in Year 1 and -$21,600 in Year 2. The discount rate is 7 percent. Should this project be accepted or rejected? Why? Accepted; because the IRR of 5.28 percent is less than the discount rate Accepted; because the IRR of 5.77 percent is less than the discount rate Rejected: because the IRR of 5.28 percent is less than the discount rate Rejected; because the IRR of 5.77 percent is less than the discount rate Rejected; because the IRR of 6.01 percent is less than the discount rate
Accepted; because the IRR of 5.77 percent is less than the discount rate
9.39% 6.10%
Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 16 years to maturity that is quoted at 105 percent of face value. The issue makes semiannual payments and has a coupon rate of 10 percent annually.
Sway's Market is considering a project that will require the purchase of $1.4 million in new equipment. The equipment will be depreciated straight-line to zero over the 5-year life of the project. The firm expects to sell the equipment at the end of the project for 20 percent of its original cost. New net working capital equal to 10 percent of sales will be required to support the project. All of the new net working capital will be recouped at the end of the project. Annual sales are estimated at $750,000 with costs of $338,000. The required rate of return is 12 percent and the tax rate is 34 percent. What is the amount of the aftertax salvage value of the equipment?
Aftertax salvage value = ($1,400,000 × .20) × (1 - .34) = $184,800
Margarite's Enterprises is considering a new project that will require $345,000 for new fixed assets, $160,000 for inventory, and $35,000 for accounts receivable. Short-term debt is expected to increase by $110,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to zero over the life of the project. At the end of the project, the fixed assets can be sold for 25 percent of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $550,000 and costs of $430,000. The tax rate is 35 percent and the required rate of return is 15 percent. What is the amount of the aftertax cash flow from the sale of the fixed assets at the end of this project?
Aftertax salvage value = .25 × $345,000 × (1 - .35) = $56,062.50
D) the rate of return decreases.
All else constant, the net present value of a typical investment project increases when A) the discount rate increases. B) each cash inflow is delayed by one year. C) the initial cost of a project increases. D) the rate of return decreases. E) all cash inflows are moved to the last year of the project.
B) cash inflows are moved earlier in time.
All else equal, the payback period for a project will decrease whenever the A) duration of a project is lengthened. B) cash inflows are moved earlier in time. C) assigned discount rate decreases. D) required return for a project increases. E) initial cost increases.
The payback period rule is a convenient and useful tool because:
All of the above.
An option that may be exercised at any time up to its expiration date is called a(n) _____ option.
American
Carie opted to exercise her May option on April 3rd and received $1,750 in exchange for her shares. She must have owned a(n):
American put
Which one of the following provides the option of selling a stock anytime during the option period at a specified price even if the market price of the stock declines to zero?
American put
_____________ is a type of transaction which must be approved by a formal vote of the shareholders of the selling firm and which, when completed, leaves the selling firm as a corporate shell.
An acquisition of assets
Which one of these statements related to MACRS depreciation is correct?
An asset will be depreciated faster using MACRS rather than the straight-line method.
A) is acceptable if its calculated payback period is less than some pre-specified period of time.
An investment A) is acceptable if its calculated payback period is less than some pre-specified period of time. B) should be accepted if the payback is positive and rejected if it is negative. C) should be rejected if the payback is positive and accepted if it is negative. D) is acceptable if its calculated payback period is greater than some prespecified period of time. E) should be accepted any time the payback period is less than the discounted payback period, given a positive discount rate.
The average accounting return (AAR) rule can be best stated as:
An investment is acceptable if its AAR exceeds a target AAR.
The internal rate of return (IRR) rule can be best stated as:
An investment is acceptable if its IRR exceeds the required return, or else it should be rejected.
The profitability index (PI) rule can be best stated as:
An investment is acceptable if its PI is greater than one.
The payback rule can be best stated as:
An investment is acceptable if its calculated payback period is less than some pre-specified number of years
Which one of the following statements is correct concerning the payback period? A. An investment is acceptable if its calculated payback period is less than some pre-specified period of time. B. An investment should be accepted if the payback is positive and rejected if it is negative. C. An investment should be rejected if the payback is positive and accepted if it is negative. D. An investment is acceptable if its calculated payback period is greater than some pre-specified period of time. E. An investment should be accepted any time the payback period is less than the discounted payback period, given a positive discount rate
An investment is acceptable if its calculated payback period is less than some pre-specified period of time.
The discounted payback rule can be best stated as:
An investment is acceptable if its discounted payback period is less than some prespecified number of years
A) greater than one.
An investment is acceptable if the profitability index (PI) of the investment is A) greater than one. B) less than one. C) greater than the internal rate of return (IRR). D) less than the net present value (NPV). E) greater than a pre-specified rate of return.
Which one of the following statements concerning net present value (NPV) is correct?
An investment should be accepted if the NPV is positive and rejected if it is negative
The net present value (NPV) rule can be best stated as:
An investment should be accepted if the NPV is positive and rejected if it is negative.
Which one of the following statements concerning net present value (NPV) is correct? A. An investment should be accepted if, and only if, the NPV is exactly equal to zero. B. An investment should be accepted only if the NPV is equal to the initial cash flow. C. An investment should be accepted if the NPV is positive and rejected if it is negative. D. An investment with greater cash inflows than cash outflows, regardless of when the cash flows occur, will always have a positive NPV and therefore should always be accepted. E. Any project that has positive cash flows for every time period after the initial investment should be accepted
An investment should be accepted if the NPV is positive and rejected if it is negative.
Announcements and News
Announcement = Expected part + Surprise - It is the surprise component that affects a stock's price and, therefore, its return. - This is very obvious when we watch how stock prices move when an unexpected announcement is made or earnings are different than anticipated
The incremental cash flows of a project are best defined as: -The cash received from the additional sales generated by the project. -Any change in a firm's cash flows resulting from the addition of the project including opportunity costs. -The cash received or lost from changes in -The sales of a firm's current products as a result of adding the project. -The increase or decrease in a firm's cash flows resulting from adding the project, excluding all sunk and opportunity costs. -The total cash flows of a firm once the new project is completely integrated into the firm's operations.
Any change in a firm's cash flows resulting from the addition of the project including opportunity costs.
A trading opportunity that offers a riskless profit is called a(n):
Arbitrage
B) internal rate of return will exceed its required rate of return.
Assume a project has normal cash flows and a positive (non-zero) net present value. The project's A) profitability index will be less than 1. B) internal rate of return will exceed its required rate of return. C) costs exceed its benefits. D) discounted payback period will exceed the life of the project. E) payback period must equal the life of the project.
C) IRR exceeds the required return.
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the A) PI is less than 1. B) AAR is less than the required AAR. C) IRR exceeds the required return. D) payback period is less than the life of the project. E) discounted payback period is less than the life of the project.
C) if the NPV is positive and reject it if the NPV is negative.
Assume a project has normal cash flows. Given this, you should accept the project A) if, and only if, the NPV is exactly equal to zero. B) only if the NPV is equal to the initial cash flow. C) if the NPV is positive and reject it if the NPV is negative. D) if the total cash inflows exceed the initial cash outflow. E) because it has positive cash flows for every time period after the initial investment.
Call Option Pricing at Expiry
At expiry, an American call option is worth the same as a European option with the same characteristics. - If the call is in-the-money, it is worth ST - E. - If the call is out-of-the-money, it is worthless: C = Max[ST - E, 0] Where ST is the value of the stock at expiry (time T) E is the exercise price. C is the value of the call option at expiry
Aspens is preparing a bond offering with a coupon rate of 5.5 percent. The bonds will be repaid in 10 years. The company plans to issue the bonds at par value and pay interest semiannually. Which one of the following statements is correct?
At issuance, the bond's yield to maturity is 5.5 percent.
Which one of the following statements is correct?
At the accounting break-even level, the pretax profit is equal to the aftertax profit.
terminal cash flows example
At the end of a project, equipment that will then have a book value of $100,000 is estimated to have a resale value of $500,000. In addition, net working capital of $50,000 is recovered. The tax rate is 50%. What terminal cash flows should be included? FCF = EBIT * (1 - t) + Depr - CAPX - change in NWC Thus, the terminal cash flow generated by disposal of an asset used for a project can be calculated as CFt = RVt - (TVt - BVt) * t Where: RVt = estimated resale value of asset at end of project (time T) BVt = projected book value of asset at end of project t = tax rate
Which of the following does NOT incorporate discounted cash flow (DCF) valuation in its calculation?
Average accounting return
Which of the following is calculated using ONLY accounting numbers?
Average accounting return
An investment's average net income divided by its average book value is the:
Average accounting return.
Average accounting return is defined as:
Average net income divided by average book value
A 35 put option on FKL stock expires today. The current price of the stock is $36. The put is A) at the money. B) out of the money. C) in the money. D) funded. E) unfunded.
B
A ____ period prohibits executives from exercising their options for a stated period of time. A. investing B. freeze-out C. valuation D. guaranteed E. strike
B
A _____ is a derivative security that gives the owner the right, but not the obligation, to buy an asset at a fixed price for a specified period of time. A. futures contract B. call option C. put option D. swap E. forward contract
B
An ________ is a derivative security that gives the owner the right, but not the obligation, to sell an asset at a fixed price on the expiration date. A) American call option B) European put option C) American put option D) Euro-American swap E) European call option
B
An increase in which one of the following will decrease the value of a call option? A. interest rate B. exercise price C. time to expiration D. stock volatility E. underlying asset price
B
An out-of-the-money call option is best defined as an option that: A. has an exercise price below the current market price of the underlying security. B. should not be exercised. C. has an exercise price equal to the current market price of the underlying security. D. has expired. E. qualifies as an American option.
B
Assume you are determining the risk-neutral probabilities of a price increase and decrease. In this situation, you know the expected return on the asset must equal the: A. sponsoring firm's cost of capital. B. risk-free rate. C. market rate of return. D. annual inflation rate. E. CAPM rate of return.
B
Hi-Tech announces a major expansion which causes the price of its stock to increase and also causes an increase in the volatility of the stock price. How will these two market reactions affect the value of call options on Hi-Tech stock? A. Both reactions decrease the value of the call options. B. Both reactions increase the value of the call options. C. Neither reaction will affect call option values. D. The reactions will have offsetting effects on call option prices. E. The change in volatility will not affect call option values while the increased stock price will increase the call option values.
B
If the risk of an investment project is different than the firm's risk then: A. you must adjust the discount rate for the project based on the firm's risk. B. you must adjust the discount rate for the project based on the project risk. C. you must exercise risk aversion and use the market rate. D. an average rate across prior projects is acceptable because estimates contain errors. E. one must have the actual data to determine any differences in the calculations.
B
If you consider stockholders to be the owners of a firm, then those stockholders: A. own a call option on the firm with an exercise price equal to the firm's total equity. B. own a put option on the firm with an exercise price equal to the firm's total debt. C. have written a put option on the firm with an exercise price equal to the firm's total equity. D. have written a call option on the firm with an exercise price equal to the firm's total debt. E. own a put option on the firm with an exercise price equal to the firm's total assets.
B
The act where an owner of an option buys or sells the underlying asset, as is his right, is called ______ the option. A. striking B. exercising C. opening D. splitting E. strangling
B
The binomial option pricing model is: A. bell-curve shaped. B. symmetrical. C. hyperbolic. D. asymmetric. E. curvilinear.
B
The cost of equity for Ryan Corporation is 8.4%. If the expected return on the market is 10% and the risk-free rate is 5%, then the equity beta is ___. A. 0.48 B. 0.68 C. 1.25 D. 1.68 E. Impossible to calculate with information given.
B
The intrinsic value of a put is equal to the: A) lesser of the stock price minus the exercise price or zero. B) greater of the strike price minus the stock price or zero. C) lesser of the stock price or zero. D) lesser of the strike price or the stock price. E) greater of the stock price minus the exercise price or zero.
B
The lower bound on a call's value is defined as the: A. greater of the strike price or zero. B. greater of the stock price minus the exercise price or zero. C. lesser of the strike price or the stock price. D. lesser of the strike price or zero. E. lesser of the stock price minus the exercise price or zero.
B
The relationship between the prices of the underlying stock, a call option, a put option, and a riskless asset is referred to as the ________ relationship. A) covered call B) put-call parity C) protective put D) straddle E) strangle
B
The seller of a call option makes the most profit when the option A) is exercised immediately. B) expires without being exercised. C) is in the money. D) is converted into shares. E) is not exercised until the expiration date.
B
The seller of a put option on 100 shares of stock makes the most profit when the A) option is exercised immediately. B) stock price exceeds the exercise price throughout the option period. C) exercise price exceeds the stock price throughout the option period. D) option is converted into shares. E) is not exercised until the expiration date.
B
To compute the value of a put using the Black-Scholes option pricing model, you: A. first have to apply the put-call parity relationship. B. first have to compute the value of both N(-d1) and N(-d2). C. compute the value of an equivalent call and then subtract that value from one. D. compute the value of an equivalent call and then subtract that value from the market price of the stock. E. compute the value of an equivalent call and then multiply that value by e-RT.
B
Which one of the following statements concerning call option writers is false? A. Writers promise to deliver shares if the call option is exercised by the buyer. B. The writer has the option to sell shares but not an obligation. C. The writer's payoff is zero if the option expires out-of-the-money. D. The writer receives a cash payment when the option is purchased. E. The writer incurs a loss if the market price rises substantially above the exercise price.
B
Which one of these combinations is a protective put? A) Writing identical puts and calls on the same asset B) Buying a put and buying the underlying asset C) Selling a call and buying the underlying asset D) Buying a call and selling the underlying asset E) Selling a put and buying the underlying asset
B
With the binominal option pricing model, it is reasonable to assume: A. there is a varying rate of price change from one time interval to the next time interval. B. any new information impacting prices is similar from one interval to another interval. C. the discount rate increases with each time interval. D. the call price will only be usable if the time interval is extremely small. E. that each project is limited to two outcomes over its life.
B
You can realize the same value as that derived from stock ownership if you A) sell a put option and invest at the risk-free rate of return. B) sell a put and buy a call on the stock as well as invest at the risk-free rate of return. C) buy a call option and write a put option on a stock and also lend out funds at the risk-free rate. D) lend out funds at the risk-free rate of return and sell a put option on the stock. E) borrow funds at the risk-free rate of return and invest the proceeds in equivalent amounts of put and call options.
B
You own an October 12 call and an October 12 put on SC stock. If the call finishes in the money, then the put will A) also finish in the money. B) finish out of the money. C) finish at the money. D) either finish at the money or out of the money. E) either finish at the money or in the money.
B
You own stock in a firm that has a pure discount loan due in 6 months. The loan has a face value of $50,000. The assets of the firm are currently worth $62,000. The stockholders in this firm basically own a ________ option on the assets of the firm with a strike price of ________. A) put; $62,000. B) call; $50,000. C) warrant; $62,000. D) call; $62,000. E) put; $50,000.
B
Using the internal rate of return method, a conventional investment project should be accepted if the internal rate of return is: A. equal to the discount rate. B. greater than the discount rate. C. less than the discount rate. D. negative. E. positive.
B. greater than the discount rate.
Hi-Tech announces a major expansion which causes the price of its stock to increase and also causes an increase in the volatility of the stock price. How will these two market reactions affect the value of call options on Hi-Tech stock? A. Both reactions decrease the value of the call options. B. Both reactions increase the value of the call options. C. Neither reaction will affect call option values. D. The reactions will have offsetting effects on call option prices. E. The change in volatility will not affect call option values while the increased stock price will increase the call option values.
B. Both reactions increase the value of the call options.
Graham and Harvey (2001) found that _____ were the two most popular capital budgeting methods. A. IRR and payback B. IRR and NPV C. NPV and PI D. IRR and modified IRR E. discounted payback and NPV
B. IRR and NPV
Comparing the NPV profile of an investment project to that of a financing project demonstrates why the: A. incremental IRR varies with changes in the market rate of interest. B. IRR decision rule for investment projects is the opposite of the rule for financing projects. C. life span of a project affects the decision as to which project to accept. D. NPV rule for financing projects is the opposite of the rule for investment projects. E. profitability index and the net present value are related.
B. IRR decision rule for investment projects is the opposite of the rule for financing projects.
The depreciation method currently allowed under U.S. tax law governing the accelerated write-off of property under various lifetime classifications is called _____ depreciation. A. FIFO B. MACRS C. straight-line D. sum-of-years digits E. curvilinear
B. MACRS
Which one of the following statements concerning call option writers is false? A. Writers promise to deliver shares if the call option is exercised by the buyer. B. The writer has the option to sell shares but not an obligation. C. The writer's payoff is zero if the option expires out-of-the-money. D. The writer receives a cash payment when the option is purchased. E. The writer incurs a loss if the market price rises substantially above the exercise price.
B. The writer has the option to sell shares but not an obligation.
Which one of the following combinations of firms would benefit the most through the use of complementary resources? A. a ski resort and a travel trailer sales outlet B. a golf resort and a ski resort C. a hotel and a home improvement center D. a swimming pool distributor and a kitchen designer E. a fast food restaurant and a dry cleaner
B. a golf resort and a ski resort
In a merger the: A. legal status of both the acquiring firm and the target firm is terminated. B. acquiring firm retains its name and legal status. C. acquiring firm acquires the assets but not the liabilities of the target firm. D. stockholders of the target firm have little, if any, say as to whether or not the merger occurs. E. target firm always continues to exist as a subsidiary of the acquiring firm.
B. acquiring firm retains its name and legal status.
One company wishes to acquire another. Which one of the following does not require a formal vote by the shareholders of the acquired firm? A. merger B. acquisition of stock C. horizontal acquisition of assets D. consolidation E. vertical acquisition of assets
B. acquisition of stock
Assume a merger of two levered firms produced no synergy. In this case, the: A. acquiring firm shareholders would neither gain nor lose any value. B. bondholders probably benefit at shareholders' expense. C. diversification effect would only benefit the acquired firm's shareholders. D. combined shareholders would benefit at the expense of all debt holders. E. shareholders and bondholders would fail to realize any benefits or losses.
B. bondholders probably benefit at shareholders' expense.
A _____ is a derivative security that gives the owner the right, but not the obligation, to buy an asset at a fixed price for a specified period of time. A. futures contract B. call option C. put option D. swap E. forward contract
B. call option
A merger in which an entirely new firm is created and both the acquired and acquiring firms cease to exist is called a: A. divestiture. B. consolidation. C. tender offer. D. spinoff. E. conglomeration.
B. consolidation.
Which of the following methods of project analysis are biased towards short-term projects? A. profitability index and internal rate of return B. discounted payback and payback C. net present value and payback D. payback and profitability index E. profitability index and discounted payback
B. discounted payback and payback
If an acquisition does not create value, then the: A. earnings per share of the acquiring firm must be the same both before and after the acquisition. B. earnings per share can change but the stock price of the acquiring company should remain constant. C. price per share of the acquiring company should increase because of the growth of the firm. D. earnings per share will most likely increase while the price-earnings ratio remains constant. E. price-earnings ratio should remain constant regardless of any changes in the earnings per share.
B. earnings per share can change but the stock price of the acquiring company should remain constant.
One purpose of identifying all of the incremental cash flows related to a proposed project is to: A. isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm. B. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project. C. make each project appear as profitable as possible for the firm. D. include both the proposed and the current operations of a firm in the analysis of the project. E. identify any and all changes in the cash flows of the firm for the past year so they can be included in the analysis.
B. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project.
One purpose of identifying all of the incremental cash flows related to a proposed project is to: A. isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm. B. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project. C. make each project appear as profitable as possible for the firm. D. include both the proposed and the current operations of a firm in the analysis of the project. E. identify any and all changes in the cash flows of the firm for the past year so they can be included in the analysis.
B. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project.
The sale of stock in a wholly owned subsidiary via an initial public offering is referred to as a(n): A. split-up. B. equity carve-out. C. counter-tender offer. D. white knight transaction. E. lockup transaction.
B. equity carve-out.
An increase in which one of the following will decrease the value of a call option? A. interest rate B. exercise price C. time to expiration D. stock volatility E. underlying asset price
B. exercise price
The act where an owner of an option buys or sells the underlying asset, as is his right, is called ______ the option. A. striking B. exercising C. opening D. splitting E. strangling
B. exercising
To compute the value of a put using the Black-Scholes option pricing model, you: A. first have to apply the put-call parity relationship. B. first have to compute the value of both N(-d1) and N(-d2). C. compute the value of an equivalent call and then subtract that value from one. D. compute the value of an equivalent call and then subtract that value from the market price of the stock. E. compute the value of an equivalent call and then multiply that value by e-RT.
B. first have to compute the value of both N(-d1) and N(-d2).
The discount rate that makes the net present value of an investment exactly equal to zero is called the: A. external rate of return. B. internal rate of return. C. average accounting return. D. profitability index. E. equalizer.
B. internal rate of return.
Net present value: A. cannot be used when deciding between two mutually exclusive projects. B. is more useful than the internal rate of return when comparing different sized projects. C. is rarely used by small firms according to the Graham and Harvey survey. D. is not as widely used in practice as payback and discounted payback. E. ignores the risk of a project.
B. is more useful than the internal rate of return when comparing different sized projects.
Net present value: A. cannot be used when deciding between two mutually exclusive projects. B. is more useful than the internal rate of return when comparing different sized projects. C. is rarely used by small firms according to the Graham and Harvey survey. D. is not as widely used in practice as payback and discounted payback. E. ignores the risk of a project.
B. is more useful than the internal rate of return when comparing different sized projects.
For investment projects, the internal rate of return (IRR): A. rule indicates acceptance of an investment when the IRR is less than the discount rate. B. is the rate generated solely by the cash flows of the investment. C. is used primarily to rank projects of varying sizes. D. is the rate that causes the net present value of a project to equal the project's initial cost. E. can effectively be used to compare all types of projects.
B. is the rate generated solely by the cash flows of the investment.
The profitability index: A. rule often results in decisions that conflict with the decisions based on the net present value rule. B. is useful as a decision tool when investment funds are limited and all available funds are allocated. C. method is most commonly used when deciding between mutually exclusive projects of varying size. D. rule adjusts for a project's size when determining which one of two projects to accept. E. produces results which typically are difficult to comprehend.
B. is useful as a decision tool when investment funds are limited and all available funds are allocated.
Erosion can be explained as the: A. additional income generated from the sales of a newly added product. B. loss of current sales due to a new project being implemented. C. loss of revenue due to employee theft. D. loss of revenue due to customer theft. E. loss of cash due to the expenses required to fix a parking lot after a heavy rain storm.
B. loss of current sales due to a new project being implemented.
If you consider stockholders to be the owners of a firm, then those stockholders: A. own a call option on the firm with an exercise price equal to the firm's total equity. B. own a put option on the firm with an exercise price equal to the firm's total debt. C. have written a put option on the firm with an exercise price equal to the firm's total equity. D. have written a call option on the firm with an exercise price equal to the firm's total debt. E. own a put option on the firm with an exercise price equal to the firm's total assets.
B. own a put option on the firm with an exercise price equal to the firm's total debt.
An attempt to gain control of a firm by soliciting a sufficient number of stockholder votes to replace the current board of directors is called a: A. tender offer. B. proxy contest. C. going-private transaction. D. leveraged buyout. E. consolidation.
B. proxy contest.
An out-of-the-money call option is best defined as an option that: A. has an exercise price below the current market price of the underlying security. B. should not be exercised. C. has an exercise price equal to the current market price of the underlying security. D. has expired. E. qualifies as an American option.
B. should not be exercised.
A contract wherein the bidding firm agrees to limit its holdings in the target firm is called a: A. supermajority amendment. B. standstill agreement. C. greenmail provision. D. poison pill amendment E. white knight provision.
B. standstill agreement.
The bottom-up approach to computing the operating cash flow applies only when: A. both the depreciation expense and the interest expense are equal to zero. B. the interest expense is equal to zero. C. the project is a cost-cutting project. D. no fixed assets are required for the project. E. taxes are ignored and the interest expense is equal to zero.
B. the interest expense is equal to zero.
The bottom-up approach to computing the operating cash flow applies only when: A. both the depreciation expense and the interest expense are equal to zero. B. the interest expense is equal to zero. C. the project is a cost-cutting project. D. no fixed assets are required for the project. E. taxes are ignored and the interest expense is equal to zero.
B. the interest expense is equal to zero.
The elements that cause problems with the use of the IRR in projects that are mutually exclusive are referred to as the: A. discount rate and scale problems. B. timing and scale problems. C. discount rate and timing problems. D. scale and reversing flow problems. E. timing and reversing flow problems.
B. timing and scale problems.
Suppose that Arby's acquired a meat packing house. This merger would be classified as a: A. monopolistic merger. B. vertical merger. C. conglomerate merger. D. horizontal merger. E. spin off.
B. vertical merger.
The pro forma income statement for a cost reduction project: A. will reflect a reduction in the sales of the firm. B. will generally reflect no incremental sales. C. has to be prepared reflecting the total sales and expenses of the entire firm. D. cannot be prepared due to the lack of any project related sales. E. will always reflect a negative project operating cash flow.
B. will generally reflect no incremental sales.
Global Enterprises has spent $134,000 on research developing a new type of shoe. For this shoe to now be manufactured, the firm will need to expand into an empty building that it currently owns. The firm was offered $229,000 last week for that building. An additional $342, 000 will be required for new equipment and building improvements. Labor and material costs are estimated at $4.98 per pair of shoes. Interest expense on the loan needed to finance the production of this new shoe will be $17,800 a year. Which one of these correctly identifies the sunk costs? A. $229,000 value of the building B. $134,000 for research C. $229,000 value of the building plus $342,000 for new equipment and improvements D. $17,800 for interest plus $134,000 for research E. $229,000 for the building plus $134,000 for research
B. $134,000 for research
Turkey Hill Motor Homes currently sells 1,200 Class A motor homes, 2,600 Class C motor homes, and 4,000 pop-up trailers each year. It is considering adding a mid-range camper and expects that if it does so the firm can sell 1,500 of them. However, if the new camper is added, the firm expects its Class A sales to decline by 10 percent while the Class C camper sales decline to 2,100 units. The sales of pop-ups will not be affected. Class A motor homes sell for an average of $162,000 each. Class C homes are priced at $59,500 and the pop-ups sell for $5,500 each. The new mid-range camper will sell for $32,900. What is the erosion cost? A. $36,250,000 B. $49,190,000 C. $49,350,000 D. $160,000 E. $118,000
B. $49,190,000 Erosion cost = [.10 × 1,200 × $162,000] + [(2,600 - 2,100) × $59,500] = $49,190,000
A project requires an initial investment of $21,600 and will produce cash inflows of $4,900, $14,200, and $8,700 over the next three years, respectively. What is the project's NPV at a required return of 14 percent? A. -$287.22 B. -$503.06 C. $6,200.00 D. $21,096.94 E. $42,696.94
B. -$503.06 NPV = -$21,600 + $4,900/1.14 + $14,200/1.142 + $8,700/1.143 = -$503.06
Benji's has an opportunity with an initial cash flow of $48,900 and future cash flows of -$31,300 in Year 1 and -$21,600 in Year 2. The discount rate is 7 percent. Should this project be accepted or rejected? Why? A. Accepted; because the IRR of 5.28 percent is less than the discount rate B. Accepted; because the IRR of 5.77 percent is less than the discount rate C. Rejected: because the IRR of 5.28 percent is less than the discount rate D. Rejected; because the IRR of 5.77 percent is less than the discount rate E. Rejected; because the IRR of 6.01 percent is less than the discount rate
B. Accepted; because the IRR of 5.77 percent is less than the discount rate IRR = $48,900 + [-$31,300/(1 + IRR)] + [-$21,600/(1 + IRR)2] IRR = 5.77% NPV = $48,900 + (-$31,300/1.07) + (-$21,600/1.072) = $781.39 Since this is a financing type project, the project should be accepted because the IRR is less than the discount rate. This is confirmed by the positive NPV computed using the discount rate.
Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and aftertax income of $74,200? A. Depreciation increases the net book value of the firm's assets. B. Depreciation in a non-cash expense that increases the firm's cash flows. C. Depreciation lowers the firm's net income but does not affect its cash flows. D. Depreciation has no effect on either the firm's net income or its cash flows. E. Depreciation decreases both the firm's net income and its cash flows.
B. Depreciation in a non-cash expense that increases the firm's cash flows.
When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: A. accepted because the internal rate of return is positive. B. accepted because the profitability index is greater than 1. C. accepted because the profitability index is negative. D. rejected because the internal rate of return is negative. E. rejected because the net present value is negative
B. accepted because the profitability index is greater than 1.
The incremental cash flows of a project are best defined as: A. the cash received from the additional sales generated by the project. B. any change in a firm's cash flows resulting from the addition of the project including opportunity costs. C. the cash received or lost from changes in the sales of a firm's current products as a result of adding the project. D. the increase or decrease in a firm's cash flows resulting from adding the project, excluding all sunk and opportunity costs. E. the total cash flows of a firm once the new project is completely integrated into the firm's operations.
B. any change in a firm's cash flows resulting from the addition of the project including opportunity costs.
One advantage of the payback method of project analysis is the method's: A. application of a discount rate to each separate cash flow. B. bias towards liquidity. C. difficulty of use. D. arbitrary cutoff point. E. consideration of all relevant cash flows.
B. bias towards liquidity.
Two key weaknesses of the internal rate of return rule are the: A. arbitrary determination of a discount rate and failure to consider initial expenditures. B. failure to correctly analyze mutually exclusive projects and the multiple rate of return problem. C. failure to consider all cash flows and the multiple rate of return problem. D. failure to consider initial expenditures and failure to correctly analyze mutually exclusive projects. E. failure to correctly analyze mutually exclusive projects and the lack of clear-cut decision rule.
B. failure to correctly analyze mutually exclusive projects and the multiple rate of return problem.
Analysis using the profitability index: A. frequently conflicts with the accept and reject decisions generated by the application of the net present value rule. B. is useful as a decision tool when investment funds are limited. C. cannot be used to aid capital rationing. D. utilizes the same basic variables as those used in the average accounting return. E. produces results which typically are difficult to comprehend or apply
B. is useful as a decision tool when investment funds are limited
The Liberty Co. is considering two projects. Project A consists of building a wholesale book outlet on lot #169 of the Englewood Retail Center. Project B consists of building a sit-down restaurant on lot #169 of the Englewood Retail Center. When trying to decide whether to build the book outlet or the restaurant, management should rely most heavily on the analysis results from the _____ method of analysis. A. profitability index B. net present value C. payback D. internal rate of return E. accounting rate of return
B. net present value
A proposed project has a positive net present value. If this project is accepted, then: A. the firm made an incorrect accept/reject decision. B. shareholder wealth will increase. C. shareholder wealth will remain constant. D. the value of the firm will decrease. E. the value of the firm will remain constant.
B. shareholder wealth will increase.
You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost. A. opportunity B. sunk C. incremental D. fixed E. relevant
B. sunk
The elements that cause problems with the use of the IRR in projects that are mutually exclusive are: A. the discount rate and scale problems. B. timing and scale problems. C. the discount rate and timing problems. D. scale and reversing flow problems. E. timing and reversing flow problems.
B. timing and scale problems.
Financial Intermediaries
Banks, mutual funds, insurance companies, pension funds
Klamath corporation, a maker of hardwood furniture, is considering a new project to produce porch swings. After careful analysis, Klamath estimates that the appropriate discount rate for evaluating this investment is 14.2%. After equally careful analysis, Klamath has estimated the cash flows relevant for this project to be the following: Year 0 1 2 3 4 5 CF -840 210 240 260 220 150
Based on the NPV of the investment, should Klamath undertake this project?
If the Incremental IRR is ______ than the discount rate do the bigger project
Bigger
Farris Industrial purchased a machine five years ago at a cost of $164,900. The machine is being depreciated using the straight-line method over eight years. The tax rate is 35 percent and the discount rate is 14 percent. If the machine is sold today for $42,500, what will the aftertax salvage value be?
Book value = $164,900 - 5 × ($164,900/8) = $61,837.50 Aftertax salvage value = $42,500 - .35 × ($42,500 - 61,837.50) = $49,268.13
Farris Industrial purchased a machine five years ago at a cost of $164,900. The machine is being depreciated using the straight-line method over eight years. The tax rate is 35 percent and the discount rate is 14 percent. If the machine is sold today for $42,500, what will the aftertax salvage value be?
Book value = $164,900 - 5 × ($164,900/8) = $61,837.50 Aftertax salvage value = $42,500 - .35 × ($42,500 - 61,837.50) = $49,268.13
Lefty's just purchased some equipment that is classified as 7-year property for MACRS. The equipment cost $67,600. The MACRS table values are .1429, .2449, .1749, .1249, and .0893, for Years 1 to 5, respectively. What will the book value of this equipment be at the end of four years?
Book valueYear 4 = $67,600 - (1 - .1429 - .2449 - .1749 - .1249)] = $21,118.24
What is the name of the strategy of minimizing costs and finding creative ways to fund the venture?
Bootstrapping
A $25 investment produces $27.50 at the end of the year with no risk. Which of the following is true?
Both NPV is positive if the required return is less than 10%; and NPV is zero if the required return is equal to 10%.
The problem of using the overall firm's beta in discounting projects of different risk is the:
Both firm would accept too many high-risk projects; and firm would reject too many low risk projects.
Modified internal rate of return:
Both handles the multiple IRR problem by combining cash flows until only one change in sign change remains; and required the use of a discount rate.
Hi-Tech announces a major expansion which causes the price of its stock to increase and also causes an increase in the volatility of the stock price. How will these two market reactions affect the value of call options on Hi-Tech stock?
Both reactions increase the value of the call options.
An out-of-the-money call option is one that:
Both should not be exercised; and has an exercise price above the current market price of the underlying security
What does the reading say is the best advice for buying a house?
Buy a first-time homebuyer's book.
Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5 percent. The company also has 4 million shares of common stock outstanding, which has a beta of 1.1 and sells for $40 a share. The US Treasury bill is yielding 4 percent and the market risk premium is 8 percent. Jack's tax rate is 35 percent. What is Jack's weighted average cost of capital?
By the CAPM: Weights: Debt: 80,000 * $1,000 = $80,000,000 Common: 4,000,000 * $40 = $160,000,000 Total = $80,000,000 + $160,000,000 = $240,000,000 WACC = (160,000,000/240,000,000 * 0.128) + (80,000,000 / 240,000,000 * 0.085 * (1 - 0.35)) = 10.38 percent Ke = 0.04 + (1.1 * 0.08) = 0.128
A _____ is a derivative security that gives the owner the right, but not the obligation, to sell an asset at a fixed price for a specified period of time. A. futures contract B. call option C. put option D. swap E. forward contract
C
A firm with high operating leverage has: A. low fixed costs in its production process. B. high variable costs in its production process. C. high fixed costs in its production process. D. high price per unit. E. low price per unit.
C
Assume N(d2) = N(3.0155) = 0.9987. Given this assumption, a drawing from the standardized normal distribution has a ________ percent probability of being less than ________. A) 3.0155; 0.9987 B) 0.13; 3.0155 C) 99.87; 3.0155 D) 0.0013; .9987 E) 0.9987; 3.0155
C
Assume you own both a May 40 put and a May 40 call on ABC stock. Which one of the following statements is correct concerning your option positions? Ignore taxes and transaction costs. A. An increase in the stock price will increase the value of your put and decrease the value of your call. B. Both a May 45 put and a May 45 call will have higher values than your May 40 options. C. The time premiums on both your put and call are less than the time premiums on equivalent June options. D. A decrease in the stock price will decrease the value of both of your options. E. You can never profit on your positions as your profits on one option will be offset by losses on the other option.
C
Carie opted to exercise her May option on April 3rd and received $1,750 in exchange for her shares. She must have owned a(n) A) warrant. B) American call. C) American put. D) European put. E) European call.
C
If a call has a positive intrinsic value at expiration, the call is said to be A) at the money. B) out of the money. C) in the money. D) funded. E) unfunded.
C
If you consider the equity of a firm to be an option on the firm's assets, then the act of paying off debt is comparable to ________ on the assets of the firm. A) purchasing a put option B) purchasing a call option C) exercising an in-the-money call option D) exercising an in-the-money put option E) selling a call option
C
If you express a firm in terms of put options, the A) current value of the firm is the exercise price. B) option will always be in the money. C) stockholders will be considered as the firm's owners. D) bondholders determine whether or not the option will be exercised. E) bondholders are the buyers of the put.
C
In the Black-Scholes option pricing model, what does the variable R represent? A) The annually compounded risk-free rate of return B) The continuously compounded variance C) The continuously compounded annual risk-free rate of return D) The annually compounded market rate of return E) The continuously compounded market rate of return
C
Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5%. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4% and the market risk premium is 8%. Jack's tax rate is 35%. What is Jack's weighted average cost of capital? A. 7.10% B. 7.39% C. 10.38% D. 10.65% E. 11.37%
C
Jeff opted to exercise his August option on August 10 and received $2,500 in exchange for his shares. Jeff must have owned a(an): A. warrant. B. American call. C. American put. D. European call. E. European put.
C
Put-call parity can be used to show: A. how far in-the-money put options can be. B. how far in-the-money call options can be. C. the precise relationship between put and call prices given equal exercise prices and equal expiration dates. D. that the value of a call option is always twice that of a put given equal exercise prices and equal expiration dates. E. that the value of a call option is always half that of a put given equal exercise prices and equal expiration dates.
C
Sam owns an oil field with a number of producing wells. In the past, he has started and stopped production of these wells as the price of oil fluctuated over time. Assume the government imposes additional requirements on non-producing wells that are still production capable. These requirements are expected to increase the cost of stopping well production by 30 percent. As a result, Sam should be: A. keeping all wells open continuously. B. closing wells only if he plans to keep them closed permanently. C. willing to keep wells operating at a lower level of profitability than he has in the past. D. increasing the cost of capital he applies to his well evaluation analysis. E. opening wells at a lower popen price.
C
The Norris Co. has an improved version of its hotel stand. The investment cost is expected to be $72 million and will return $13.5 million for 5 years in net cash flows. The ratio of debt to equity is 1 to 1. The cost of equity is 13%, the cost of debt is 9%, and the tax rate is 34%. The appropriate discount rate, assuming average risk, is: A. 8.65% B. 9% C. 9.47% D. 10.5% E. 13%
C
The call option on a dividend-paying stock compared to a comparable non-dividend paying stock is: A. more valuable because of the dividend payments. B. equal in value. C. less valuable because cash dividends lower the stock price. D. equal to the cost of the non-dividend paying stock option. E. either equal to or greater than the value of the non-dividend paying stock option.
C
The delta of a call measures the: A. time remaining to expiration compared to the option's original maturity. B. change between an option's original value and its current value. C. swing in the price of the call relative to the swing in the underlying stock price. D. ratio of the change in the option price to the change in the time to expiration. E. volatility of the underlying security.
C
The fixed price in an option contract at which the owner can buy or sell the underlying asset is called the option's: A. opening price. B. intrinsic value. C. strike price. D. market price. E. time value.
C
The minimum payoff to the seller of a put is A) zero. B) a loss equal to the stock price. C) a loss equal to the exercise price. D) equal to the exercise price minus the stock price. E) unlimited.
C
The ticker symbol for a stock option indicates all of the following except the A) underlying stock. B) expiration date. C) intrinsic value. D) type of option. E) strike price.
C
The value of an executive stock option will be lowered if: A. the volatility of the firm's stock returns increases. B. the executive improves firm performance causing the stock price to rise. C. a freeze-out period is required. D. the firm extends the expiration date. E. the strike price is lowered.
C
The value of an option if it were to immediately expire is called the option's ________ value. A) strike B) time C) intrinsic D) volatility E) market
C
What is the value of a 9-month call with a strike price of $45 given the Black-Scholes Option Pricing Model and the following information? Stock price $48 Exercise price $45 Time to expiration .75 Risk-free rate .05 N(d1) .718891 N(d2) .641713 a. $2.03 b. $4.86 c. $6.69 d. $8.81 e. $9.27
C
Which of the following statements are correct concerning option values, all else held constant? I. The value of an in-the-money call increases as the price of the underlying stock increases. II. The value of a call decreases as the exercise price increases. III. The value of an in-the-money put increases as the price of the underlying stock increases. IV. The value of a put decreases as the exercise price increases. A) I and III only B) II and IV only C) I and II only D) II and III only E) I, II, and IV only
C
Which one of the following provides the option of selling a stock anytime during the option period at a specified price even if the market price of the stock declines to zero? A. American call B. European call C. American put D. European put E. either an American or a European put
C
Which one of the following statements is correct concerning in-the-money option values? A. The value of a put decreases as the exercise price increases. B. The value of a put increases as the price of the underlying stock increases. C. The value of a call decreases as the exercise price increases. D. An increase in the underlying stock price decreases both the value of a put and a call. E. The value of a call decreases as the price of the underlying stock increases.
C
You can realize the same value as that derived from stock ownership if you: A. sell a put option and invest at the risk-free rate of return. B. buy a call option and write a put option on a stock and also borrow funds at the risk-free rate. C. sell a put and buy a call on a stock as well as invest at the risk-free rate of return. D. lend out funds at the risk-free rate of return and sell a put option on the stock. E. borrow funds at the risk-free rate of return and invest the proceeds in equivalent amounts of put and call options.
C
You own both a May 20 call and a May 20 put. If the call finishes in the money, then the put will: A. also finish in the money. B. finish at the money. C. finish out of the money. D. either finish at the money or in the money. E. either finish at the money or out of the money.
C
put call parity example a client wants to purchase a 1 yr european call option on ABCD with a strike price = $20. Another dealer is willing to write a 1 yr European put option on ABCD with K = $20 and sell you the option for $2.50 a share. ABCD pays no dividend and is currently trading at $18 per share. If the risk free rate = 6%, how much should you charge for the call option?
C = P + S - PV(K) = 2.5 + 18 - (20/1.06) = $1.60 is what call should cost
Which of the following entities suffers from double taxation?
C-Corp
A project which is designed to improve the manufacturing efficiency of a firm but will generate no additional sales revenue is referred to as a(n) _____ project. A. sunk cost B. opportunity C. cost-cutting D. revenue-cutting E. revenue-generating
C. cost-cutting
A situation in which accepting one investment prevents the acceptance of another investment is called the: A. net present value profile. B. operational ambiguity decision. C. mutually exclusive investment decision. D. issues of scale problem. E. multiple rates of return decision.
C. mutually exclusive investment decision.
Toni's Tools is comparing machines to determine which one to purchase. The machines sell for differing prices, have differing operating costs, differing machine lives, and will be replaced when worn out. These machines should be compared using: A. net present value only. B. both net present value and the internal rate of return. C. their equivalent annual costs. D. the depreciation tax shield approach. E. the replacement parts approach.
C. their equivalent annual costs.
Which one of the following provides the option of selling a stock anytime during the option period at a specified price even if the market price of the stock declines to zero? A. American call B. European call C. American put D. European put E. either an American or a European put
C. American put
Jeff opted to exercise his August option on August 10 and received $2,500 in exchange for his shares. Jeff must have owned a(an): A. warrant. B. American call. C. American put. D. European call. E. European put.
C. American put.
Which statement concerning the net present value (NPV) of an investment or a financing project is correct? A. A financing project should be accepted if, and only if, the NPV is exactly equal to zero. B. An investment project should be accepted only if the NPV is equal to the initial cash flow. C. Any type of project should be accepted if the NPV is positive and rejected if it is negative. D. Any type of project with greater total cash inflows than total cash outflows, should always be accepted. E. An investment project that has positive cash flows for every time period after the initial investment should be accepted.
C. Any type of project should be accepted if the NPV is positive and rejected if it is negative.
Why do managers suggest that ignoring all cash flows following the assigned payback period is not a major flaw of the payback method of capital budgeting analysis? A. Payback is never used in real practice so it makes no difference how academics apply the method in their studies B. All cash flows after the first two years are highly inaccurate so including them lessens the reliability of the resulting decision. C. If the cash flows after the required payback period are significant, managers will use their discretion to override the payback rule. D. All cash flows after the assigned payback period are relatively worthless in today's dollars so ignoring them has no consequence. E. The results of including the cash flows after the required payback period rarely have any effect on the accept/reject decision.
C. If the cash flows after the required payback period are significant, managers will use their discretion to override the payback rule.
Which one of the following statements is correct? A. If an acquisition is made with cash, then the cost of that acquisition is dependent upon the acquisition gains. B. Acquisitions made by exchanging shares of stock are normally taxable transactions. C. Shareholders of the acquired firm must realize capital gains/losses in a cash acquisition. D. The stockholders of the acquiring firm will be better off when an acquisition results in losses if the acquisition was made with cash rather than with stock. E. Acquisitions based on legitimate business purposes are not taxable transactions regardless of the means of financing used.
C. Shareholders of the acquired firm must realize capital gains/losses in a cash acquisition.
Assume you own both a May 40 put and a May 40 call on ABC stock. Which one of the following statements is correct concerning your option positions? Ignore taxes and transaction costs. A. An increase in the stock price will increase the value of your put and decrease the value of your call. B. Both a May 45 put and a May 45 call will have higher values than your May 40 options. C. The time premiums on both your put and call are less than the time premiums on equivalent June options. D. A decrease in the stock price will decrease the value of both of your options. E. You can never profit on your positions as your profits on one option will be offset by losses on the other option.
C. The time premiums on both your put and call are less than the time premiums on equivalent June options.
____ can provide a potential tax gain from an acquisition. A. A reduction in the level of debt B. An increase in surplus funds C. The use of net operating losses D. A decreased use of leverage E. Increased diseconomies of scale
C. The use of net operating losses
Which one of the following statements is correct concerning in-the-money option values? A. The value of a put decreases as the exercise price increases. B. The value of a put increases as the price of the underlying stock increases. C. The value of a call decreases as the exercise price increases. D. An increase in the underlying stock price decreases both the value of a put and a call. E. The value of a call decreases as the price of the underlying stock increases.
C. The value of a call decreases as the exercise price increases.
A classified board is: A. a communication network that identifies firms that are willing to be acquired. B. the inclusion a super majority provision to prevent a small number of directors from exerting total control over the board's decisions. C. a board where only a portion of the directors are elected in any one year. D. a communication network that distributes resumes for potential board candidates. E. a listing of criteria that a firm is seeking for a targeted purchase.
C. a board where only a portion of the directors are elected in any one year.
The net working capital of a firm will decrease if there is: A. a decrease in accounts payable. B. an increase in inventory. C. a decrease in accounts receivable. D. an increase in the firm's checking account balance. E. a decrease in fixed assets.
C. a decrease in accounts receivable.
The net working capital of a firm will decrease if there is: A. a decrease in accounts payable. B. an increase in inventory. C. a decrease in accounts receivable. D. an increase in the firm's checking account balance. E. a decrease in fixed assets.
C. a decrease in accounts receivable.
All of the following represent potential gains from an acquisition except: A. the replacement of ineffective managers. B. lower costs per unit produced. C. an increase in production size such that diseconomies of scale are realized. D. increased asset utilization. E. spreading of overhead costs.
C. an increase in production size such that diseconomies of scale are realized.
In a tax-free acquisition, the shareholders of the target firm: A. receive income that is considered to be tax-exempt. B. gift their shares to a tax-exempt organization and therefore have no taxable gain. C. are viewed as having exchanged their shares. D. sell their shares to a qualifying entity thereby avoiding both income and capital gains taxes. E. sell their shares at cost thereby avoiding the capital gains tax.
C. are viewed as having exchanged their shares.
One characteristic of the payback method of project analysis is the: A. use of variable discount rates. B. standardized cutoff point for cash flow consideration. C. bias towards liquidity. D. consideration of the risk level of each project. E. discounting of all cash flows.
C. bias towards liquidity.
The internal rate of return is: A. more reliable as a decision making tool than net present value whenever you are considering mutually exclusive projects. B. equivalent to the discount rate that makes the net present value equal to one. C. computed using a project's cash flows as the only source of inputs. D. dependent on the interest rates offered in the marketplace. E. a better methodology than net present value when dealing with unconventional cash flows.
C. computed using a project's cash flows as the only source of inputs.
The internal rate of return is: A. more reliable as a decision making tool than net present value whenever you are considering mutually exclusive projects. B. equivalent to the discount rate that makes the net present value equal to one. C. computed using a project's cash flows as the only source of inputs. D. dependent on the interest rates offered in the marketplace. E. a better methodology than net present value when dealing with unconventional cash flows.
C. computed using a project's cash flows as the only source of inputs.
If Microsoft were to acquire an airline, the acquisition would be classified as a _____ acquisition. A. horizontal B. longitudinal C. conglomerate D. vertical E. complementary resources
C. conglomerate
The cash flow tax savings generated as a result of a firm's tax-deductible depreciation expense is called the: A. aftertax depreciation savings. B. depreciable basis. C. depreciation tax shield. D. operating cash flow. E. aftertax salvage value.
C. depreciation tax shield.
Assume Uptown Markets just made a tender offer to purchase shares of its own stock. This offer was made to all its shareholders except for the largest outside shareholder. This offer is referred to as a(n): A. limited recapitalization. B. white knight offer. C. exclusionary self-tender. D. asset restructuring. E. greenmail offer.
C. exclusionary self-tender.
You own both a May 20 call and a May 20 put. If the call finishes in the money, then the put will: A. also finish in the money. B. finish at the money. C. finish out of the money. D. either finish at the money or in the money. E. either finish at the money or out of the money.
C. finish out of the money.
A business deal in which all publicly owned stock in a firm is replaced with complete equity ownership by a private group is called a: A. tender offer. B. proxy contest. C. going-private transaction. D. acquisition. E. consolidation.
C. going-private transaction.
The payments made by a firm to repurchase shares of its outstanding stock from an individual investor in an attempt to eliminate a potential unfriendly takeover attempt are referred to as: A. a golden parachute. B. standstill payments. C. greenmail. D. a poison pill. E. a white knight.
C. greenmail.
Sunk costs include any cost that: A. will change if a project is undertaken. B. will be incurred if a project is accepted. C. has previously been incurred and cannot be changed. D. will be paid to a third party and cannot be refunded for any reason whatsoever. E. will occur if a project is accepted and once incurred, cannot be recouped.
C. has previously been incurred and cannot be changed.
Assume you use all available methods to evaluate projects. If there is a conflict in the indicated decision between two mutually exclusive projects due to the IRR-based indicator, you should: A. accept both projects since both are acceptable based on some method. B. combine both projects into one larger project. C. ignore the IRR and rely on the decision indicated by the NPV method. D. base the final decision on the payback method. E. reject both projects due to ambiguity in the decision making process.
C. ignore the IRR and rely on the decision indicated by the NPV method.
The cash flows of a project should: A. be computed on a pretax basis. B. include all sunk costs and opportunity costs. C. include all incremental and opportunity costs. D. be applied to the year when the related expense or income is recognized by GAAP. E. include all financing costs related to new debt acquired to finance the project.
C. include all incremental and opportunity costs.
When evaluating an acquisition, you should: A. concentrate on book values and ignore market values. B. focus on the total cash flows of the merged firm. C. include synergies. D. ignore any one-time acquisition fees or transaction costs. E. ignore any potential changes in management.
C. include synergies.
The IRS is most apt to disallow an acquisition if it: A. moves the foreign operations of the acquired firm to the U.S. B. is totally financed with debt. C. is designed primarily to reduce federal taxes. D. is designed to transfer technology in a tax-free transfer. E. allows shareholders to avoid currently realizing their gains from a stock acquisition.
C. is designed primarily to reduce federal taxes.
Payback is frequently used to analyze independent projects because: A. it considers the time value of money. B. all relevant cash flows are included in the analysis. C. it is easy and quick to calculate. D. it is the most desirable of all the available analytical methods from a financial perspective. E. it produces better decisions than those made using either NPV or IRR.
C. it is easy and quick to calculate.
For the acquiring firm, diversification: A. will automatically produce gains. B. will reduce both risk and debt capacity. C. may provide financial benefits. D. will provide risk reduction for all shareholders' portfolios. E. may result in a risk-free firm.
C. may provide financial benefits.
Tax shield refers to a reduction in taxes created by: A. a reduction in sales. B. an increase in interest expense. C. noncash expenses. D. a project's incremental expenses. E. opportunity costs.
C. noncash expenses.
All of the following are anticipated effects of a proposed project. Which of these should be considered when computing the cash flow for the final year of a project? A. operating cash flow and salvage values B. salvage values and net working capital recovery C. operating cash flow, net working capital recovery, salvage values D. net working capital recovery and operating cash flow E. operating cash flow only
C. operating cash flow, net working capital recovery, salvage values
All of the following are anticipated effects of a proposed project. Which of these should be considered when computing the cash flow for the final year of a project? A. operating cash flow and salvage values B. salvage values and net working capital recovery C. operating cash flow, net working capital recovery, salvage values D. net working capital recovery and operating cash flow E. operating cash flow only
C. operating cash flow, net working capital recovery, salvage values
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the: A. cash period. B. net working capital period. C. payback period. D. profitability index. E. discounted payback period.
C. payback period.
A dissident group solicits votes in an attempt to replace existing management. This is called a: A. tender offer. B. shareholder derivative action. C. proxy contest. D. management freeze-out. E. shareholder's revenge.
C. proxy contest.
A _____ is a derivative security that gives the owner the right, but not the obligation, to sell an asset at a fixed price for a specified period of time. A. futures contract B. call option C. put option D. swap E. forward contract
C. put option
Which one of the following is the best example of two mutually exclusive projects? A. planning to build a warehouse and a retail outlet side by side B. buying sufficient equipment to manufacture both desks and chairs simultaneously C. renting out a company warehouse or selling it outright D. using the company sales force to promote sales of both shoes and socks E. buying both inventory and fixed assets using funds from the same bank loan
C. renting out a company warehouse or selling it outright
The payback method: A. determines a cutoff point so that all projects accepted by the NPV rule will be accepted by the payback period rule. B. determines a cutoff point equal to the point where all initial capital investments have been fully depreciated. C. requires an arbitrary choice of a cutoff point. D. varies the cutoff point with the market rate of interest. E. is rarely used in actual practice.
C. requires an arbitrary choice of a cutoff point.
The salvage value of an asset creates an aftertax cash flow in an amount equal to the: A. sales price of the asset. B. sales price minus the book value. C. sales price minus the tax due based on the sales price minus the book value. D. sales price plus the tax due based on the sales price minus the book value. E. sales price plus the tax due based on the book value minus the sales price.
C. sales price minus the tax due based on the sales price minus the book value.
You can realize the same value as that derived from stock ownership if you: A. sell a put option and invest at the risk-free rate of return. B. buy a call option and write a put option on a stock and also borrow funds at the risk-free rate. C. sell a put and buy a call on a stock as well as invest at the risk-free rate of return. D. lend out funds at the risk-free rate of return and sell a put option on the stock. E. borrow funds at the risk-free rate of return and invest the proceeds in equivalent amounts of put and call options.
C. sell a put and buy a call on a stock as well as invest at the risk-free rate of return.
The fixed price in an option contract at which the owner can buy or sell the underlying asset is called the option's: A. opening price. B. intrinsic value. C. strike price. D. market price. E. time value.
C. strike price.
A cost that has already been paid, or the liability to pay has already been incurred, is a(n): A. salvage value expense. B. net working capital expense. C. sunk cost. D. opportunity cost. E. erosion cost.
C. sunk cost.
The delta of a call measures the: A. time remaining to expiration compared to the option's original maturity. B. change between an option's original value and its current value. C. swing in the price of the call relative to the swing in the underlying stock price. D. ratio of the change in the option price to the change in the time to expiration. E. volatility of the underlying security.
C. swing in the price of the call relative to the swing in the underlying stock price.
A public offer by one firm to directly buy the shares of another firm is called a: A. merger. B. consolidation. C. tender offer. D. spinoff. E. divestiture.
C. tender offer.
Put-call parity can be used to show: A. how far in-the-money put options can be. B. how far in-the-money call options can be. C. the precise relationship between put and call prices given equal exercise prices and equal expiration dates. D. that the value of a call option is always twice that of a put given equal exercise prices and equal expiration dates. E. that the value of a call option is always half that of a put given equal exercise prices and equal expiration dates.
C. the precise relationship between put and call prices given equal exercise prices and equal expiration dates.
If the All-Star Fuel Filling Company, a chain of gasoline stations, acquires the Mid-States Refining Company, a refiner of oil products, this would be an example of a: A. conglomerate acquisition. B. white knight. C. vertical acquisition. D. going-private transaction. E. horizontal acquisition.
C. vertical acquisition.
A friendly suitor that a target firm turns to as an alternative to a hostile bidder is called a: A. golden suitor. B. poison put. C. white knight. D. shark repellent. E. crown jewel.
C. white knight.
A project will produce operating cash flows of $42,000 a year for four years. During the life of the project, inventory will be lowered by $12,000, accounts receivable will increase by $15,000, and accounts payable will increase by $10,000. The project requires $120,000 of new equipment that will be depreciated straight-line to a zero book value over four years. At the end of the project, net working capital will return to its normal level and the equipment will be sold for $25,000, after taxes. What is the net present value given a required return of 14 percent? A. $13,483.48 B. $18,117.05 C. $20,033.36 D. $12,037.86 E. $14,322.49
C. $20,033.36 NWC requirement = $12,000 - 15,000 + 10,000 = $7,000 CF0 = $7,000 - 120,000 = -$113,000 C04, excluding OCF = -$7,000 + 25,000 = $18,000 NPV = -$113,000 + $42,000[(1 - 1/1.144)/.14] + $18,000/1.144 = $20,033.36
Farris Industrial purchased a machine five years ago at a cost of $164,900. The machine is being depreciated using the straight-line method over eight years. The tax rate is 35 percent and the discount rate is 14 percent. If the machine is sold today for $42,500, what will the aftertax salvage value be? A. $35,731.88 B. $27,625.00 C. $49,268.13 D. $63,696.88 E. $52,011.18
C. $49,268.13 Book value = $164,900 - 5 × ($164,900/8) = $61,837.50 Aftertax salvage value = $42,500 - .35 × ($42,500 - 61,837.50) = $49,268.13
Assume that after 2010, earnings before interest and tax will remain constant at $210 million, depreciation will equal capital expenditures in each year, and working capital will not change. ThinkSmart's WACC is 14 percent and its tax rate is 40 percent. What is the estimated market value of ThinkSmart at the end of 2006. Following is a four-year forecast for ThinkSmart LLC. Free cash flow ($ mil) 2007: -85 2008: -32 2009: 62 2010: 66
First, we need to recognize that this is a DCF approach, so the market value will equal the present value of the 2007-2010 free cash flows plus the present value of the terminal value. The present value of the 2007-2010 FCF equals -$18,300,000. The terminal value equals FCF/r (according to perpetuity or a zero growth Gordon Model). FCF = [EBIT * (1 - tax rate)] + depreciation - CAPEX - Inc NWC. The problem tells us that depreciation = CAPEX, so they cancel each other out. The problem also says that NWC does not change, so it equals zero. Therefore, FCF = EBIT * (1 - tax rate). (This is the same as EBIT - taxes in dollars.) So the terminal value = EBIT(1 - t) / r = $126 / 0.14 = $900,000,000 The present value of $900 million is $532.9 million. Add the PV of FCF to the PV of TV, -$18.3 + $532.9 = $514,600,000
A deal in which all publicly owned stock in a firm is replaced with complete equity ownership by a private group is called a:
Going-private transaction
A transaction involving only one firm, which results in a stock being delisted and no longer available to the public is a(n):
Going-private transaction
The profitability index will be:
Greater than 1.0 when the IRR is greater than the discount rate.
Using internal rate of return, a conventional project should be accepted if the internal rate of return is:
Greater than the discount rate.
A targeted stock repurchase of the firm directed at a potential bidder to discourage an unfriendly takeover attempt is called (a):
Greenmail
An in-the-money put option is one that:
Has an exercise price greater than the underlying stock price
Daniel's Enterprises has a beta of 1.98 and a growth rate of 12 percent. The stock is currently selling for $12 a share. The overall stock market has an 11 percent rate of return and a market risk premium of 8 percent. What is the expected rate of return on Daniel's Enterprises stock?
Here, you have to figure out that you should use the CAPM. They give us some parts to the Gordon model, but the dividend is not provided. We can't use the Gordon model, and the growth rate and current price are extraneous. Also, note that they give use the market risk premium (Rm-Rf) of 11 percent. To find the Rf we have to subtract the 8 percent market return from the overall market risk premium. Re = (0.11 - 0.08) + (1.98 * 0.08) = 18.84 percent
The beta of a firm is more likely to be high under what two conditions?
High cyclical business activity and high operating leverage
Jillian owns an option which gives her the right to purchase shares of WAN stock at a price of $20 a share. Currently, WAN stock is selling for $24.50. Jillian would like to profit on this stock but is not permitted to exercise her option for another two weeks. Which of the following statements apply to this situation? I. Jillian must own a European call option. II. Jillian must own an American put option. III. Jillian should sell her option today if she feels the price of WAN stock will decline significantly over the next two weeks. IV. Jillian cannot profit today from the price increase in WAN stock.
I III
The use of which of the following could lead to incorrect decisions in comparing mutually exclusive investments? I. Internal rate of return II. Profitability index III. Average accounting return
I and II only
The use of which of the following could lead to incorrect decisions when comparing mutually exclusive investments? I. Internal rate of return II. Profitability index III. Average accounting return
I and II only
Which of the following are general requirements for an acquisition to be tax-free? I. The acquisition must involve two Canadian corporations subject to corporate income tax. II. The stockholders in the target firm must retain an equity position in the bidder. III. The acquirer must apply to the CRA for tax-free status prior to launching the acquisition bid. IV. The acquirer must offer cash to the equity holders of the acquired firm.
I and II only
Which of the following are given as common reasons why the management of a newly merged firm will opt to divest that firm of some of its operations? I. To raise cash II. To comply with antitrust regulations III. To avoid the taxes normally imposed on a stock acquisition IV. To comply with a government-imposed standstill agreement
I and II only
Which of the following have been suggested as reasons why the stockholders in acquiring firms may not benefit to any significant degree from an acquisition? I. The price paid for the target firm might equal that firm's total value II. Management may have priorities other than the interest of the stockholders III. The target firms tend to be much larger than the acquiring firms IV. The merger benefits may have been underestimated
I and II only
Which of the following refer to synergistic gains from merger due to revenue enhancement? I. Marketing gains II. Strategic benefits III. Unused debt capacity IV. Surplus funds
I and II only
Which of the following represent synergistic benefits from a merger? I. Revenue enhancement II. Tax reductions III. Cost increases IV. Increased capital needs
I and II only
The internal rate of return (IRR): I. rule states that a project is acceptable when the IRR exceeds the required rate of return. II. ignores the initial investment in a project. III. is the rate that causes the net present value of a project to equal zero. IV. can effectively be used to analyze all investment scenarios.
I and III only
Which of the following is (are) biased in favour of liquid investments? I. Payback period II. AAR III. Discounted payback
I and III only
Which of the following statements concerning acquisitions are correct? I. Being acquired by another firm is an effective method of replacing senior management. II. The net present value of an acquisition should have no bearing on whether or not the acquisition occurs. III. Acquisitions are often relatively complex from an accounting and tax point of view. IV. The value of a strategic fit is easy to estimate using discounted cash flow analysis.
I and III only
Which of the following statements concerning the average accounting return is (are) correct? I. The information used in the AAR calculation is easily obtainable. II. A project is accepted if the target AAR exceeds the project AAR. III. The AAR ignores the time value of money. IV. The AAR is based on cash flows and market values
I and III only
Which of these may occur if a company uses its overall cost of capital as the discount rate for all projects? I. Profitable low-risk projects may be incorrectly rejected. II. Only projects with risks similar to the current company will be accepted. III. Too many high-risk projects may be accepted. IV. Only low-risk projects will be accepted.
I and III only
Jillian owns an option which gives her the right to purchase shares of WAN stock at a price of $20 a share. Currently, WAN stock is selling for $24.50. Jillian would like to profit on this stock but is not permitted to exercise her option for another two weeks. Which of the following statements apply to this situation?
I and III only ( I. Jillian must own a European call option. & III. Jillian should sell her option today if she feels the price of WAN stock will decline significantly over the next two weeks.)
Which of the following are beneficial attributes of leveraged buyouts? I. Leveraged buyouts often create entrepreneurial incentives for managers. II. The required repayment of the debt used in the buyout induces reduced managerial efficiencies. III. Conflicts of interest between shareholders and managers are increased. IV. Bureaucratic obstacles are often eliminated
I and IV only
Which of the following will NOT lead to ambiguous decision-making when considering mutually exclusive projects? I. AAR II. PI III. IRR IV. NPV
I and IV only
An acquisition of a firm through the purchase of shares of the outstanding stock: I. is frequently more expensive than if the two firms had just merged. II. can be accomplished without the involvement of the target firm's board of directors. III. can be accomplished without having the shareholders vote on the acquisition. IV. may be made either by circular bid or by stock exchange bid.
I, II, III, and IV
Which of the following activities are commonly associated with takeovers? I. The acquisition of assets II. Proxy contests III. Management buyouts IV. Leveraged buyouts
I, II, III, and IV
Which of the following are possible sources of cash flow benefits derived from a merger? I. An improvement in the marketing of the firm's products II. Economy of scale benefits III. Better use of tax losses IV. Utilizing any unused debt capacity
I, II, III, and IV
Which of the following are reasons why a firm may want to divest itself of some of its assets? I. To raise cash II. To get rid of unprofitable operations III. To get rid of some assets received in an acquisition IV. To cash in on some profitable operations
I, II, III, and IV
Which of the following statements are correct concerning the variance of the annual returns on an investment? I. The larger the variance, the more the actual returns differ from the average return. II. The larger the variance, the larger the standard deviation. III. The larger the variance, the greater the risk of the investment. IV. The larger the variance, the higher the expected return.
I, II, III, and IV
Which of these may be a source of synergy? I. Unused debt capacity II. Economies of scale III. Increase in overall revenue IV. Unused net operating losses
I, II, III, and IV
If financial managers only invest in projects that have a profitability index greater than one: I. firm value will be maximized. II. shareholder wealth will be maximized. III. share price will be maximized.
I, II, and III
Which of the following questions are addressed in the capital budgeting process? I. What products or services will we offer or sell? II. In what markets will we compete? III. What new products will we introduce?
I, II, and III
A proposed acquisition may create synergy by: I. increasing the market power of the combined firm. II. improving the distribution network of the acquiring firm. III. providing the combined firm with a strategic advantage. IV. reducing the utilization of the acquiring firm's assets
I, II, and III only
Which of the following statements is (are) true concerning the comparison between payback and discounted payback? I. From a financial point of view, the discounted payback method is preferred over the payback method. II. The discounted payback is more difficult to compute and thus is not as widely used as the payback method. III. Both methods are biased towards liquidity. IV. Both methods consider the time value of money.
I, II, and III only
Which of the following represent potential gains from an acquisition? I. The replacement of ineffective managers II. Lower costs per unit produced III. An increase in firm size so that diseconomies of scale are realized IV. Spreading of overhead costs
I, II, and IV only
The intrinsic value of a call is:
I, II, and IV only ( I. the value of the call if it were about to expire., II. equal to the lower bound of a call's value.IV.) always equal to zero if the call is currently out of the money.
The incremental cash flows of a merger can relate to changes in which of the following? I. Revenues II. Number of outstanding shares of stock III. Taxes IV. Capital requirements
I, III, and IV only
Which of the following refer to synergistic gains due to cost reductions in an acquisition? I. Complementary resources II. Marketing gains III. Economies of scale IV. Economies of vertical integration
I, III, and IV only
Which of the following is/are accurate with regards to the advantages or disadvantages in using a merger as a method of acquisition? I. An advantage of a merger is that it is legally complex. II. A disadvantage of a merger is that it requires shareholder approval of both firms. III. An advantage of a merger is that there is no need to transfer title to the individual assets of the acquired firm to the acquiring firm.
II and III only
Which of the following statements is/are true? I. In a successful takeover, the shareholders of the acquiring firm usually realize substantial gains. II. It appears that the gains reaped by target firms from tender offer takeovers are higher than the gains realized from mergers. III. On average, friendly mergers may be arranged at lower premiums than unfriendly tender offers
II and III only
Which two of these are required for an acquisition to be considered tax-free? I. The bidder must purchase the target firm for less than its current market value. II. The acquisition must have a business purpose other than the avoidance of taxes. III. The stockholders in the target firm must retain an equity interest in the bidder. IV. The acquisition must be a lump sum cash transaction.
II and III only
Which of the following capital budgeting techniques employ some sort of arbitrary value against which the project measurement must be compared when determining whether to accept or reject a project? I. Net present value II. Average accounting return III. Profitability index IV. Discounted payback
II and IV only
Which of the following statements concerning the standard deviation are correct? I. The greater the standard deviation, the lower the risk. II. The standard deviation is a measure of volatility. III. The higher the standard deviation, the less certain the rate of return in any one given year. IV. The higher the standard deviation, the higher the expected return.
II, III, and IV only
The advantages of the payback method of project analysis include the: I. application of a discount rate to each separate cash flow. II. bias towards liquidity. III. ease of use. IV. arbitrary cutoff point.
II. bias towards liquidity. III. ease of use.
If a project has a net present value equal to zero, then: I. the present value of the cash inflows exceeds the initial cost of the project. II. the project produces a rate of return that just equals the rate required to accept the project. III. the project is expected to produce only the minimally required cash inflows. IV. any delay in receiving the projected cash inflows will cause the project to have a negative net present value.
II. the project produces a rate of return that just equals the rate required to accept the project. III. the project is expected to produce only the minimally required cash inflows. IV. any delay in receiving the projected cash inflows will cause the project to have a negative net present value.
Which of the following are features of the purchase method of accounting? I. The balance sheets of the acquirer and the acquired are just added together. II. Since the new firm is jointly owned by the shareholders of the old firms, no goodwill exists. III. The assets of the target firm must be shown at their fair market value on the books of the bidder. IV. The difference between the purchase price and the estimated fair market value of the net assets of the target firm must be classified as goodwill and recorded on the balance sheet.
III and IV only
Which of the following methods of project analysis are biased towards short-term projects? I. internal rate of return II. net present value III. payback IV. discounted payback
III and IV only
Which of the following represent potential tax gains from an acquisition? I. A reduction in the level of debt II. An increase in surplus funds III. The use of net operating losses IV. An increased use of leverage
III and IV only
In which of the following cases can NPV and IRR lead to different decisions? I. Project cash flows are conventional. II. The IRR is negative. III. An investment decision involves mutually exclusive choices.
III only
Complete the following decision rule: A project should be accepted if its ______ exceeds the firm's required rate of return.
IRR
Reinvestment assumption: All future cash flows assumed reinvested at the ____ Advantages: Easy to understand and communicate Disadvantages: Does not distinguish between investing and borrowing may not exist if Multiple ____ problems with mutual exclusive investments problem with scale and timing ignores magnitude of problem
IRR
Which capital investment evaluation technique is described by the following characteristics? (1) Easy to understand and communicate; (2) May result in multiple answers; (3) May lead to incorrect decisions when applied to mutually exclusive investments.
IRR
Comparing the NPV profile of an investment project to that of a financing project demonstrates why the:
IRR decision rule for investment projects is the opposite of the rule for financing projects.
A project should be accepted when the:
IRR exceeds the required rate
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the:
IRR exceeds the required return
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the
IRR exceeds the required return.
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the...
IRR exceeds the required return.
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the:
IRR exceeds the required return.
Assume a project has normal cash flows. According to the accept/reject rules, the project should be accepted if the: PI is less than 1. AAR is less than the required AAR. IRR exceeds the required return. payback period is less than the life of the project. discounted payback period is less than the life of the project.
IRR exceeds the required return.
Which one of the following statements is correct?
If either an increase or a decrease in the level of production causes the average cost per unit to increase the firm is currently operating at its optimal size.
Why do managers suggest that ignoring all cash flows following the assigned payback period is not a major flaw of the payback method of capital budgeting analysis?
If the cash flows after the required payback period are significant, managers will use their discretion to override the payback rule.
Which of the following statements is false?
If the cost of capital is greater than the IRR, the project should be accepted.
B) Payback is easier to compute than discounted payback.
If the discounted payback method is preferable to the payback method, then why is the payback method ever used? A) The discounted payback requires an arbitrary cutoff point while payback does not. B) Payback is easier to compute than discounted payback. C) Payback considers all of a project's cash flows but discounted payback does not. D) Payback requires the initial investment be recovered during a project's life while the required discounted payback period may be shorter. E) Payback can be used with mutually exclusive projects but discounted payback cannot.
MM1:
In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure.
Which one of the following statements concerning taxes and acquisitions is correct?
In a taxable acquisition, the shareholders in the target firm are treated as though they sold their shares and any capital gains or losses will be realized
Projects A and B require an initial investment of $48,000 and $98,000, respectively. The projects are mutually exclusive and both have positive net present values. Which of these methods is probably the best method to use to determine which project to accept?
Incremental IRR
Projects A and B require an initial investment of $48,000 and $98,000, respectively. The projects are mutually exclusive and both have positive net present values. Which of these methods is probably the best method to use to determine which project to accept? Payback Modified IRR AAR Incremental IRR IRR
Incremental IRR
*Changes in the firms cash flows that occur as a direct consequence of accepting the project. We are interested in the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.*
Incremental cash flows
Projects A and B require an initial investment of $48,000 and $98,000, respectively. The projects are mutually exclusive, and you know the smaller project has a positive NPV. Which one of these methods is probably the best method to use to determine which project to accept?
Incremental internal rate of return
When the decision to accept or reject one project does not affect the decision to accept or reject any other project, the project is said to be:
Independent.
Which one of these is handled differently in calculating cash flows for accounting versus financial purposes?
Interest expense
_____will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent.
Internal Rate of Return (IRR)
the discount rate that will make the NPV = 0; the rate of return generate by the project
Internal Rate of Return (IRR)
Graham and Harvey (2001) found that ___ and ___ were the two most popular capital budgeting methods.
Internal Rate of Return; Net Present Value
Graham and Harvey (2001) found that ________ and _______ were the two most popular capital budgeting methods.
Internal Rate of Return; Net Present Value
The discount rate that makes the net present value of an investment exactly equal to zero is called the:
Internal rate of return
By definition, the net present value is equal to zero when the discount rate is equal to the:
Internal rate of return.
The discount rate that makes the net present value of an investment exactly equal to zero is called the:
Internal rate of return.
The discount rate that makes the net present value of investment exactly equal to zero is the:
Internal rate of return.
Analysis using the profitability index is useful when...
Investment funds are limited... (capital rationing)
The internal rate of return (IRR) is often preferred by managers over the net present value (NPV) because the IRR:
Is expressed as a rate while the NPV is expressed in dollar terms
Which of the following accurately completes the following statement: A tender offer:
Is followed up by a merger in many acquisitions
The payback method:
Is prejudiced towards short-term projects.
According to the text, what specific phrase should you almost always use when negotiating?
Is that the very best you can do?
In general, a leveraged buyout:
Is used by current managers or financiers to take a firm private
The primary idea behind the net present value rule is that an investment:
Is worthwhile if it creates value for the owners.
Which of the following is considered to be a redeeming feature of average accounting return analysis?
It is relatively easy to calculate.
Which of the following is not a definition of required rate of return?
It is the Sharpe ratio. It is the compensation investors require for accepting risk. It is the return on an investment required by investors given the investment's risk. It is the risk free rate plus (+) the risk premium. = It is the Sharpe ratio
You are considering purchasing stock S. This stock has an expected return of 8 percent if the economy booms and 3 percent if the economy goes into a recessionary period. How will the overall expected rate of return on this stock behave?
It will increase as the probability of a boom economy increases. Remember the equation for expected rate of return: ER = sum (each probability * each state of return). See section "Return to Review" on page 8-2. If the probability of a boom increases, there will be more weight on the 8 percent and less on the 3 percent, so the expected rate of return will increase.
Which of the following is not one of the types of business entity structures mentioned in the reading?
L-corp
Direct costs
Legal and administrative costs
Other international exchanges
London, Tokyo, Hong Kong, Africa
indirect costs of bankruptcy
Loss of Customers, loss of suppliers, cost to employees, fire sales of assets
If the Incremental IRR is _____ than the discount rate do the smaller project
Lower
What is the relationship between risk and correlation?
Lower correlation leads to lower risk
The depreciation method currently allowed under US tax law, which governs the accelerated write-off of property under various lifetime classifications, is called __________ depreciation.
MACRS
Bruno's, Inc. is analyzing two machines to determine which one it should purchase. The company requires a 14% rate of return and uses straight-line depreciation to a zero book value. Machine A has a cost of $290,000, annual operating costs of $8,000, and a 3-year life. Machine B costs $180,000, has annual operating costs of $12,000, and has a 2-year life. Whichever machine is purchased will be replaced at the end of its useful life. Which machine should Bruno's purchase and why? (Round your answer to whole dollars.)
Machine B; because it will save the company about $11,600 a year
The crossover point is defined as the discount rate that:
Makes the net present values of two projects equal.
Details of cash flow calculations - Net working capital (NWC)
Many projects require an increase in current assets (inventory, cash, A/R) and current liabilities (A/P). Often, net working capital (NWC) is included in the calculation of initial outflow and is reversed at the end of the project. NWC = current assets - current liabilities Increased NWC is an outflow year 0 and an inflow at the end of the project Other incremental increases in NWC may need to be projected for subsequent years
The amount paid by an acquirer to the shareholders of the acquired firm that exceeds the stand-alone value is called the:
Merger premium.
Which of the following is NOT a correct statement of a reason why computation of NPV in a merger or an acquisition may be complicated?
Mergers and acquisitions are sometimes friendly
12.63%
Miller Manufacturing has a target debt-equity ratio of .35. Its cost of equity is 15 percent, and its cost of debt is 9 percent. If the tax rate is 35 percent, what is the company's WACC?
What is the name of the person who won the 2006 Nobel Peace Prize for his work in microfinance?
Muhammad Yunus
11.90%
Mullineaux Corporation has a target capital structure of 75 percent common stock and 25 percent debt. Its cost of equity is 14 percent, and the cost of debt is 8 percent. The relevant tax rate is 30 percent. What is Mullineaux's WACC?
A situation in which taking one investment prevents the taking of another is called:
Mutually exclusive investment decisions.
Uptown Developers is considering two projects. Project A consists of building a wholesale book outlet on the firm's downtown lot. Project B consists of building a sit-down restaurant on that same lot. The lot can only accommodate one of the projects. When trying to decide whether to build the book outlet or the restaurant, management should rely most heavily on the analysis results from which one of these methods?
NPV
A new project has an initial cost of $125,000 and cash flows of $33,300, $78,700, and $69,500 for years 1 to 3, respectively. What is the NPV of this project if the discount rate is 19.3 percent. What is the NPV if the discount rate is 12.7 percent?
NPV 19.3% = -$125,000 + $33,300 / 1.193 + $78,700 / 1.193^2 + $69,500 / 1.193^3 = -$859.11 NPV 12.7% = -$125,000 + $33,300 / 1.127 + $78,700 / 1.127^2 + $69,500 / 1.127^3 = 15,062.34
A project will produce an operating cash flow of $7,300 a year for three years. The initial cash outlay for equipment will be $11,600. The net aftertax salvage value of $3,500 will be received at the end of the project. The project requires $800 of net working capital that will be fully recovered. What is the net present value of the project if the required rate of return is 11 percent?
NPV = -$11,600 - 800 + $7,300[(1 - 1/1.113)/.11] + ($3,500 + 800)/1.113 = $8,583.24
A project has an initial cash outflow of $22,400 and cash inflows of $13,400 a year for years 1 and 2 and a final cash inflow in year 6 of $7,500. The required return is 15.5 percent. What is the net present value?
NPV = -$22,400 + $13,400 / 1.155 + $13,400 / 1.155^2 + $7,500 / 1.155^6 = $2,405.66
A project requires an initial investment of $59,600 and will produce cash inflows of $21,200, $44,500, $11,700 over the next 3 years, respectively. What is the project's NPV at a required return of 16 percent?
NPV = -$59,600 + $21,200 / 1.16 + $44,500 / 1.16^2 + $11,700 / 1.16^3 = -$757.69
A $25 investment produces $27.50 at the end of the year with no risk. Which of the following is true?
NPV is positive if the required return is less than 10%. AND NPV is zero if the required return is equal to 10%. (NPV = ($27.50/1.1) - $25.00 = $0)
Which of the following is NOT correct?
NPV's can normally be directly observed in the market.
A project will produce operating cash flows of $42,000 a year for four years. During the life of the project, inventory will be lowered by $12,000, accounts receivable will increase by $15,000, and accounts payable will increase by $10,000. The project requires $120,000 of new equipment that will be depreciated straight-line to a zero book value over four years. At the end of the project, net working capital will return to its normal level and the equipment will be sold for $25,000, after taxes. What is the net present value given a required return of 14 percent?
NWC requirement = $12,000 - 15,000 + 10,000 = $7,000 CF0 = $7,000 - 120,000 = -$113,000 C04, excluding OCF = -$7,000 + 25,000 = $18,000 NPV = -$113,000 + $42,000[(1 - 1/1.144)/.14] + $18,000/1.144 = $20,033.36
the difference between an investment's market value and its cost
Net Present Value (NPV)
Assume a firm has no interest expense or extraordinary items. Given this, the operating cash flow can be computed as:
Net income + Depreciation.
The __________ decision rule is considered the "best" in principle.
Net present value
Uptown Developers is considering two projects. Project A consists of building a wholesale book outlet on the firm's downtown lot. Project B consists of building a sit-down restaurant on that same lot. The lot can only accommodate one of the projects. When trying to decide whether to build the book outlet or the restaurant, management should rely most heavily on the analysis results fro which one of these methods?
Net present value
Uptown Developers is considering two projects. Project A consists of building a wholesale book outlet on the firm's downtown lot. Project B consists of building a sit-down restaurant on that same lot. The lot can only accommodate one of the projects. When trying to decide whether to build the book outlet or the restaurant, management should rely most heavily on the analysis results from which one of these methods?
Net present value
The difference between the market value of an investment and its cost is the:
Net present value.
The difference between the present value of an investment's future cash flows and its initial cost is the:
Net present value.
The profitability index is closely related to:
Net present value.
_________ quantifies, in dollar terms, how stockholder wealth will be affected by undertaking a project.
Net present value.
In project analysis, which one of these is a common assumption regarding net working capital? -Only changes in current assets are included in net working capital for project analysis purposes. -The aftertax salvage value of an asset that is sold is included as a net working capital item. -Net working capital will be returned to its pre-project level at the end of a project. -Increases in net working capital will be treated as a cash inflow. -Any change in net working capital will only occur when a project commences.
Net working capital will be returned to its pre-project level at the end of a project.
In project analysis, which one of these is a common assumption regarding net working capital?
Net working capital will be returned to its pre-projected level at the end of a project.
In project analysis, which one of these is a common assumption regarding net working capital?
Net working capital will be returned to its preproject level at the end of a project.
A project has an initial cost of $8,600 and produces cash inflows of $3,200, $4,900, and $1,500 over the next three years, respectively. What is the discounted payback period if the required rate of return is 8%?
Never
Does diversification achieved through a merger create value? Why or why not?
No, diversification lowers unsystematic risk but has no real value to shareholders.
Miller's is considering a 2-year expansion project that will require $410,000 up front. The project will produce cash flows of $358,000 and $98,000 for Years 1 and 2, respectively. Based on the profitability index (PI) rule, should the project be accepted if the discount rate is 12 percent? Why or why not? Yes; because the PI is 1.03 Yes; because the PI is .97 Yes; because the PI is .94 No; because the PI is 1.03 No; because the PI is .97
No; because the PI is .97
Uptown Motors is analyzing a project with sales of $420,000, depreciation of $30,000, and a net working capital requirement of $56,000. The firm has a tax rate of 35 percent and a profit margin of 5 percent. The firm has no interest expense. What is the amount of the operating cash flow?
OCF = ($420,000 × .05) + $30,000 = $51,000
Who Dat Restaurant is considering the purchase of a $9,700 soufflé maker. The soufflé maker has an economic life of four years and will be fully depreciated by the straight-line method. The machine will produce 1,850 soufflés per year, with each costing $2.10 to make and priced at $5.10. Assume that the discount rate is 15 percent and the tax rate is 34 percent. What is the NPV of the project?
OCF = (Sales − Costs)(1 − tC) + tCDepreciation OCF = [($5.10 × 1,850) − ($2.10 × 1,850)](1 − .34) + .34($9,700 / 4) OCF = $4,487.50 So, the NPV of the project is: NPV = −$9,700 + $4,487.50(PVIFA15%,4) NPV = $3,111.72
Thornley Co. is considering a 3-year project with an initial cost of $587,000. The project will not directly produce any sales but will reduce operating costs by $265,000 a year. The equipment is classified as MACRS 7-year property. The MACRS table values are .1429, .2449, .1749, .1249, .0893, .0892, .0893, and .0446 for Years 1 to 8, respectively. At the end of the project, the equipment will be sold for an estimated $295,000. The tax rate is 34 percent and the required return is 9 percent. An extra $23,000 of inventory will be required for the life of the project. What is the total cash flow for Year 3?
OCF3 = $265,000 (1 - .34) + ($587,000 × .1749)(.34) = $209,806.54 Book value3 = $587,000 × (1 - .1429 - .2449 - .1749) = $256,695.10 Aftertax salvage value = $295,000 - .34($295,000 - 256,695.10) = $281,976.33 C03 = $209,806.54 + 23,000 + 281,976.33 = $514,782.87
Depreciation example - straight-line
On a straight-line system, a $100, 3-year machine will be depreciated over 3 years, as (assuming $0 salvage value): Depr in y1 = (cost - salvage) / life = 33.34 Depr in y2 = (cost - salvage) / life = 33.33 Dept in y3 = (cost - salvage) / life = 33.33
B) simplicity.
One advantage of the payback method of project analysis is the method's A) application of a discount rate to each separate cash flow. B) simplicity. C) difficulty of use. D) arbitrary cutoff point. E) consideration of all relevant cash flows.
A conventional cash flow is defined as a series of cash flows where:
Only the initial cash flow is negative.
The most valuable investment given up if an alternative investment is chosen is referred to as a(n)
Opportunity Cost
A financial contract that gives its owner the right, but not the obligation, to buy or sell a specified asset at an agreed-upon price on or before a given future date is called a(n) _____ contract.
Option
The Efficient Set
Or efficient frontier, is a graphical representation of a set of possible portfolios that: - Minimize risk at specific return levels; and, - Maximize returns at specific risk levels.
A put option with a $35 exercise price on ABC stock expires today. The current price of ABC stock is $36. The put is:
Out of the money
1 yr european put option strike price = $75. Another dealer willing to write 1 yr euro call option with K = $75 and sell you the option for $11 per share. No dividend, currently trading at $81/share. risk free rate = 5% how much should you charge for the put option?
P = C - S + PV(K) = 11 - 81 + 75/1.05 = $1.43
Put Call Parity
P0 + S0 = C0 + E/(1+ R)^T
VCs are typically considered a subclass of what type of investors?
PEs
Which capital investment evaluation technique is described by the following characteristics? (1) Closely related to NPV; (2) Easy to understand and communicate; (3) May lead to incorrect decisions when comparing mutually exclusive investments; (4) May be useful when the available investment funds are limited.
PI
A project has a required return of 15% and a five year life. Which of the following is inconsistent with the other four?
PI = 0
The external funds needed (EFN) equation projects the addition to retained earnings as:
PM × Projected sales × (1 - d).
in the case of permanent debt, debt is =
PV(interest)
Which of the following decision rules is best for evaluating projects for which cash flows beyond a specified point in time, and the time value of money, can both be ignored?
Payback
Problems Timing of cash flows within the payback period -Does not consider the timing of the cash flows within the payback period. Uses an arbitrary benchmark cutoff rate (payments after the payback period - ignores all cash flows occurring after the payback period. Because of the short term orientation of the payback period some valuable long term projects are likely to be rejected. Arbitrary standard for payback period - no comparable guide for choosing the payback cutoff date Advantages: Accounting information is usually available Easy to calculate
Payback period
Which capital investment evaluation technique is described by the following characteristics? (1) Easy to understand; (2) Biased towards liquidity; (3) Requires an arbitrary cutoff point; (4) Ignores the time value of money.
Payback period
Which one of these actions by a firm is an example of milking the property? Assume the firm is in a period of financial distress.
Paying an extra dividend
Dividends
Payments made out of a firm's earnings to its owners in the form of cash or stock
NYSE
Physical exchange
Chapter 7 bankruptcy
Piecemeal liquidation of the firm's assets. - Trustee is appointed to sell off all of the firm's assets in an auction.
A financial device designed to make unfriendly takeover attempts financially unappealing, if not impossible, is called (a):
Poison pill
Synergy is defined as the:
Positive incremental net gain associated with the combination of two firms.
A manager will prefer the IRR rule over the NPV rule if the manager:
Prefers to talk in terms of rates of return
The profitability index is the ratio of:
Present value of cash flows to initial investment cost.
Live within our means
President Heber J Grant
As the required rate of return increases, the:
Profitability index decreases.
Randy's Manufacturing is considering two mutually exclusive projects. The company has a required rate of return of 13.5% on projects of this nature. Project A costs $100,000 and has an IRR of 14.5%. Project B costs $150,000 and has an IRR of 14%. Which project should be accepted and why?
Project B because it has the largest net present value
Project I has an initial cash outflow of $18,300 and annual cash flows of $8,700 for Years 1 to 3. Project II has an initial cash outflow of $25,400 and annual cash flows of $10,500 for Years 1 to 3. These projects are mutually exclusive. The required rate of return is 11 percent. Based on the incremental NPV(II - I), which project(s) should be accepted and why? Project II; because the incremental NPV(II - I) is negative Project I; because both the incremental NPV(II - I) and NPVI are positive Both Project I and II; because both project NPVs are positive Project II; because it has the larger NPV Project I; because the incremental NPV(II - I) is negative and NPVI is positive
Project I; because the incremental NPV(II - I) is negative and NPVI is positive
Ranking conflicts can arise if one relies on IRR instead of NPV when:
Projects are mutually exclusive.
An attempt to gain control of a firm by soliciting a sufficient number of shareholder votes to replace the current board of directors is called a:
Proxy contest
Assume that 20% of the shareholders of ABC Co. are extremely unhappy with the company's management and would like to replace all of the senior executives. To do this, they need control over the board of directors. This situation has a high probability of leading to a:
Proxy contest
A _____ is a derivative security that gives the owner the right, but not the obligation, to sell an asset at a fixed price for a specified period of time.
Put Option
A project has an initial cash inflow of $40,800 and a cash outflow of $44,900 in Year 1. The discount rate is 10 percent. Should this project be accepted or rejected based on IRR? Why?
Rejected, because the IRR is greater than the discount rate. IRR = $40,800 + (-$44,900) / (1 + IRR) IRR = 10.05% NPV = $40,800 + (-$44,900) / 1.10 NPV = -$18.18 Because this is a financing-type project, the project should be rejected since the IRR of 10.05 percent is greater than the discount rate of 10 percent. This is verified by the negative NPV at the 10 percent discount rate.
Which one of the following is an example of an incremental cash flow for Project A?
Rental cost of some new machinery that will be acquired for Project A
Which one of the following is the best example of two mutually exclusive projects?
Renting out a company warehouse or selling it outright.
Chapter 11 bankruptcy
Reorganization of the business.
The payback period rule:
Required an arbitrary choice of a cutoff point.
Which one of these formulas will provide an estimate of the growth rate of a security's dividends?
Retention ratio × Return on equity
For a firm with a constant payout ratio, the dividend growth rate can be estimated as:
Return on retained earnings × Retention ratio.
Which of the following is NOT given as a possible way to harvest?
Reverse leveraged buyout
Expected return equation
Rf + Bi (Rm - Rf)
CAPM equation
Ri = Rf + Bi (Rm - Rf) Ri = return on the ith security Rf = risk free rate Rm = return on the market Bi = security's beta (Rm - Rf) = market risk premium
According to the reading, what is risk?
Risk is uncertainty.
The sale of an asset creates an aftertax cash flow in an amount equal to the:
Sale price - Tax rate × (Sales price - Book value).
Walks Softly sells customized shoes. Currently, it sells 16,000 pairs of shoes annually at an average price of $68 a pair. The company is considering adding a lower-priced line of shoes that will sell for $39 a pair. Walks Softly estimates it can sell 7,000 pairs of the lower-priced shoes but will sell 1,000 less pairs of the higher-priced shoes by doing so. What is the amount of the sales that should be used when evaluating the addition of the lower-priced shoes?
Sales = (7,000 × $39) - (1,000 × $68) = $205,000
Which one of these is represented by the slope of the characteristic line?
Security Beta
Beta
Sensitivity of a stock's return to the return on the market portfolio
An advantage of the payback method is its:
Simplicity.
put-call parity
Since the values of call and put options both depend on the same underlying stock price, it is natural that the prices of these options are related.
Based on the period of 1926 through 2012, which category of securities has outperformed all of the other categories?
Small-company stocks
Which one of the following is a correct ranking of securities based on their volatility over the period of 1926 to 2012? Rank from highest volatility to lowest volatility.
Small-company stocks, large-company stocks, long-term government bonds
A contract that limits the holdings of a bidder to a minority stake in the target firm is called a:
Standstill agreement
In a stock split, a company distributes additional shares to its shareholders.
Stock splits have no impact on the market value of the firm's equity, they only increase the total number of shares outstanding. • Thus, the stock price falls because equity value is divided over more shares. • Unlike cash dividends, stock splits are untaxed. Thus, there is no effect on value.
Which of the following is a correct statement?
Stockholders can achieve diversification on their own
Over the period 1925-2012, stocks outperformed bonds by a wide margin. What conclusion should you draw from this performance?
Stocks are riskier than bonds.
For our historical comparison purposes, how are large-company stocks defined?
Stocks of firms included in the S&P 500 composite index
Over the long-term, which one of the following is a correct statement concerning risk premium?
Stocks tend to have a higher risk premium than bonds.
The fixed price in an option contract at which the owner can buy or sell the underlying asset is called the option's:
Strike Price
The discounted payback period is best defined as the length of time until the:
Sum of the discounted cash flows is equal to the initial investment.
Which one of these defines the maximum price that a bidder should pay for a target firm?
Summation of the target firm's market value plus the value of the synergy created by the merger
You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost.
Sunk
A change in the corporate charter making it more difficult for the firm to be acquired by increasing the percentage of shareholders that must approve a merger offer is called a:
Supermajority amendment.
Depreciation example - MACRS
Suppose you purchase a new machine for $100. The machine is in the 3 year MACRS category. Hence, it will be depreciated over 4 years, as: cost * percentage for y1 = 100 * .33 = $33 cost * percentage for y2 = 100 * .45 = $45 cost * percentage for y3 = 100 * .15 = $15 cost * percentage for y4 = 100 * .07 = $7 Accounts for implementation mid-year. Other MACRS tables are available if needed.
Which one of these should be the primary appeal of unused debt capacity to a bidder firm?
Tax savings resulting from increased interest expense on additional debt
Consider the pie models of corporate structure. What is the difference between the all-equity pie and the levered pie for a firm in the presence of taxes?
Taxes eat a slice of both pies but take a larger slice of the all-equity pie.
7.82%
Taylor s has a beta of .78 and a debt-to-equity ratio of .2. The market rate of return is 10.6 percent, the tax rate is 34 percent, and the risk-free rate is 1.4 percent. The pretax cost of debt is 6.1 percent. What is the firm's WACC?
The ABC Company contacts the shareholders of XYZ Company and offers to buy their shares at a premium. This is an illustration of a:
Tender offer
A horizontal merger is the acquisition of a firm
That competes in the same industry as the acquiring firm
You're trying to decide whether to continue a project that began last year. It required R&D expenditures of $1 million last year and will require additional R&D expenditures of $2 million two years from now. What R&D expenditures should be included in your DCF analysis?
The $1 million spent last year is a sunk cost. No decision can be made to get that $1 million back.
Which of the following statements related to the internal rate of return (IRR) is correct?
The IRR is equal to the required return when the net present value is equal to zero.
If the required return is zero, then:
The NPV equals the difference between the undiscounted future cash flows and the initial cost.
9.16%
The Saunders Investment Bank has the following financing outstanding. Debt: 110,000 bonds with a coupon rate of 7 percent and a current price quote of 109.5; the bonds have 20 years to maturity. 280,000 zero coupon bonds with a price quote of 18 and 30 years until maturity. Assume semiannual compounding. Preferred stock: 200,000 shares of 5 percent preferred stock with a current price of $71, and a par value of $100. Common stock: 3,100,000 shares of common stock; the current price is $57, and the beta of the stock is 1.1. Market: The corporate tax rate is 25 percent, the market risk premium is 8 percent, and the risk-free rate is 5 percent. What is the WACC for the company?
The Template Corporation has an equity beta of 1.2 and a debt beta of .8. The firm's market value debt to equity ratio is .6. Template has a zero tax rate. What is the asset beta? Multiple Choice 0.70 0.72 0.96 1.04 1.05
The Template Corporation has an equity beta of 1.2 and a debt beta of .8. The firm's market value debt to equity ratio is .6. Template has a zero tax rate. What is the asset beta? A. 0.70 B. 0.72 C. 0.96 D. 1.04 E. 1.05 .8(.6/1.6) + 1.2(1/1.6) = 1.05
Homemade dividend policy
The ability of shareholders to undo the dividend policy of the firm and create an alternative dividend payment policy via reinvesting dividends or selling shares of stock
Which one of the following statements is correct concerning the average accounting return (AAR)?
The average book value used in the AAR formula will always equal one-half of the initial investment as long as straight-line depreciation over the life of the project is used.
long position
The buyer (or holder) of the option The option holder only exercises if the decision is profitable ("in-the- money").
Liquidation
The complete termination of a firm as a going business concern
Which one of these statements is correct?
The cost of test marketing a product prior to deciding whether or not to produce is a sunk cost.
Which one of these statements is correct?
The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
Which one of these statements is correct? -Operating cash flow is equal to net income plus depreciation plus taxes. -Sunk costs should be included in the initial cost of a project. -Synergy occurs when a new product reduces the sales of a current product. -The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost. -Real cash flows must be discounted at the nominal rate.
The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
Which one of these statements is correct?- - Operating cash flow is equal to net income plus depreciation plus taxes. Sunk costs should be included in the initial cost of a project. Synergy occurs when a new product reduces the sales of a current product. Correct The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost. Real cash flows must be discounted at the nominal rate.
The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
Indirect Bankruptcy Costs
The costs of avoiding a bankruptcy filing by a financially distressed firm
Bloomfield's has some equipment sitting idle in a warehouse. The equipment is fully paid for and also fully depreciated. If the firm decides to use this equipment for a new project, what cost, if any, should the firm include in its startup costs for the project? -There is no cost to the project for this equipment. -The original purchase price of the equipment should be included in the startup costs. -The original purchase price minus any tax savings realized to date on the depreciation should be included in the startup costs. -The current market value of the equipment should be included in the startup costs. -The annual storage cost for the equipment should be included as a cash inflow in the startup costs.
The current market value of the equipment should be included in the startup costs.
Speculative Value
The difference between the option premium and the intrinsic value of the option. Option premium = Intrinsic Value + Speculative Value
The internal rate of return may be defined as:
The discount rate that makes the NPV equal to zero.
B) internal rate of return.
The discount rate that makes the net present value of an investment exactly equal to zero is called the A) profitable rate of return. B) internal rate of return. C) average accounting return. D) profitability index. E) risk-free rate.
You are considering a project with conventional cash flows, an IRR of 11.63 percent, a PI of 1.04, an NPV of $987, and a payback period of 2.98 years. Which one of the following statements is correct given this information?
The discount rate used to in computing the net present value was less than 11.63 percent
D) uses an arbitrary cutoff period.
The discounted payback method A) discounts a project's initial cost. B) is simpler and more reliable than the payback period. C) is as reliable as NPV because both methods use discounted cash flo. D) uses an arbitrary cutoff period. E) ignores a project's initial costs.
If a project with conventional cash flows has a profitability index less than one, then:
The discounted payback period is greater than the project's life
C) discount rate applied to the project is decreased.
The discounted payback period of a project will decrease whenever the A) initial cash outlay for the project is increased. B) amount of each projected cash inflow is decreased. C) discount rate applied to the project is decreased. D) time period of the project is increased. E) costs of the fixed assets utilized in the project increase.
Which one of the following statements is correct if a firm has a receivables turnover of 10?
The firm collects on its sales in an average of 36.5 days.
D) will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent.
The internal rate of return A) is more reliable as a decision making tool than net present value when considering mutually exclusive projects. B) is the discount rate that makes the net present value of a project equal to one. C) is easier to apply than net present value when cash flows are unconventional. D) will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent. E) is influenced by daily changes in the market rate of interest.
You are trying to determine whether to accept project A or project B. These projects are mutually exclusive. As part of your analysis, you should compute the incremental IRR by determining:
The internal rate of return for the differences in the cash flows of the two projects.
An independent project has conventional cash flows and a positive net present value. It can be stated with certainty that the project is acceptable according to the capital budgeting technique known as:
The internal rate of return.
Which one of the following statements is correct?
The management of an acquiring firm may put itself at risk of losing control of the firm if they do acquisitions using shares of stock
What type of risk-taking is rewarded?
The market compensates investors for accepting risk - but only for market risk. Firm-specific risk can and should be diversified away. That's the mystery element - how much market risk does a security have? We need to be able to measure market risk.
E) The project is earning $210 in addition to the project's required rate of return.
The net present value of a project is projected at $210. How should this amount be interpreted? A) The project's cash inflows exceed its outflows by $210. B) The project will return an accounting profit of $210. C) The project's discounted cash flows are $210 less than its undiscounted cash flows. D) The project will increase the firm's cash account by $210 when the project is started. E) The project is earning $210 in addition to the project's required rate of return.
call option put option
The option to buy an asset for a fixed price on a future date the option to sell the asset
Which one of the following statements is correct when a project is operating at its financial break-even point?
The present value of the cash flows subsequent to the initial cash flow equals the amount of the initial investment.
Given an exercise price, E, time to maturity, t, and European put-call parity, the present value of the strike price plus the value of the call option on the stock is equal to:
The price of the stock plus the price of the put option.
You decide to value an IPO using a price-to-sales ratio because the firm has negative earnings and a PE ratio would result in a negative price. Your discount rate is 20 percent, price-to-sales ratio is 1.1, and market-to-book ratio is 1.3. What is the value of your firm if it has the following simplified income statement? Sales $60,000 Cogs (40,000) Expenses (20,000) Depreciation (10,000) Taxes 4,000 Earnings (6,000)
The problem states that you want to use the price-to-sales ratio because a PE approach would not make sense. A negative price means the company is worth less than nothing using a PE, so instead you take sales of $60,000 and multiply it by the price-to-sales ratio of 1.1 to get $66,000.
Which of the following is NOT a true statement?
The profitability index is closely related to the payback period.
For a project with conventional cash flows, if NPV is greater than zero, then:
The profitability index is greater than 1.
The net present value of a project is projected at $210. How should this amount be interpreted?
The project is earning $210 in addition to the project's required rate of return
The net present value of a project is projected at $210. How should this amount be interpreted?
The project is earning $210 in addition to the project's required rate of return.
What is the key reason why a positive NPV project should be accepted?
The project is expected to increase shareholder value
What is the key reason why a positive NPV project should be accepted?
The project is expected to increase shareholder value.
A project has a net present value of $1,200 and a project life of 4 years. Which one of these statements must be true?
The project is expected to return $1,200 in Time 0 dollars over and above the discount rate.
How should a profitability index of zero be interpreted?
The project's cash flows subsequent to the initial cash flow have a present value of zero.
If a project has a net present value equal to zero, then:
The project's internal rate of return is exactly equal to the discount rate
Hi-Tech announces a major expansion which causes the price of its stock to increase and also causes an increase in the volatility of the stock price. How will these two market reactions affect the value of put options on Hi-Tech stock?
The reactions will have offsetting effects on put option prices.
put-call parity relationship
The relationship between the prices of the underlying stock, a call option, a put option, and a riskless asset
You are considering a project with conventional cash flows. The IRR is 12.6 percent, NPV is -$198, and the payback period is 2.87 years. Which one of the following statements is correct given this information?
The required rate of return must be greater than 12.6 percent
You are considering a project with conventional cash flows. The IRR is 12.6 percent, NPV is -$198, and the payback period is 2.87 years. Which one of the following statements is correct given this information?
The required rate of return must be greater than 12.6 percent.
index funds
The section "Strategies for Personal Investing," on page 15-7, says that BYU professors and many others have documented that if you invest in index funds you will earn more on average than if you invested in actively-managed funds.
short position
The seller of the option The seller has no control over whether the option holder exercises. • Why does anyone sell options? They get paid up-front for the contract.
Which of the following is a case in which tax gains are used as a justification for purchasing another firm?
The target firm has unused net operating losses that can be used by the bidder
Which one of the following is a characteristic of an acquisition by stock?
The target firm's management can be bypassed by the use of a tender offer
You purchased an asset three years ago at a cost of $135,000 and sold it today for $82,500. The equipment is 5-year property for MACRS. The MACRS table values are .2000, .3200, .1920, .1152, .1152, and .0576 for Years 1 to 6, respectively. Which one of the following statements is correct if tax rate is 34 percent?
The tax due on the sale is $14,830.80.
What is the primary shortcoming of the average accounting rate of return from a financial perspective? The lack of use in the business world The lack of a clear-cut decision rule The degree of the calculation difficulty The degree of estimation involved with the initial cost The use of net income rather than cash flows
The use of net income rather than cash flows
overall rate which the firm must earn on its existing assets to maintain the value of its stock.
The weighted average cost of capital for a firm is the:
Pecking Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. Rule 1: Use internal financing first. Rule 2: Issue debt next, new equity last. The pecking-order theory is at odds with the tradeoff theory: There is no target D/E ratio. Profitable firms use less debt. Companies like financial slack.
The problem of multiple IRRs can occur when:
There is more than one sign change in the cash flows.
Which of the following statements is false?
There will typically be a gain in an acquisition if the target firm's management is better than the management of the acquiring firm
You are considering a project with the following data: Internal rate of return 8.7% Profitability ratio .98 Net present value -$393 Payback period 2.44 years Required return 9.5% Which one of the following is correct given this information? A. The discount rate used in computing the net present value must have been less than 8.7%. B. The discounted payback period will have to be less than 2.44 years. C. The discount rate used to compute the profitability ratio was equal to the internal rate of return. D. This project should be accepted based on the profitability ratio. E. This project should be rejected based on the internal rate of return
This project should be rejected based on the internal rate of return
You are considering a project with the following data: Internal rate of return 8.7% Profitability ratio .98 Net present value −$393 Payback period 2.44 years Required return 9.5% Which one of the following is correct given this information?
This project should be rejected based on the internal rate of return.
The elements that cause problems with the use of the IRR in projects that are mutually exclusive are:
Timing and scale problems.
An asset used in a four-year project falls in the five-year MACRS class for tax purposes. The asset has an acquisition cost of $6,180,000 and will be sold for $1,380,000 at the end of the project. If the tax rate is 34 percent, what is the aftertax salvage value of the asset?
To find the BV at the end of four years, we need to find the accumulated depreciation for the first four years. We can add the MACRS depreciation amounts for each of the first four years and multiply this percentage times the cost of the asset. We can then subtract this from the asset cost. Doing so, we get: BV4 = $6,180,000 − 6,180,000(.2000 + .3200 + .1920 + .1152) BV4 = $1,067,904 The asset is sold at a gain to book value, so this gain is taxable. Aftertax salvage value = $1,380,000 + ($1,067,904 − 1,380,000)(.34) Aftertax salvage value = $1,273,887.36
In foreign exchange markets, the amount of trading in forward contracts is at least 10 times greater than the amount of trading in futures contracts.
True
T/F: An asset will be depreciated faster using MACRS rather than the straight-line method.
True
True or False? The acquiring firm's shareholders are better served if a negative NPV acquisition is a stock, rather than a cash, transaction.
True
Details of cash flow calculations Depreciation expense
Two methods: MACRS depreciation expense = cost * percentage percentage determined by life cost, or basis, never changes straight-line depreciation expense = (cost - salvage) / life
Details of cash flow calculations - Taxes
Two situations Tax on annual cash flows - usually a fixed marginal rate Tax on sale of equipment Calculate book value: cost - accumulated depr If BV < estimated resale value, then there is a taxable gain If BV > estimated resale value, then there is a taxable loss Important: even if the equipment is not expected to be sold, you still need to figure the tax consequence of writing off the remaining BV
Which one of the following types of securities has tended to produce the lowest real rate of return for the period 1926 through 2012?
U.S. Treasury bills
Which one of these categories of securities has had the lowest volatility of returns over the period of 1926 through 2012?
U.S. Treasury bills
Which of the following is NOT a source of acquisition gains from cost reduction?
Unused debt capacity
D) Net present value
Uptown Developers is considering two projects. Project A consists of building a wholesale book outlet on the firm's downtown lot. Project B consists of building a sit-down restaurant on that same lot. The lot can only accommodate one of the projects. When trying to decide whether to build the book outlet or the restaurant, management should rely most heavily on the analysis results from which one of these methods? A) Profitability index B) Internal rate of return C) Payback D) Net present value E) Accounting rate of return
The value of target Firm B to acquiring Firm A is normally expressed as:
VB + V
MM Proposition I (no taxes)
Value of the levered firm is the same value of the unlevered firm.
A successful merger requires that the
Value of the whole exceeds the value of the sum of the parts.
a pioneer in low cost index funds
Vanguard
The acquisition of a firm in a different production process stage than the bidder is called a:
Vertical acquisition.
When using a DCF method with free cash flows to the firm to value a firm, what measure should we use for the discount rate?
WACC
Teri's Tires pays $7 per share on its preferred stock that sells for $68 a share. What is Teri's cost of preferred stock if flotation costs equal 5 percent?
We use a perpetuity for preferred stock. Don't forget to take out float costs. Rp = $7 / ($68 * (1 - 0.05)) = 11 percent
Expected return on a portfolio
Weighted average of the expected returns on the individual securities
A) The project is expected to increase shareholder value.
What is the key reason why a positive NPV project should be accepted? A) The project is expected to increase shareholder value. B) The present value of the expected cash flows equals the project's cost. C) The project will produce positive cash flows in the future. D) The project's payback will be positive during its life. E) The project's PI will be less than 1, which indicates acceptance.
A Cost of Zero
What value should you assign as the flotation cost of internally-generated equity financing?
exercising the option
When the holder of a call (put) option decides to buy (sell) the asset at expiration
A. Accepted because the profitability index is greater than 1.
When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: A. Accepted because the profitability index is greater than 1. B. Rejected because the internal rate of return is negative. C. Rejected because the net present value is positive. D. Accepted because the payback period is less than the required time period.
B) Payback and discounted payback
Which methods of project analysis are most biased towards short-term projects? A) Net present value and internal rate of return B) Payback and discounted payback C) Accounting rate of return and internal rate of return D) Payback and accounting rate of return E) Internal rate of return and discounted payback
B. The IRR is equal to the required return when the net present value is equal to zero.
Which of the following statements related to the internal rate of return (IRR) is correct? A. A project with an IRR equal to the required return would reduce the value of a firm if accepted. B. The IRR is equal to the required return when the net present value is equal to zero. C. The payback period is a better method of analysis than the IRR from a financial point of view. D.The IRR yields the same accept and eject decisions as the net present value method given mutually exclusive projects.
Financial leverage refers to a firm's use of debt and its related fixed costs of finance.
Which one of these statements is correct?
Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and aftertax income of $74,200? -Depreciation increases the net book value of the firm's assets. -Depreciation in a non-cash expense that increases the firm's cash flows. -Depreciation lowers the firm's net income but does not affect its cash flows. -Depreciation has no effect on either the firm's net income or its cash flows. -Depreciation decreases both the firm's net income and its cash flows.
Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and aftertax income of $74,200?
Eat M Up is considering a hostile takeover of the Everyday Company. To prevent such an event, the Everyday Company scrambles to get the Good Guys Network to buy them. The Good Guys Network is referred to as the:
White Knight.
According to the capital budgeting surveys cited in the text, in general, most financial managers of large Canadian firms:
Who use payback analysis use it only in conjunction with some other type of analysis
An investment has the following cash flows. Should the project be accepted if it has been assigned a required return of 14 percent? Why or why not?
Yes; The IRR exceeds the required return by about 1.08 percent.
Webster's wants to introduce a new product that has a startup cost of $15,000. The product has a 2-year life and will provide cash flows of $12,700 in Year 1 and $6,300 in Year 2. The required rate of return is 10 percent. Should the product be introduced? Why or why not? Yes; The PI is 1.04. No; The PI is .90. Yes; The IRR is 19.74 percent. Yes; The NPV is $851.24. No; The IRR is 8.78 percent.
Yes; The IRR is 19.74 percent.
An investment has the following cash flows. Should the project be accepted if it has been assigned a return of 9.5%? Why or why not? Year Cash Flows 0 -$24,000 1 $8,000 2 $12,000 3 $9,000
Yes; because the IRR exceeds the required return by about .39%.
D. The discount rate used to in computing the net present value was less than 11.63 percent
You are considering a project with conventional cash flows, an IRR of 11.63 percent, a PI of 1.04, an NPV of $987, and a payback period of 2.98 years. Which one of the following statements is correct given this information? A. The project must be rejected based on its PI value B. The breakeven discount rate is less than 11.63 percent C. The discounted payback period must be less than 2.98 years D. The discount rate used to in computing the net present value was less than 11.63 percent
E) The required rate of return must be greater than 12.6 percent.
You are considering a project with conventional cash flows. The IRR is 12.6 percent, NPV is -$198, and the payback period is 2.87 years. Which one of the following statements is correct given this information? A) The discount rate used in computing the net present value was less than 12.6 percent. B) The discounted payback period will have to be less than 2.87 years. C) The project life must be 2.87 years. D) This project should be accepted based on the internal rate of return. E) The required rate of return must be greater than 12.6 percent.
You are considering an investment with the following cash flows. If the required rate of return for this investment is 13.5%, should you accept it based solely on the internal rate of return rule? Why or why not? Year Cash Flows 0 -$12,000 1 $5,500 2 $8,000 3 -$1,500
You can not apply the IRR rule in this case because there are multiple IRRs.
You are considering an investment with the following cash flows. If the required rate of return for this investment is 13.5%, should you accept it based solely on the internal rate of return rule? Why or why not?
You can not apply the IRR rule in this case because there are multiple IRRs. (Since C03 is a negative value resulting in more than one sign change, there are multiple IRRs. Thus, the IRR rule does not apply.)
A project has an initial cost of $51,900 and cash flows of $18,700, $56,500, and -$9,100 for Years 1 to 3, respectively. If the required rate of return for this investment is 17 percent, should you accept it based solely on the internal rate of return rule? Why or why not?
You cannot apply the IRR rule in this case because there are multiple IRRs.
A project has an initial cost of $51,900 and cash flows of $18,700, $56,500, and -$9,100 for Years 1 to 3, respectively. If the required rate of return for this investment is 17 percent, should you accept it based solely on the internal rate of return rule? Why or why not?
You cannot apply the IRR rule in this case because there are multiple IRRs. Since the cash flow in Year 3 is a negative value, there are multiple IRRs. Thus, the IRR rule does not apply
You are considering two independent projects with the following cash flows. The required return for both projects is 10%. Given this information, which one of the following statements is correct? Year 0 PA: -$950,000 PB: -$125,000 Year 1 PA: $330,000 PB: $55,000 Year 2 PA: $400,000 PB: $50,000 Year 3 PA: $450,000 PB: $50,000
You should accept both projects if the funds are available to do so since both NPV's are > 0. (Since these are independent projects and both the IRR and NPV rules say accept, you should accept both projects if there are sufficient funds to do so.)
You are considering two independent projects both of which have been assigned a discount rate of 8%. Based on the profitability index, what is your recommendation concerning these projects? Year Cash Flows Project A: 0: -$38,500 1: $20,000 2: $24,000 Project B: 0: -$42,000 1: $10,000 2: $40,000
You should accept both projects since both of their PIs are greater than 1. (Because the projects are independent and their PIs exceed 1.0, both projects should be accepted.)
Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated
^ interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e., 8% * 0.65) WACC = (0.3 * 5.2%) + (0.7 * 14%) = 11.4%
30. Assigning discount rates to individual projects based on the risk level of each project: A. May cause the firm's overall weighted average cost of capital to either increase or decrease over time. B. Will prevent the firm's overall cost of capital from changing over time. C. Will cause the firm's overall cost of capital to decrease over time. D. Decreases the value of the firm over time. E. Negates the firm's goal of creating the most value for the shareholders.
a
45. Highway Express has paid annual dividends of $1.05, $1.10, $1.12, $1.15, and $1.25 over the past five years, respectively. What is the average dividend growth rate? A. 4.49 percent B. 3.60 percent C. 5.98 percent D. 2.47 percent E. 4.39 percent
a
For the levered firm the equity beta is __________ the asset beta. A. greater than B. less than C. equal to D. sometimes greater than and sometimes less than E. None of the above.
a
The buyer of a European call option has the: a. right but not the obligation to buy a stock at a specified price on a specified date. b. right but not the obligation to buy a stock at a specified price during a specified period of time. c. obligation to buy a stock on a specified date but only at the specified price. d. obligation to buy a stock sometime during a specified period of time at the specified price. e. obligation to buy a stock at the lower of the exercise price or the market price on the expiration date.
a
An option that grants the right, but not the obligation, to sell shares of the underlying asset on a particular date at a specified price is called:
a European put
An option that grants the right, but not the obligation, to sell shares of the underlying asset on a particular date at a specified price is called:
a European put.
When compiling the relevant cash flows for a project, the aftertax value of any asset sold any time during the life of the project should be treated as:
a cash flow in the year of sale.
firm-specific risk
a company's labor force goes on strike, a company's top management dies in a plane crash, a huge oil tank bursts and floods a company's production area
Under a fixed exchange rate system,
a country that ties its currency to that of another country LOSES control over its monetary policy
All else constant, a bond will sell at _____ when the yield to maturity is _____ the coupon rate.
a discount; greater than
option
a financial contract between two parties that gives the buyer the right, but not the obligation, to purchase an underlying asset for a fixed price at some future date from the option seller
Which one of the following combination of firms is most apt to create synergistic benefits through their use of complementary resources?
a hotel and a convention center
golden parachute
a lucrative severance package for the firm's senior managers in the event of a merger, actually increases the likelihood of a takeover.
Diversified Industries is a multiproduct company operating in a number of industries. Assume the company is analyzing a new project that has risks unrelated to those of the current company's products. When computing the net present value of the new project the cash flows should be discounted using
a rate commensurate with the risk level of the project.
Puffy's Pastries generates five cents of net income for every $1 in equity. Thus, Puffy's has _______ of 5 percent.
a return on equity
Another common name for a poison pill takeover defense is ______________.
a share rights plan
One example of ______________ is called greenmail
a targeted repurchase agreement
All else constant, a coupon bond that is selling at a premium, must have:
a yield to maturity that is less than the coupon rate.
Suppose you sold the following options on General Electric (GE) stock that expire on Friday. The stock price of GE on Friday afternoon is $30 per share. Which options will be exercised and what is your exposure? a) Put option with a strike price of $20. b) Put option with a strike price of $40. c) Call option with a strike price of $25. d) Call option with a strike price of $35.
a) wont be exercised, can buy it for $30 and sell for $20 b) 40-30 = 10 c) buy for 25 sell for 30 30-25 = 5 d) wont be exercised, buy for 35 sell for 30
Alto and Solo are all-equity firms. Alto has 2,400 shares outstanding at a market price of $24 a share. Solo has 4,000 shares outstanding at a price of $17 a share. Solo is acquiring Alto for $63,000 in cash. The incremental value of the acquisition is $5,500. What is the net present value of acquiring Alto to Solo? a. $100 b. $400 c. $1,200 d. $2,400 e. $5,500
a. $100
Rudy's, Inc. and Blackstone, Inc. are all-equity firms. Rudy's has 1,500 shares outstanding at a market price of $22 a share. Blackstone has 2,500 shares outstanding at a price of $38 a share. Blackstone is acquiring Rudy's for $36,000 in cash. What is the merger premium per share? a. $2.00 b. $4.25 c. $6.50 d. $8.00 e. $14.00
a. $2.00
Goodday & Sons is being acquired by Baker, Inc. for $19,000 worth of Baker stock. Baker has 1,500 shares of stock outstanding at a price of $25 a share. Goodday has 1,000 shares outstanding with a market value of $16 a share. The incremental value of the acquisition is $2,000. How many new shares of stock will be issued to complete this acquisition? a. 760.0 shares b. 840.0 shares c. 960.0 shares d. 1,187.5 shares e. 1,312.5 shares
a. 760.0 shares
Which one of the following statements is correct? a. A spin-off frequently follows an equity carve-out. b. A split-up frequently follows a spin-off. c. An equity carve-out is a specific type of acquisition. d. A spin-off involves an initial public offering. e. A divestiture means that the original firm ceases to exist.
a. A spin-off frequently follows an equity carve-out.
(Capital Gains tax) Hammer Inc. is considering selling one of its old machines. The machine was purchased 8 years ago for $40,000, had an expected life of 10 years and an expected value of zero. Hammer uses simplified straight-line depreciation, creating depreciation of $4,000 per year. Moreover, Hammer can sell the machine for $45,000. Also assume a 34% marginal tax rate. a. What would be the taxes associated with this sale? b. If the machine was sold for $40,000, what would be the taxes associated with this sale? c. If the machine was sold $8,000, what would be the taxes associated with this sale? d. If the machine was sold for $5,000, what would be the taxes associated with this sale?
a. Book value: 40000-32000 (8 years @ $4,000/year) = 8000 Gain on sale: 45,000 (sale price) - 8000 (book value) = 37000 37000 * .64 = 12580 taxes associated with sale b. Gain on sale: 40000 - 8000 = 32000 32000 * 0.34 = $10,880 taxes associated with sale c. Gain on sale: 8000 - 8000 = 0 no taxes associated with sale d. Loss on sale: 5000-8000 - -3000 -3000 * 0.34 = $1020 tax savings associated with sale
Which of the following statements concerning acquisitions are correct? I. Being acquired by another firm is an effective method of replacing senior management. II. The net present value of an acquisition should have no bearing on whether or not the acquisition occurs. III. Acquisitions are often relatively complex from an accounting and tax point of view. IV. The value of a strategic fit is easy to estimate using discounted cash flow analysis. a. I and III only b. II and IV only c. I and IV only d. I, III, and IV only e. I, II, III, and IV
a. I and III only
Which one of the following is most likely a good candidate for an acquisition that could benefit from the use of complementary resources? a. a sports arena that is home only to an indoor hockey team b. a hotel in a busy downtown business district of a major city c. a day care center located near a major route into the main business district of a large city d. an amusement park located in a centralized Florida location e. a fast food restaurant located near a major transportation hub
a. a sports arena that is home only to an indoor hockey team
The shareholders of a target firm benefit the most when: a. an acquiring firm has the better management team and replaces the target firm's managers. b. the management of the target firm is more efficient than the management of the acquiring firm which replaces them. c. the management of both the acquiring firm and the target firm are as equivalent as possible. d. their current management team is kept in place even though the managers of the acquiring firm are more suited to manage the target firm's situation. e. their management team is technologically knowledgeable yet ineffective.
a. an acquiring firm has the better management team and replaces the target firm's managers.
A change in the corporate charter making it more difficult for the firm to be acquired by increasing the percentage of shareholders that must approve a merger offer is called a: a. supermajority amendment. b. standstill agreement. c. greenmail provision. d. poison pill amendment. e. white knight provision.
a. supermajority amendment
The value of a target firm to the acquiring firm is equal to: a. the value of the target firm as a separate entity plus the incremental value derived from the acquisition. b. the purchase cost of the target firm. c. the value of the merged firm minus the value of the target firm as a separate entity. d. the purchase cost plus the incremental value derived from the acquisition. e. the incremental value derived from the acquisition.
a. the value of the target firm as a separate entity plus the incremental value derived from the acquisition.
According to the interest parity condition, if the domestic interest rate is ________ the foreign interest rate, then ________.
above; there is expected appreciation of the foreign currency
You are considering the following two mutually exclusive projects. Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage value. Project A: CF0: -$75,000 CF1: $19,000 CF2: $48,000 CF3: $12,000 Project B: CF0: -$70,000 CF1: $10,000 CF2: $16,000 CF3: $72,000 Required rate of return 10%, 13%; Required payback period 2.0 years, 2.0 years Based on the net present value method of analysis and given the information in the problem, you should:
accept project B and reject project A.
Internal Rate of Return (IRR) method decision criteria
accept project if IRR ≥ required return (cost of capital) reject project if IRR < required return (cost of capital)
Net Present Value (NPV) method decision criteria
accept project if NPV is ≥ 0 (positive) reject project if NPV is < 0 (negative)
Profitability Index (P.I.) method decision criteria
accept project it P.I. is ≥ 1 reject project is P.I. is < 1
When the present value of the cash inflows exceeds the initial cost of a project, then the project should be:
accepted because the NPV is greater than 0.
If the project beta and IRR coordinates plot above the SML the project should be:
accepted.
An investment's average net income divided by its average book value defines the average:
accounting return.
The purpose of a proxy contest is for a group of shareholders to:
accumulate sufficient votes to gain controlling seats on the board of directors
The primary difference between a merger and a consolidation is that the _____ firm continues to exist in a _____ but not in a _____.
acquiring firm; merger; consolidation
Investors exit in two main ways
acquisitions and public offerings.
When a specialist is caught in the middle of a trade between informed and uniformed traders, which effectively eliminates the spread or causes a loss, is subject to:
adverse selection.
cash flow rule #2
after-tax flows are what you have left to distribute to suppliers of capital
Which of the following is not a major business entity structure discussed in the text? -S-corp -LLC -all of the above -partnership -sole proprietorship
all of the above
The DCF approach has five steps. Which of the following is not a step? all of the above are steps use time value of money to discount the future cash flows to present value estimate a terminal value compute free cash flow for each forecasted period forecast and construct pro forma statements
all of the above are steps
Utilizing a decision tree, the NPV used to make the decision to commence the testing for a project is dependent on:
all project cash flows and probabilities over the project's entire life.
Putable bonds
allow bond holders to request repayment on specified put dates.
Economies of scope
allow large firms to cut costs by combining the marketing and distribution of different but related products
We can view the interest tax shield as decreasing the firm's cost of capital
allows us to lower WACC, if we lower WACC firm value increases
The book value of an asset is primarily used to compute the:
amount of tax due on the sale of an asset.
The incremental cash flows of a project are best defined as:
any change in a firm's cash flows resulting from the addition of the project including opportunity costs.
When the exchange rate for the euro changes from $1.00 to $1.20, then, holding everything else constant, the euro has
appreciated and German cars sold in the United States become more expensive.
Angel investors
are individual investors who buy equity in small private firms.
Venture capital firms
are limited partnerships that raise money to invest in the private equity of young firms. "mutual fund" of young firms
The return earned in an average year over a multi-year period is called the _____ average return.
arithmetic
26. If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to do all of the following except: A. Reject some positive net present value projects. B. Lower the average risk level of the firm over time. C. Increase the firm's overall level of risk over time. D. Accept some negative net present value projects. E. Favor high risk projects over low risk projects.
b
34. Which one of the following statements is correct? A. The subjective approach assesses the risks of each project and assigns an adjustment factor that is unique just for that project. B. Overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects. C. Firms will correctly accept or reject every project if they adopt the subjective approach. D. Mandatory projects should only be accepted if they produce a positive NPV when the firm's WACC is used as the discount rate. E. The pure play approach should only be used with low-risk projects.
b
36. 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.
b
42. The Shoe Outlet has paid annual dividends of $.65, $.70, $.72, and $.75 per share over the last four years, respectively. The stock is currently selling for $9a share. What is this firm's cost of equity? A. 8.74 percent B. 13.65 percent C. 10.38 percent D. 9.53 percent E. 11.79 percent
b
49. Tidewater Fishing has a current beta of 1.08. The market risk premium is 7.9 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 1.16? A. .88 percent B. .63 percent C. 2.60 percent D. 3.12 percent E. 3.83 percent
b
Which of the following is not true concerning call option writers? a. Writers promise to deliver shares if exercised by the buyer. b. The writer has the option to sell shares but not an obligation. c. The writer's liability is zero if the option expires out-of-the-money. d. The writer receives a cash payment from the buyer at the time the option is purchased. e. The writer has a loss if the market price rises substantially above the exercise price.
b
You wrote ten call option contracts on JIG stock with a strike price of $40 and an option price of $.40. What is your net gain or loss on this investment if the price of JIG is $46.05 on the option expiration date? a. -$6,450 b. -$5,650 c. $400 d. $5,650 e. $6,450
b
Jennifer's Boutique has 2,100 shares outstanding at a market price per share of $26. Sally's has 3,000 shares outstanding at a market price of $41 a share. Neither firm has any debt. Sally's is acquiring Jennifer's for $58,000 in cash. What is the merger premium per share? a. $1.43 b. $1.62 c. $1.81 d. $2.04 e. $2.07
b. $1.62
ABC and XYZ are all-equity firms. ABC has 1,750 shares outstanding at a market price of $20 a share. XYZ has 2,500 shares outstanding at a price of $28 a share. XYZ is acquiring ABC for $36,000 in cash. The incremental value of the acquisition is $3,000. What is the net present value of acquiring ABC to XYZ? a. $1,000 b. $2,000 c. $3,000 d. $4,000 e. $5,000
b. $2,000
Turner, Inc. has $4.2 million in net working capital. The firm has fixed assets with a book value of $48.6 million and a market value of $53.4 million. Martin & Sons is buying Turner, Inc. for $60 million in cash. The acquisition will be recorded using the purchase accounting method. What is the amount of goodwill that Martin & Sons will record on its balance sheet as a result of this acquisition? a. $0 b. $2.4 million c. $6.6 million d. $7.2 million e. $11.4 million
b. $2.4 million
Firm X is being acquired by Firm Y for $35,000 worth of Firm Y stock. The incremental value of the acquisition is $2,500. Firm X has 2,000 shares of stock outstanding at a price of $16 a share. Firm Y has 1,200 shares of stock outstanding at a price of $40 a share. What is the actual cost of the acquisition using company stock? a. $34,750 b. $34,789 c. $35,000 d. $35,289 e. $35,500
b. $34,789
One company wishes to acquire another. Which of the following forms of acquisition does not require a formal vote by the shareholders of the acquired firm? a. Merger b. Acquisition of stock c. Acquisition of assets d. Consolidation e. All of the above require a formal vote.
b. Acquisition of stock
Which one of the following combinations of firms would benefit the most through the use of complementary resources? a. a ski resort and a travel trailer sales outlet b. a golf resort and a ski resort c. a hotel and a home improvement center d. a swimming pool distributor and a kitchen designer e. a fast food restaurant and a dry cleaner
b. a golf resort and a ski resort
A merger is which an entirely new firm is created and both the acquired and acquiring firms cease to exist is called a: a. divestiture b. consolidation c. tender off d. spinoff e. conglomeration
b. consolidation
If an acquisition does not create value, then the: a. earnings per share of the acquiring firm must be the same both before and after the acquisition. b. earnings per share can change but the stock price of the acquiring firm should remain constant. c. price per share of the acquiring firm should increase because of the growth of the firm. d. earnings per share will most likely increase while the price-earnings ratio remains constant. e. price-earnings ratio should remain constant regardless of any changes in the earnings per share.
b. earnings per share can change but the stock price of the acquiring firm should remain constant.
The sale of stock in a wholly owned subsidiary via an initial public offering is referred to as a(n): a. split-up. b. equity carve-out. c. countertender offer. d. white knight transaction. e. lockup transaction.
b. equity carve-out
an attempt to gain control of a firm by soliciting a sufficient number of stockholder votes to replace existing management is called a: a. tender offer b. proxy contest c. going private transaction d. leveraged buyout e. consolidation
b. proxy contest
The distribution of shares in a subsidiary to existing parent company stockholders is called a(n): a. lockup transaction. b. bear hug. c. equity carve-out. d. spin-off. e. split-up.
b. spinoff
A contract wherein the bidding firm agrees to limit its holdings in the target firm is called a: a. supermajority amendment. b. standstill agreement. c. greenmail provision. d. poison pill amendment. e. white knight provision.
b. standstill agreement
Suppose that Exxon-Mobil acquired Schlumberger, an exploration/drilling company. Ignoring potential antitrust problems, this merger would be classified as a: a. monopolistic merger. b. vertical merger. c. conglomerate merger. d. horizontal merger. e. None of the above.
b. vertical merger.
FILO work principle
be the first in to work and the last out if that's what it takes
Systematic risk is measured by which of the following?
beta
Regression analysis can be used to estimate:
beta.
One advantage of the payback method of project analysis is the method's:
bias towards liquidity.
One advantage of the payback method of project analysis is the method's: application of a discount rate to each separate cash flow. bias towards liquidity. difficulty of use. arbitrary cutoff point. consideration of all relevant cash flows.
bias towards liquidity.
A consolidation is defined as a merger wherein
both the acquiring firm and the acquired firm cease to exist
if you are investing for a long term (15 to 40 years) historically, a ________ has been best
broad stock index
Why valuation?
buy / sell acquisition / divestiture partnership trouble understanding market divorce
long
buyer of option
Which combination is referred to as a protective put? Assume all sales and purchases refer to ABC stock and its options.
buying a put and buying 100 shares of stock
31. Which one of the following statements is correct? A. Firms should accept low-risk projects prior to funding high-risk projects. B. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm. C. A project that is unacceptable today might be acceptable tomorrow given a change in market returns. D. The pure play method is most frequently used for projects involving the expansion of a firm's current operations. E. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate.
c
32. Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an after tax cost of capital of 13 percent and Travel Excitement has an after tax cost of capital of 11 percent. Both firms are considering investing in new web sites that will enhance online reservations. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project? A. Wilderness Adventures only. B. Travel Excitement only. C. Both Wilderness Adventures and Travel Excitement. D. Neither Wilderness Adventures nor Travel Excitement. E. Cannot be determined without further information.
c
33. The subjective approach to project analysis: A. Is used only when a firm has an all-equity capital structure. B. Uses the WACC of Firm X as the basis for the discount rate for a project under consideration by Firm Y. C. Assigns discount rates to projects based on the discretion of the senior managers of a firm. D. Allows managers to randomly adjust the discount rate assigned to a project once the project's beta has been determined. E. Applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt.
c
For a multi-product firm, if a project's beta is different from that of the overall firm, then the: A. CAPM can no longer be used. B. project should be discounted using the overall firm's beta. C. project should be discounted at a rate commensurate with its own beta. D. project should be discounted at the market rate. E. project should be discounted at the T-bill rate.
c
The use of WACC to select investments is acceptable when the: A. correlation of all new projects are equal. B. NPV is positive when discounted by the WACC. C. risk of the projects are equal to the risk of the firm. D. firm is well diversified and the unsystematic risk is negligible. E. None of the above.
c
Which of the following statements are correct concerning option values? I. The value of a call increases as the price of the underlying stock increases. II. The value of a call decreases as the exercise price increases. III. The value of a put increases as the price of the underlying stock increases. IV. The value of a put decreases as the exercise price increases. a. I and III only b. II and IV only c. I and II only d. II and III only e. I, II, and IV only
c
You own both a May 20 call and a May 20 put. If the call finishes in the money, then the put will: (Note that May 20 call option is call option that matures in May with E = $20) a. also finish in the money. b. finish at the money. c. finish out of the money. d. either finish at the money or in the money. e. either finish at the money or out of the money.
c
You purchased four WXO 30 call option contracts at a quoted price of $.34. What is your profit or loss on this investment if the price of WXO is $33.60 on the option expiration date? a. -$1,576 b. -$136 c. $1,304 d. $1,440 e. $1,576
c
Firm A is acquiring Firm B for $25,000 in cash. Firm A has 2,000 shares of stock outstanding at a market value of $21 a share. Firm B has 1,200 shares of stock outstanding at a market price of $17 a share. Neither firm has any debt. The net present value of the acquisition is $1,500. What is the price per share of Firm A after the acquisition? a. $21.00 b. $21.25 c. $21.75 d. $22.00 e. $22.50
c. $21.75
Winslow Co. has agreed to be acquired by Ferrier, Inc. for $25,000 worth of Ferrier stock. Ferrier currently has 1,500 shares of stock outstanding at a price of $21 a share. Winslow has 1,000 shares outstanding at a price of $22. The incremental value of the acquisition is $4,000. What is the merger premium per share? a. $1 b. $2 c. $3 d. $4 e. $5
c. $3
Principal, Inc. is acquiring Secondary Companies for $29,000 in cash. Principal has 2,500 shares of stock outstanding at a market price of $30 a share. Secondary has 1,600 shares of stock outstanding at a market price of $15 a share. Neither firm has any debt. The net present value of the acquisition is $4,500. What is the price per share of Principal after the acquisition? a. $30.00 b. $30.70 c. $31.80 d. $32.10 e. $32.50
c. $31.80
Jennifer's Boutique has 2,100 shares outstanding at a market price per share of $26. Sally's has 3,000 shares outstanding at a market price of $41 a share. Neither firm has any debt. Sally's is acquiring Jennifer's for $58,000 in cash. The incremental value of the acquisition is $2,500. What is the value of Jennifer's Boutique to Sally's? a. $26,000 b. $27,600 c. $57,100 d. $58,200 e. $60,500
c. $57,100
Which of the following represent potential gains from an acquisition? I. the replacement of ineffective managers II. lower costs per unit produced III. an increase in firm size so that diseconomies of scale are realized IV. spreading of overhead costs a. II and III only b. I and IV only c. I, II, and IV only d. I, III, and IV only e. I, II, III, and IV
c. I, II, and IV only
Which of the following represent potential tax gains from an acquisition? I. a reduction in the level of debt II. an increase in surplus funds III. the use of net operating losses IV. an increased use of leverage a. I and IV only b. II and III only c. III and IV only d. I and III only e. II, III, and IV only
c. III and IV only
Which one of the following statements is correct? a. If an acquisition is made with cash, then the cost of that acquisition is dependent upon the acquisition gains. b. Acquisitions made by exchanging shares of stock are normally taxable transactions. c. The management of an acquiring firm may put itself at risk of losing control of the firm if they make acquisitions using shares of stock. d. The stockholders of the acquiring firm will be better off when an acquisition results in losses if the acquisition was made with cash rather than with stock. e. Acquisitions based on legitimate business purposes are not taxable transactions regardless of the means of financing used.
c. The management of an acquiring firm may put itself at risk of losing control of the firm if they make acquisitions using shares of stock.
Cowboy Curtiss' Cowboy Hat Company recently completed a merger. When valuing the combined firm after the merger, which of the following is an example of the type of common mistake that can occur? a. The use of market values in valuing either the new firm. b. The inclusion of cash flows that are incremental to the decision. c. The use of Curtiss' discount rate when valuing the cash flows of the entire company. d. The inclusion of all relevant transactions cost associated with the acquisition. e. None of the above.
c. The use of Curtiss' discount rate when valuing the cash flows of the entire company.
If a firm wants to take over another firm but feels the attempt to do so will be viewed as unfriendly it could decide to take a _____ approach to the acquisition. a. crown jewel b. shark repellent c. bear hug d. countertender offer e. lockup
c. bear hug
the payments made by a firm to repurchase shares of its outstanding stock from an individual investor in an attempt to eliminate a potential unfriendly takeover attempt are referred to as: a. a golden parachute b. a standstill payments c. greenmail d. a poison pill e. a white knight
c. greenmail
an agreement between firms to create a separate, co-owned entity established to pursue a joint goal is called a: a. consolidation b. strategic alliance c. joint venture d. merged alliance e. takeover project
c. joint venture
A dissident group solicits votes in an attempt to replace existing management. This is called a: a. tender offer. b. shareholder derivative action. c. proxy contest. d. management freeze-out. e. shareholder's revenge.
c. proxy contest.
a public offer by one firm to directly buy the shares of another firm is called a: a. merger b. consolidation c. tender offer d. spinoff e. divestiture
c. tender offer
If the All-Star Fuel Filling Company, a chain of gasoline stations acquire the Mid-States Refining Company, a refiner of oil products, this would be an example of a: a. conglomerate acquisition. b. white knight. c. vertical acquisition. d. going-private transaction. e. horizontal acquisition.
c. vertical acquisition.
A friendly suitor that a target firm turns to as an alternative to a hostile bidder is called a: a. golden suitor. b. poison put. c. white knight. d. shark repellent. e. crown jewel.
c. white knight
A _____ is a derivative security that gives the owner the right, but not the obligation, to buy an asset at a fixed price for a specified period of time.
call option
Changes in net working capital:
can affect the cash flows of a project every year of the project's life.
The lower bound of a call option:
can be equal to zero.
The difference between an American call and a European call is that the American call:
can be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.
callable bonds
can be pre-paid by the company at specified call dates, allowing the company to retire debt early if interest rates decline. Other bonds cannot be repaid before maturity.
The market value proportions of the firm's assets, financed via debt, common stock, and preferred stock, are called the firm's ____________.
capital structure weights
A supplier, who requires payment within ten days, should be most concerned with which one of the following ratios when granting credit?
cash
From a cash flow position, which one of the following ratios best measures a firm's ability to pay the interest on its debts?
cash coverage ratio
All else equal, the payback period for a project will decrease whenever the:
cash inflows are moved earlier in time
All else equal, the payback period for a project will decrease whenever the
cash inflows are moved earlier in time.
All else equal, the payback period for a project will decrease whenever the...
cash inflows are moved earlier in time.
In a world with corporate taxes, MM theory implies that that all firms should:
choose an all-debt capital structure.
comparables
comparison to known values
Many ski resorts build golf courses on their property. This creates synergy primarily based on
complementary resources.
Suppose Ford acquires K-Mart. This would be an example of a _____________ acquisition.
conglomerate
The discounted payback period rule:
considers the time value of money.
A merger in which an entirely new firm is created, with both the acquired and acquiring firms ceasing to exist, is called a _________________.
consolidation
We should never enter into financial bondage through..
consumer debt
All else constant, as the variable cost per unit for a project increases, the:
contribution margin decreases.
The main benefit of vertical integration is ______.
coordination management can ensure that different stages of the production cycle are working together
In the discounted cash flow method, which rate of return is associated with free cash flow to equity in the valuation equation?
cost of equity
The return that shareholders require on their investment in the firm is called the _____________.
cost of equity
replacement cost approach: right side of balance sheet
cost to re-finance the firm (issue equity, etc)
replacement cost
cost to replace the firm
A potential merger that has synergy
creates value and therefore should be pursued.
A financial contract that obligates one party to exchange a set of payments it owns for another set of payments owned by another party is called a ________.
cross put option
The text mentions some valuation caveats. Which of the following is not one of them? all of the above are mentioned as caveats crown jewel adjustment taking out salary control premium liquidity discount
crown jewel adjustment
A swap that involves the exchange of a set of payments in one currency for a set of payments in another currency is a(n) ________.
currency swap
Rexton Oil is an all-equity firm with 100 million shares outstanding. Rexton has $150 million in cash and expects future free cash flows of $65 million per year. Management plans to use the cash to expand the firm's operations, which will in turn increase future free cash flows to $72.8 million per year. If the cost of capital of Rexton's investments is 10%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?
current share price = E = perpetuity 65/.1 = 650 V = E + cash = 650 + 150 = 800 P = 800/100 = $8 1. share after repurchase shares AR = 100M - (150M/8) = 81.25 M price AR = 650/81.25 = $8 after repurchases 2. share after investment E AI = 72.8/.1 = 728M value of equity AND firm (no cash) price AI = V/shares outstanding = 728/100 = $7.28 NPV of investment = new cash flow - old cash flow / cost of capital - cash =(72.8-65/.1) - 150 = -72M
Swaps are _________ agreements involving the exchange of interest payments _________________________.
customized, on a stated notional principal amount
37. Incorporating flotation costs into the analysis of a project will: A. Cause the project to be improperly evaluated. B. Increase the net present value of the project. C. Increase the project's rate of return. D. Increase the initial cash outflow of the project. E. Have no effect on the present value of the project.
d
38. Flotation costs for a levered firm should be: A. Ignored when analyzing a project because they are a sunk cost. B. Spread over the life of a project thereby reducing the cash flows for each year of the project. C. Considered only when two projects are mutually exclusive. D. Weighted and included in the initial cash flow. E. Totally ignored when internal equity funding is utilized.
d
40. Why does the tax amount need adjusted when valuing a firm using the cash flow from assets approach? A. The tax effect of the dividend payments must be eliminated. B. Only straight-linedepreciation can be used when computing taxes for valuation purposes. C. Taxes must be computed for valuation purposes based solely on the marginal tax rate. D. The tax effect of the interest expense must be removed. E. The taxes must be computed for valuation purposes based on the average tax rate for the past 10 years.
d
41. Chelsea Fashions is expected to pay an annual dividend of $1.10 a share next year. The market price of the stock is $21.80 and the growth rate is 4.5 percent. What is the firm's cost of equity? A. 9.77 percent B. 7.91 percent C. 9.24 percent D. 9.55percent E. 10.54 percent
d
43. Sweet Treats common stock is currently priced at $17.15 a share. The company just paid $1.22 per share as its annual dividend. The dividends have been increasing by 2.4 percent annually and are expected to continue doing the same. What is this firm's cost of equity? A. 9.41 percent B. 9.51 percent C. 8.47 percent D. 9.68 percent E. 9.82 percent
d
77. Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 16.7 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 12.6 percent. The project under consideration has initial costs of $755,000 and anticipated annual cash inflows of $152,000 a year for 10 years. Which firm(s), if either, should accept this project? A. Company A only. B. Company B only. C. Both Company A and Company B. D. Neither Company A nor Company B. E. Cannot be determined without further information.
d
Beta measures depend highly on the: A. direction of the market variance. B. overall cycle of the market. C. variance of the market and asset, but not their co-movement. D. covariance of the security with the market and how they are correlated. E. All of the above.
d
The beta of a security provides an: A. estimate of the market risk premium. B. estimate of the slope of the Capital Market Line. C. estimate of the slope of the Security Market Line. D. estimate of the systematic risk of the security. E. None of the above.
d
Three weeks ago, you purchased a July 45 put option on RPJ stock at an option price of $3.20. The market price of RPJ stock three weeks ago was $42.70. Today, RPJ stock is selling at $44.75 a share and the July 45 put is priced at $.80. What is the intrinsic value of your put contract? a. -$295 b. -$210 c. $0 d. $25 e. $110
d
You own two call option contracts on ABC stock with a strike price of $15. When you purchased the shares the option price was $1.20 and the stock price was $15.90. What is the total intrinsic value of these options if ABC stock is currently selling for $14.50 a share? a. -$280 b. -$180 c. -$100 d. $0 e. $100
d
You sold ten put option contracts on PLT stock with an exercise price of $32.50 and an option price of $1.10. Today, the option expires and the underlying stock is selling for $34.30 a share. Ignoring trading costs and taxes, what is your total profit or loss on this investment? a. -$2,900 b. -$1,100 c. $700 d. $1,100 e. $2,900
d
Firm A is being acquired by Firm B for $24,000 worth of Firm B stock. The incremental value of the acquisition is $3,500. Firm A has 1,500 shares of stock outstanding at a price of $15 a share. Firm B has 1,200 shares of stock outstanding at a price of $30 a share. What is the value per share of Firm B after the acquisition? a. $17.50 b. $24.00 c. $30.00 d. $31.00 e. $35.00
d. $31.00
Rudy's, Inc. and Blackstone, Inc. are all-equity firms. Rudy's has 1,500 shares outstanding at a market price of $22 a share. Blackstone has 2,500 shares outstanding at a price of $38 a share. Blackstone is acquiring Rudy's for $36,000 in cash. The incremental value of the acquisition is $3,500. What is the value of Rudy's Inc. to Blackstone? a. $30,000 b. $32,500 c. $33,000 d. $36,500 e. $39,500
d. $36,500
A reason for acquisitions is synergy. Synergy includes: a. revenue enhancements. b. cost reductions. c. lower taxes. d. All of the above. e. None of the above.
d. All of the above.
A proposed acquisition may create synergy by: I. increasing the market power of the combined firm. II. improving the distribution network of the acquiring firm. III. providing the combined firm with a strategic advantage. IV. reducing the utilization of the acquiring firm's assets. a. I and III only b. II and III only c. I and IV only d. I, II, and III only e. I, II, III, and IV
d. I, II, III only
Which of the following is not true of an acquisition of stock or tender offers? a. No stockholder meetings need to be held. b. No vote is required. c. The bidding firm deals directly with the stockholders of the target firm. d. In most cases, 100% of the stock of the target firm is tendered. e. All of the above are true of tender offers.
d. In most cases, 100% of the stock of the target firm is tendered.
Firm A and Firm B join to create Firm AB. This is an example of: a. a tender offer. b. an acquisition of assets. c. an acquisition of stock. d. a consolidation. e. Both B and C.
d. a consolidation.
The discounted payback period of a project will decrease whenever the: a. discount rate applied to the project is increased. b. initial cash outlay of the project is increased. c. number of cash inflows is increased. d. amount of each cash inflow is increased. e. costs of the fixed assets utilized in the project increase
d. amount of each cash inflow is increased
All else equal, the payback period for a project will decrease whenever the: a. initial cost increases. b. required return for a project increases. c. assigned discount rate decreases. d. cash inflows are adjusted such that they occur sooner. e. duration of a project is lengthened
d. cash inflows are adjusted such that they occur sooner.
Suppose that General Motors has made an offer to acquire General Mills. Ignoring potential antitrust problems, this merger would be classified as a: a. monopolistic merger. b. horizontal merger. c. vertical merger. d. conglomerate merger. e. None of the above.
d. conglomerate merger.
One of the most basic reasons for a merger is: a. revenue enhancing in the hopes that net losses may decrease. b. increased competition. c. employee benefits. d. cost reductions. e. to keep lawyers and accountants employed.
d. cost reductions.
When the management and/or a small group of investors take over a firm and the shares of the firm are delisted and no longer publicly available, this action is known as a: a. consolidation. b. vertical acquisition. c. proxy contest. d. going-private transaction. e. None of the above.
d. going-private transaction.
Going-private transactions in which a large percentage of the money used to buy the outstanding stock is borrowed is called a: a. tender offer. b. proxy contest. c. merger. d. leveraged buyout. e. consolidation.
d. leveraged buyout
going private transactions in which a large percentage of money used to buy the outstanding stock is borrowed is called a: a. tender offer b. proxy contest c. merger d. leveraged buyout e. consolidation
d. leveraged buyout
Which of the following is incorrect? a. net working capital Appears on the balance sheet b. net working capital Appears on the statement of cash flows c. net working capital Not on the income statement d. net working capital On the income statement
d. net working capital On the income statement
The discounted payback rule may cause: A. projects with discounted payback periods in excess of the project's life to be accepted. B. the most liquid projects to be rejected in favor of less liquid projects. C. projects to be incorrectly accepted due to ignoring the time value of money. D. some projects with negative net present values to be accepted. E. some positive net present value projects to be rejected.
d. some positive net present value projects to be rejected.
The purchase accounting method for mergers require that: a. the excess of the purchase price over the fair market value of the target firm be recorded as a one-time expense on the income statement of the acquiring firm. b. goodwill be amortized on a yearly basis. c. the equity of the acquiring firm be reduced by the excess of the purchase price over the fair market value of the target firm. d. the assets of the target firm be recorded at their fair market value on the balance sheet of the acquiring firm. e. the excess amount paid for the target firm be recorded as a tangible asset on the books of the acquiring firm.
d. the assets of the target firm be recorded at their fair market value on the balance sheet of the acquiring firm.
When a building supply store acquires a lumber mill it is making a ______ acquisition. a. horizontal b. longitudinal c. conglomerate d. vertical e. complementary resources
d. vertical
The optimal capital structure has been achieved when the:
debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.
ATC has a value of $70,000 in a good economy and $55,000 in a recession. The firm has $60,000 of debt. The probability of a recession is 50 percent. The firm is considering a project that would change the firm values to $73,000 in a good economy and $50,000 in a recession. If the firm accepts this project, the firm value will ______ and shareholder value will ______.
decrease by $1,000; increase by $1,500
When Firm A acquired Firm B, no incremental value was created but earnings per share increased. If the financial markets are astute, the price-earnings ratio of Firm A should ____ and the stock price of Firm A should _____.
decrease; remain constant
The effect on an option's value of a small change in the value of the underlying asset is called the option:
delta
If there is a conflict between mutually exclusive projects due to the IRR, one should:
depend on the NPV as it will always provide the most value.
When the value of the British pound changes from $1.50 to $1.25, the pound has ________ and the dollar has ________.
depreciated; appreciated
When the value of the dollar changes from £0.50 to £0.75, the pound has ________ and the dollar has ________.
depreciated; appreciated
All else constant, the accounting break-even level of sales will decrease when the:.
depreciation expense decreases.
Call option
derivative security that gives the owner the right, but not the obligation, to buy an asset at a fixed price during a specified period of time
If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the:
difference between the return on the market and the risk-free rate.
All else equal, new shareholders will ____ the capital gains of existing shareholders.
dilute
The primary purpose of a flip-over provision is to:
dilute a corporate raider's ownership position thereby increasing the cost of a takeover.
The exchange rate is 45 rubles per US dollar. (Ruble is official currency in Russia). This is
direct quotation if you live in Russia
The discounted payback period of a project will decrease whenever the:
discount rate applied to the project is decreased
The discounted payback period of a project will decrease whenever the
discount rate applied to the project is decreased.
The market price of a bond increases when the:
discount rate decreases.
discounted cash flow (DCF)
discount the relevant CFs
The WACC is used to _______ the expected cash flows when the firm has ____________.
discount; debt and equity in the capital structure
Before setting the offer price, the underwriters work with the company to come up with a reasonable price range using two techniques
discounted cash flow comparables analysis
Which of the following methods of project analysis are biased towards short-term projects?
discounted payback and payback
The length of time required for a project's discounted cash flows to equal the initial cost of the project is called the A. net present value. B.internal rate of return. C. payback period. D. discounted profitability index. E. discounted payback period
discounted payback period
The length of time required for a project's discounted cash flows to equal the initial cost of the project is called the:
discounted payback period.
Conglomerate mergers appear to offer benefits of ________.
diversification however not a real benefit because investors can eliminate idiosyncratic risk on their own
if two stocks are perfectly positively correlated,
diversification has no effect on risk
The total return on a stock is equal to the:
dividend yield plus the dividend growth rate.
When Americans and foreigners expect the return on ________ deposits to be high relative to the return on ________ deposits, there is a higher demand for dollar deposits and a correspondingly lower demand for foreign deposits.
dollar; foreign
28. Jenner's is a multi division firm that uses its overall WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to: A. Receive less project funding if its line of business is riskier than that of the other divisions. B. Avoid risky projects so it can receive more project funding. C. Become less risky over time based on the projects that are accepted. D. Have an equal probability with all the other divisions of receiving funding. E. Prefer higher risk projects over lower risk projects.
e
29. The discount rate assigned to an individual project should be based on the: A. Firm's weighted average cost of capital. B. Actual sources of funding used for the project. C. Average of the firm's overall cost of capital for the past five years. D. Current risk level of the overall firm. E. Risks associated with the use of the funds required by the project.
e
35. When a firm has flotation costs equal to 6.8 percent of the funding need, project analysts should: A. Increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.068. B. Increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 - .068). C. Add 6.8 percent to the firm's WACC to determine the discount rate for the project. D. Increase the initial project cost by multiplying that cost by 1.068. E. Increase the initial project cost by dividing that cost by (1 - .068).
e
44. The common stock of Metal Molds has a negative growth rate of 1.2 percent and a required return of 17.5 percent. The current stock price is $12.20. What was the amount of the last dividend paid? A. $2.07 B. $2.11 C. $2.19 D. $2.22 E. $2.31
e
47. National Home Rentals has a beta of 1.24, a stock price of $22, and recently paid an annual dividend of $.94 a share. The dividend growth rate is 4.5 percent. The market has a 10.6 percent rate of return and a risk premium of 7.5 percent. What is the firm's cost of equity? A. 7.05 percent B. 8.67 percent C. 9.13 percent D. 10.30 percent E. 10.68 percent
e
In the Black-Scholes option pricing formula, N(d1) is the probability that a standardized, normally distributed random variable is: a. less than or equal to N(d2). b. less than one. c. equal to one. d. equal to d1. e. less than or equal to d1.
e
The problem of using the overall firm's beta in discounting projects of different risk is the: A. firm would accept too many high-risk projects. B. firm would reject too many low risk projects. C. firm would reject too many high-risk projects. D. firm would accept too many low risk projects. E. Both A and B.
e
Brite Industries has agreed to merge with Nu-Day, Inc. for $20,000 worth of Nu-Day stock. Brite has 1,200 shares of stock outstanding at a price of $15 a share. Nu-Day has 2,000 shares outstanding with a market value of $19 a share. The incremental value of the acquisition is $3,500. What is the value of Nu-Day after the merger? a. $53,000 b. $54,250 c. $56,000 d. $57,750 e. $59,500
e. $59,500
Holiday & Sons is being acquired by Miller's, Inc. for $20,000 worth of Miller's stock. Miller has 1,300 shares of stock outstanding at a price of $20 a share. Holiday has 1,000 shares outstanding with a market value of $18 a share. The incremental value of the acquisition is $2,000. What is the total number of shares in the new firm? a. 1,000 shares b. 1,300 shares c. 1,500 shares d. 2,000 shares e. 2,300 shares
e. 2,300 shares
Which of the following activities are commonly associated with takeovers? I. the acquisition of assets II. proxy contests III. management buyouts IV. leveraged buyouts a. I and III 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
Which of the following are reasons why a firm may want to divest itself of some of its assets? I. to raise cash II. to get rid of unprofitable operations III. to get rid of some assets received in an acquisition IV. to cash in on some profitable operations a. I and II only b. I, II, and III only c. I, III, and IV only d. II, III, and IV only e. I, II, III, and IV
e. I, II, III, and IV
The two fatal flaws of the internal rate of return rule are: a. arbitrary determination of a discount rate and failure to consider initial expenditures. b. arbitrary determination of a discount rate and failure to correctly analyze mutually exclusive investment projects. c. arbitrary determination of a discount rate and the multiple rate of return problem. d. failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment projects. e. failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem
e. failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem
the positive incremental net gain associated with the combination of two firms through a merger or acquisition is called: a. the agency conflict b. goodwill c. the merger cost d. the consolidation effect e. synergy
e. synergy
The acquisition of a firm involved with a different production process stage than the bidder is called a _____ acquisition. a. conglomerate b. forward c. backward d. horizontal e. vertical
e. vertical
In a decision tree, caution should be used in the analysis because:
early stage decisions are probably riskier than later stages
If the average cost per unit decreases when a horizontal merger occurs then the combined firm is benefiting from synergy arising from:
economies of scale.
In the study of Guatemala microfinance discussed in the text, how many measures of outcomes did they use?
eight
The sale of stock in a wholly owned subsidiary via an initial public offering is referred to as a(n):
equity carve-out.
The annual annuity stream of payments with the same present value as a project's costs is called the project's _____ cost.
equivalent annual
New product reduces the sales and the cash flows of existing products.
erosion (Incremental IRR side effect)
The cash flows of a new project that come at the expense of a firm's existing projects are called:
erosion costs.
The cash flows of a new project that come at the expense of a firm's existing projects are called: -opportunity costs. -net working capital expenses. -erosion costs. -salvage value expenses. -sunk costs.
erosion costs.
The beta of a security provides an:
estimate of the systematic risk of the security.
You run a small bagel shop and are considering replacing your four employees with automated machines that allow customers to buy their bagels without any human interaction. Of the following, the most difficult task you face in computing the NPV of this change is the:
estimation of the total change in sales that will result from the change.
An option that may be exercised only on the expiration date is called a(n) _____ option.
european
Consider a firm whose asset values plunge from $10M to $7M. The value of its liabilities remains at $9M. Along comes a project opportunity with projected cost of $1M and projected benefit of $2M. The problem is that the $2M of benefit will go directly to the creditors, and none will go to the firm's equity owners. In other words, it's a money-losing scenario for the equity owners, even if pursuing the project keeps the firm alive
example of debt overhang
An investment is acceptable if its IRR:
exceeds the required return.
An investment is acceptable if its average accounting return (AAR)...
exceeds the target AAR.
The act where an owner of an option buys or sells the underlying asset, as is his right, is called ______ the option.
exercising
The discount rate for a project should equal the
expected return on a financial asset of comparable risk.
Noncash items refer to:
expenses charged against revenues that do not directly affect cash flow.
The last day on which an owner of an option can elect to exercise is the _____ date
expiration
Two key weaknesses of the internal rate of return rule are the...
failure to correctly analyze mutually exclusive projects and the multiple rate of return problem.
Two key weaknesses of the internal rate of return rule are the:
failure to correctly analyze mutually exclusive projects and the multiple rate of return problem.
Two key weaknesses of the internal rate of return rule are the: arbitrary determination of a discount rate and failure to consider initial expenditures. failure to correctly analyze mutually exclusive projects and the multiple rate of return problem. failure to consider all cash flows and the multiple rate of return problem. failure to consider initial expenditures and failure to correctly analyze mutually exclusive projects. failure to correctly analyze mutually exclusive projects and the lack of clear-cut decision rule.
failure to correctly analyze mutually exclusive projects and the multiple rate of return problem.
If the 2005 inflation rate in Britain is 6 percent, and the inflation rate in the U.S. is 4 percent, then the theory of purchasing power parity predicts that, during 2005, the value of the British pound in terms of U.S. dollars will
fall by 2 percent
What is needed to "give birth" to an LLC?
file articles of organization with fees and open LLC bank account
The use of debt is called
financial leverage.
The use of debt is called:
financial leverage.
the cash flow principle
financial statements are intended to track firm performance profits generally do not give a true picture of how much cash the firm is bringing in value is derived ultimately from cold, hard cash - not a number on the income statement "if the money doesn't move, don't count it"
The cash flow principle
financial statements are intended to track firm performance; profits generally do not give a true picture of how much cash the firm is bringing in; value is derived ultimately from cold, hard cash - not a number on the income statement; "if the money doesn't move, don't count it"
Which of the following is the cost incurred by the firm when new issues of stocks or bonds are sold?
flotation costs
From which viewpoint does the text not teach how to think about the cost of capital?
from the viewpoint of auditors
The average compound return earned per year over a multi-year period is called the _____ average return.
geometric
payment in kind (PIK) bonds
give the company the option ot make interest payments in the form of new bonds rather than cash.
Generous compensation plans paid to a firm's top management in the event of a takeover are called ___________.
golden parachutes
Under the purchase accounting method of reporting acquisitions:
goodwill is recorded in an amount equal to the purchase price less the estimated fair market value of the net assets acquired.
The intrinsic value of a put is equal to the:
greater of the strike price minus the stock price or zero.
For the levered firm the equity beta is __________ the asset beta.
greater than
A par value bond offers a coupon rate of 7 percent with semiannual interest payments. The effective annual rate provided by these bonds must be:
greater than 7 percent but less than 8 percent.
An investment is acceptable if the profitability index (PI) of the investment is:
greater than one
An investment is acceptable if the profitability index (PI) of the investment is
greater than one.
An investment is acceptable if the profitability index (PI) of the investment is...
greater than one.
An investment is acceptable if the profitability index (PI) of the investment is:
greater than one.
Using internal rate of return, a conventional project should be accepted if the internal rate of return is:
greater than the discount rate.
The management of Traynor Enterprises is fighting a takeover attempt led by one of its shareholders. To try and stop this takeover, management decides to offer the shareholder $50 a share if she will sell all of her shares in the firm. Traynor stock is currently priced at $36 a share. This offer is an example of:
greenmail
The payments made by a firm to repurchase shares of its outstanding stock from an individual investor in an attempt to eliminate a potential unfriendly takeover attempt are referred to as:
greenmail.
Modified internal rate of return:
handles the multiple IRR problem by combining cash flows until only one change in sign change remains & requires the use of a discount rate.
A zero coupon bond:
has a market price that is computed using semiannual compounding of interest
An in-the-money put option is one that:
has an exercise price greater than the underlying stock price.
If a firm produces a return on assets of 15 percent and also a return on equity of 15 percent, then the firm:
has no debt of any kind.
Sunk costs include any cost that
has previously been incurred and cannot be changed.
A stock with an actual return that lies above the security market line:
has yielded a higher return than expected for the level of risk assumed.
7.37%
he Lumber Shack just paid an annual dividend of $1.23 a share. The dividend growth rate is 4 percent, the tax rate is 34 percent, and the common stock sells for $38 a share. What is the cost of equity?
Firms whose revenues are strongly cyclical and whose operating leverage is high are likely to have:
high betas.
A firm with high operating leverage has:
high fixed costs in its production process.
A firm with high operating leverage is characterized by __________ while one with high financial leverage is characterized by __________.
high fixed costs of production; high fixed financial costs
A firm with high operating leverage is best defined as a firm that has
high fixed costs relative to variable costs.
When forecasting the future, the arithmetic average historical return is probably too ____ of an estimate for longer periods and the geometric average historical return is:
high; probably too low.
When one automaker acquires another automaker the acquisition is classified as a:
horizontal acquisition
Betas may vary substantially across an industry. The decision to use the industry or firm beta to estimate the cost of capital depends on:
how similar the firm's operations are to the operations of all other firms in the industry.
Which website below is not a webpage mentioned in the text to further your education of car values and other information you should know prior to purchasing a vehicle?
http://careerfair.com
Assume a project has normal cash flows. Given this, you should accept the project:
if the NPV is positive and reject it if the NPV is negative
Assume a project has normal cash flows. Given this, you should accept the project
if the NPV is positive and reject it if the NPV is negative.
Annual cash flows example (income statement)
in 2004: FCF = EBIT (1-t) + depr - CAPX - change NWC EBIT = 265 t = 35% Change NWC = (170+45-25-90) - (130+50-20-70) = 100-90 = 10 FCF = 265 * (1-.35) + 50 - 40 - 10 = 172.25
If a call has a positive intrinsic value at expiration the call is said to be:
in the money
If a call has a positive intrinsic value at expiration the call is said to be:
in the money.
Dutch auction share repurchase
in which the firm gives a range of prices (e.g. $30 to $40) and shareholders indicate how many shares they would be willing to tender at each price.
In project analysis, flotation costs are generally
included in the amount raised.
Including the option to expand in your project analysis will tend to:
increase the net present value of a project.
Raising leverage increases PV(Tax Shield), ______ the firm value. Raising leverage increases PV(Distress Costs), ________ the firm value.
increasing reducing as leverage increases, tax shield increases, but so does distress costs
Project analysis is focused on _____ costs.
incremental
The changes in a firm's future cash flows that are a direct consequence of accepting a project are called __________ cash flows.
incremental
The cash flows of a project include the
incremental operating cash flow, as well as any changes in capital spending and net working capital.
The cash flows of a project include the...
incremental operating cash flow, as well as any changes in capital spending and net working capital.
The cash flows for a project include the:
incremental operating cash flow, as well as the capital spending and net working capital requirements.
Your firm's CFO presents you with two capital budgeting analyses: one that involves buying a new delivery truck to replace the existing truck and one that involves the purchase of a three-ton metal stamping press to replace the existing press on the plant floor. This is an example of a decision involving ___________
independent projects
What type of funds historically out-performs actively-managed mutual funds (in terms of average return rate)?
index funds The section "Strategies for Personal Investing," on page 15-7, says that BYU professors and many others have documented that if you invest in index funds you will earn more on average than if you invested in actively-managed funds.
A swap that involves the exchange of one set of interest payments for another set of interest payments is called a(n) ________.
interest-rate swap
To find the __________ we begin by setting the NPV of a project equal to zero.
internal rate of return
The two most commonly used methods of capital budgeting analysis are the:
internal rate of return and net present value methods
The two most commonly used methods of capital budgeting analysis are the
internal rate of return and net present value methods.
You are trying to determine whether to accept Project A or Project B. These projects are mutually exclusive. As part of your analysis, you should compute the incremental IRR by determining the:
internal rate of return for the differences in the cash flows of the two projects.
Assume a project has normal cash flows and a positive (non-zero) net present value. The project's:
internal rate of return will exceed its required rate of return
Assume a project has normal cash flows and a positive (non-zero) net present value. The project's
internal rate of return will exceed its required rate of return.
Assume a project has normal cash flows and a positive (non-zero) net present value. The project's...
internal rate of return will exceed its required rate of return.
The discount rate that makes the net present value of an investment exactly equal to zero is called the
internal rate of return.
The discount rate that makes the net present value of an investment exactly equal to zero is called the...
internal rate of return.
The discount rate that makes the net present value of an investment exactly equal to zero is called the:
internal rate of return.
The value of an option if it were to immediately expire, that is, its lower pricing bound, is called an option's _____ value.
intrinsic
The value of an option if it were to immediately expire, that is, its lower pricing bound, is called an option's _____ value.
intrinsic value
An increase in which one of the following accounts increases a firm's current ratio without affecting its quick ratio?
inventory
Institutional investors
invest in VC funds or directly invest in private firms.
Diversification
investing in more than one security to reduce risk
What is net working capital?
is a capital expenditure on fixed assets
An investment
is acceptable if its calculated payback period is less than some pre-specified period of time.
An investment:
is acceptable if its calculated payback period is less than some prespecified period of time
The pre-tax cost of debt for a firm:
is equal to the yield to maturity on the outstanding bonds of the firm.
A project whose NPV equals zero ______________.
is expected to earn a return equal to the firm's required return
The discounted payback rule states that you should accept an investment project if its discounted payback period: A. exceeds some pre-specified period of time. B. is positive and rejected if it is negative. C. is less than the payback period. D. is less than some pre-specified period of time. E. exceeds the life of the investment
is less than some pre-specified period of time
For investment projects, the internal rate of return (IRR):
is the rate generated solely by the cash flows of the investment.
Pre-money valuation
is the value of the firm's old shares at the price of the new funding round (i.e. the post-money valuation minus the amount raised).
Post-money valuation
is the value of the whole firm (old plus new shares) at the price per share at which new equity is sold in the current round.
The profitability index:
is useful as a decision tool when investment funds are limited and all available funds are allocated.
Analysis using the profitability index
is useful as a decision tool when investment funds are limited.
Analysis using the profitability index:
is useful as a decision tool when investment funds are limited.
recapitalization
issue new debt and repurchase shares - Increasingleverageallowsthefirmtotakeadvantageofthetaxshield and reduces the availability of excess cash, forcing the manager to run the firm more efficiently
The payback method is a convenient and useful tool because:
it provides a quick estimate of how rapidly an initial investment will be recouped
The payback method is a convenient and useful tool because
it provides a quick estimate of how rapidly an initial investment will be recouped.
Assume that both firm A and firm B formally agree to each put up $10 million to form firm C. The operations of firm C are restricted to conducting research and development activities for the benefit of firms A and B. Firm C is a _____ of firms A and B.
joint venture
An agreement between firms to create a separate, co-owned entity established to pursue a joint goal is called a:
joint venture.
Which is not a part of the build-up method for finding the required rate of return?
large-cap risk premium
The payback period rule accepts all investment projects in which the payback period for the cash flows is:
less than the cutoff point.
The higher the inventory turnover, the:
less time inventory items remain on the shelf.
Suppose the employees of Air Canada borrowed heavily to buy all of the firm's stock and take the company private. This would be an example of a(n) _______________.
leveraged buyout
the financing decision
liabilities and equity - current liabilities - long-term debt - preferred stock - common equity
protective put
long a put and the underlying stock. The value of a long call plus enough cash to exercise at expiration is equal to the value of a protective put
A contract that requires the investor to buy securities on a future date is called a
long contract
capital structure includes
long term debt, preferred stock, common equity
capital structure
long-term debt preferred stock common equity
cash flow rule #1 - project incremental cash flows
look only at changes in cash flow directly attributable to the project. sunk costs should be ignored. opportunity costs should be included. allocated costs should be included only after careful thought. excess capacity should be included only if it's an actual cost to the whole company. when in doubt, remember the with-without principle. imagine two worlds, one with the project, and one without. any cash flows different in those two worlds are relevant
Erosion can be best explained as the:
loss of current sales due to a new project being implemented.
________ predicts divorce far better than wealth levels
materialism
If a stock portfolio is well diversified, then the portfolio variance:
may be less than the variance of the least risky stock in the portfolio.
The option to wait:
may have value even if a project currently does not.
The complete absorption of one company by another, where the acquiring firm retains its identity and the acquired firm ceases to exist, is called a __________.
merger
investment
mimumum acceptable rate of return
investment
minimum acceptable rate of return
As the degree of sensitivity of a project to a single variable rises, the:
more attention management should place on accurately forecasting that variable.
The possibility that more than one discount rate will make the NPV of an investment zero is called the ___________ problem.
multiple rates of return
Which of the following is not a valuation caveat mentioned in the text?
multiples approach
The risk premium for an individual security is computed by:
multiplying the security's beta by the market risk premium
When two projects both require the total use of the same limited economic resource, the projects are generally considered to be: A. marginally profitable. B. independent. C. acceptable. D. mutually exclusive. E. internally profitable.
mutually exclusive
A situation in which accepting one investment prevents the acceptance of another investment is called the:
mutually exclusive investment decision.
Project A is opening a bakery at 10 Center Street. Project B is opening a specialty coffee shop at the same address. Both projects have unconventional cash flows, that is, both projects have positive and negative cash flows that occur following the initial investment. When trying to decide which project to accept, given sufficient funding to accept either, you should rely most heavily on the _____ method of analysis.
net present value
The difference between the present value of an investment and its cost is the a. net present value b. internal rate of return c. payback period d. profitability index e discounted payback period
net present value
The difference between the present value of an investment and its cost is the:
net present value
The profitability index is closely related to:
net present value.
In the absence of taxes, MM argues that:
no one capital structure for a firm is superior to any other capital structure for that firm.
Jack is considering adding toys to his general store. He estimates that the cost of inventory will be $4,200. The remodeling and shelving costs are estimated at $1,500. Toy sales are expected to produce net cash inflows of $1,200, $1,500, $1,600, and $1,750 over the next four years, respectively. Should Jack add toys to his store if he assigns a three-year payback period to this project?
no; because the payback period is 3.80 years. (Jack should reject the toy project because the payback period exceeds 3 years.)
According to the reading, what does NGO stand for?
non-government organization
The advantage of forward contracts over futures contracts is that forward contracts
none of the above (are standardized, have lower default risk, are more liquid)
A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation is the _____ distribution.
normal
V(equity) = sum of FCFEt / (1 + kcs)^t
numerator matches denominator result = equity value firm value = debt value + equity value debt value = ? book value ? market value?
A put option with a $35 exercise price on ABC stock expires today. The current price of ABC stock is $36. The put is:
out of the money.
$60,672,918
outhern Alliance Company needs to raise $55 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 65 percent common stock, 15 percent preferred stock, and 20 percent debt. Flotation costs for issuing new common stock are 11 percent, for new preferred stock, 8 percent, and for new debt, 5 percent. What is the true initial cost figure Southern should use when evaluating its project?
The weighted average cost of capital for a firm is the:
overall rate which the firm must earn on its existing assets to maintain the value of its stock.
Market timing: Firms may issue stock when they believe it is _______, and issue debt or used retained earnings for financing when stock is _________.
overvalued undervalued
Which entity below does not require registering with the state in order to start the business?
partnership
If a firm is more concerned about the quick return of its initial investment than it is about the amount of value created, then the firm is most apt to evaluate a capital project using the _____ method of analysis.
payback
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the A. net present value. B. internal rate of return. C. payback period. D. profitability index. E. discounted cash period.
payback period
length of time it takes for a project to bring back its initial investment
payback period
market portfolio
portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market
When using the cost of debt, the relevant number is the:
post-tax cost of debt since interest is tax deductible.
If its yield to maturity is less than its coupon rate, a bond will sell at a _____, and increases in market interest rates will:
premium; decrease this premium.
What does the PE ratio stand for in the comparable trades method?
price-to-earnings
Disadvantages: Problems with mutually exclusive investments (scale). Advantages: May be useful when available investment funds are limited Easy to understand and communicate. Correct decision when evaluating independent projects
profitability index
If an investment has a(n) ___________ of 1.2 it can be said that the investment generates $1.20 in present value benefits for each dollar of invested costs.
profitability index
The present value of an investment's future cash flows divided by the initial cost of the investment is called the:
profitability index.
corporate investors
provide capital to private firms for strategic reasons, in addition to the potential for financial returns. - Example: Microsoft invested $240 million in Facebook in 2007 in exchange for a 1.6% stake and control over banner ad placement outside the U.S.
As it applies to an acquisition, the term goodwill is defined as the difference between the
purchase price and the estimated fair market value of the net assets acquired.
A _____ is a derivative security that gives the owner the right, but not the obligation, to sell an asset at a fixed price for a specified period of time.
put option
The relationship between the prices of the underlying stock, a call option, a put option, and a riskless asset is referred to as the _____ relationship.
put-call parity
You would like to invest in the following project. Y0: -$55,000 Y1: $30,000 Y2: $37,000 Victoria, your boss, insists that only projects that can return at least $1.10 in today's dollars for every $1 invested can be accepted. She also insists on applying a 10% discount rate to all cash flows. Based on these criteria, you should:
reject the project because the PI is 1.05. (You should reject the project since the PI of 1.05 is less than Victoria's requirement of 1.10. It is worth mentioning that the NPV of this project is $2,851.24 and the IRR is 13.71%, both of which would normally indicate project acceptance. However, neither the NPV nor the IRR meet the requirement of returning $1.10 for every $1 spent.)
Ginny Trueblood is considering an investment which will cost her $120,000. The investment produces no cash flows for the first year. In the second year the cash inflow is $35,000. This inflow will increase to $55,000 and then $75,000 for the following two years before ceasing permanently. Ginny requires a 10% rate of return and has a required discounted payback period of three years. Ginny should _____ this project because the discounted payback period is ____.
reject; 3.97 years (Ginny should reject the project since the payback period of 3.97 years exceeds the required 3 years.)
Sinking fund bonds
require the company to repay principal over the life of the bond, rather than in a lump sum payment at maturity.
The excess return you earn by moving from a relatively risk-free investment to a risky investment is called the:
risk premium
market risk premium
risk premium of market portfolio. It is the difference between market return and return on risk-free treasury bills
For a treasury security, what is the required rate of return?
risk-free rate of return
For a corporate stock or bond, what is the required rate of return?
risk-free rate of return + risk premium
The use of WACC to select investments is acceptable when the:
risks of the projects are equal to the risk of the firm.
The salvage value of an asset creates an after-tax cash inflow to the firm in an amount equal to which of the following?
sales price minus the tax due, based on the sales price minus the book value, plus the recapture of working capital
terminal cash flow clarification of terms
salvage value - the value to which an asset is fully depreciated using straight-line depreciation Although salvage value sometimes is used (not improperly) to refer to the resale value, for clarity we will refer to salvage value as just the accounting term, i.e., the value to which an asset is depreciated (which could be very different from expected resale value) It's common when figuring tax depreciation to assume a salvage value of zero at the end of the asset's depreciable life. But when reporting to shareholders, salvage value is stated as greater than 0. resale value - the value for which we expect we can actually sell an asset at the end of its life book value - the value of an asset on the books, i.e., the initial cost less accumulated depreciation When an asset is fully depreciated using MACRS, the book value will be 0 When an asset is fully depreciated using straight-line, the book value will equal the salvage value (0 or a value chose by the company)
A firm is employing a _____________ if it sells its crown jewels as a takeover defense.
scorched earth policy
In order to make a decision utilizing a decision tree, you must:
start at the most distant point in time and work backwards to Time 0.
When comparing levered versus unlevered capital structures, leverage works to increase EPS for high levels of EBIT because interest payments on the debt:
stay fixed, leaving more income to be distributed over fewer shares.
Call options on two different stocks expire tomorrow with strike prices of $100. Stock 1 will have a price of $100 tomorrow with certainty. Stock 2 will have a price of $120 with 25% probability and $60 with 75% probability. Which option price is higher?
stock 2 higher stock 1 definitely worth zero, stock 2 is more volatile, possible to pay more
represents the difference between the value of a levered and an unlevered firm?
tcB
A public offer by one firm to directly buy the shares of another firm is called a ____________.
tender offer
life insurance: term vs. cash value
term is almost
The internal rate of return may be defined as:
the discount rate that makes the NPV equal to zero.
Internal Rate of Return
the discount rate that will make the NPV = 0. (Popular Method)
Toni's Tools is comparing machines to determine which one to purchase. The machines sell for differing prices, have differing operating costs, differing machine lives, and will be replaced when worn out. These machines should be compared using:
the equivalent annual cost method.
Exercising the option
the purchase or sale of an underlying asset via an option contract
If a project is assigned a required rate of return of zero, then:
the timing of the project's cash flows has no bearing on the value of the project.
treasury securities
treasury securities are as close to riskless as possible
financing
weighted average cost of funds
What is the replacement cost method for valuing a firm?
what it would cost to build up the company from nothing
The equivalent annual cost method is useful in determining:
which one of two machines to purchase when the machines are mutually exclusive, have different machine lives, and will be replaced once they are worn out.
tax advantage of leverage implies a tax disadvantage of holding cash
why hold cash? to cover potential cash shortfalls
Simulation analysis is based on assigning a _____ and analyzing the results.
wide range of values to multiple variables simultaneously
The internal rate of return
will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent.
The internal rate of return (IRR):
will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent.
Fixed costs for a new project:
will remain constant on a per unit basis over a given range of output.
it is ____ and _____ that make the family independent
work and thrift
Issuing debt instead of new equity in a closely held firm more likely causes owner-managers to:
work harder than they would if equity had been issued.
You are considering two mutually exclusive projects with the following cash flows. Will your choice between the two projects differ if the required rate of return is 8% rather than 11%? If so, what should you do? Year 0 PA: -$240,000 PB: -$198,000 Year 1 PA: $0 PB: $110,800 Year 2 PA: $0 PB: $82,500 Year 3: PA: $325,000 PB: $45,000
yes; Select A at 8% and B at 11%.
An investment has the following cash flows. Should the project be accepted if it has been assigned a required return of 9.5%? Why or why not? CF0: -$24,000 CF1: $8,000 CF2: $12,000 CF3: $9,000
yes; because the IRR exceeds the required return by about 0.39%. The project should be accepted because the IRR of 9.89% exceeds the required return of 9.5%.
good reasons not to index
you are stuck in funds that have a high exit cost, index funds are unavailable in some plans and foreign markets, legal proprietary information is routinely available to you, in taxable accounts, complex tax and donation strategies are possible
If the risk of an investment project is different than the firm's risk then
you must adjust the discount rate for the project based on the project risk.
Which one of the following will decrease the net working capital of a firm?
making a payment on a long-term debt
The purchase _______ best fits the definition of a vertical acquisition.
of a coal mine by an electric utility company
Your proposed project is small relative to the size of your company, and it isn't expected to require the hiring of additional administrative or office support staff. Still, the accounting department wants to charge $10,000 in annual overhead expense to your project. Is this appropriate?
$10,000 in annual overhead would likely be spent whether or not you do your project. Don't include it
A project will increase sales by $140,000 and cash expenses by $95,000. The project will cost $100,000 and be depreciated using the straight-line method to a zero book value over the 4-year life of the project. The company has a marginal tax rate of 34%. What is the value of the depreciation tax shield?
$8,500
You're evaluating a proposed project for which a plot of land is needed. The company owns some suitable land which it purchased 3 years previously for $100,000. A recent appraisal indicates the land could be sold today for $80,000. What is the appropriate cost to include in cash flows? (Ignore taxes for now)
$80,000 should be used. It is the current market value. Historical values do not impact cash flows.
You're evaluating a proposed project for which a plot of land is needed. The company owns some suitable land which it purchased 3 years previously for $100,000. A recent appraisal indicates the land could be sold today for $80,000. What is the appropriate cost to include in cash flows? (Ignore taxes for now.)
$80,000 should be used. It is the current market value. Historical values do not impact cash flows.
EZ Mart purchased an asset for $208,000 three years ago and sold it today for $86,000. The asset is 7-year MACRS property. The MACRS table values are .1429, .2449, .1749, .1249, .0893, .0892, .0893, and .0446 for Years 1 through 8, respectively. What is the aftertax salvage value from this sale if the tax rate is 35 percent?
$87,735.44
The difference between the public-offer price and the price paid by the underwriter is called (A) underpricing (B) spread (C) commission (D) margin
(B) spread
Beta
- "Best" measure of the risk of a security in a large portfolio is the beta of the security - Measures the responsiveness of a security to movements in the market portfolio (ex. systematic risk) Beta = (Covariance between return on asset I)/(return on market portfolio)
Which of the following is not a rationale for using the NPV method in capital budgeting?
- An NPV of zero signifies that the project's cash flows are just sufficient to repay the invested capital and to provide the required rate of return on that capital. - A project is not considered acceptable if it has a negative NPV. - A project whose NPV is positive will increase the value of the firm if that project is accepted.
Options
- An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or before) a given date, at prices agreed upon today. - Exercising the Option: The act of buying or selling the underlying asset - Strike Price or Exercise Price: Refers to the fixed price in the option contract at which the holder can buy or sell the underlying asset. - Expiry (Expiration Date): The maturity date of the option
Variance
- Assess volatility of a security's return - Measure of the squared deviations of a security's return from its expected return
Standard deviation
- Assess volatility of a security's return - Square root of the variance
Put Option Pricing at Expiry
- At expiry, an American put option is worth the same as a European option with the same characteristics. - If the put is in-the-money, it is worth E - ST. - If the put is out-of-the-money, it is worthless. P = Max[E - ST, 0]
Call options
- Call options give the holder the right, but not the obligation, to buy a given quantity of some asset on or before some time in the future, at prices agreed upon today. - When exercising a call option, you "call in" the asset.
European versus American options
- European options can be exercised only at expiry. - American options can be exercised at any time up to expiry.
Eduardo owns an option which gives him the right to purchase shares of ABC stock at a price of $18 a share. Currently, the stock is selling for $21.60. He would like to profit on this stock but is not permitted to exercise his option for another two weeks. Which of the following statements apply to this situation?
- He must own a European call option. - He should sell his option today if he feels the price of the stock will decline significantly over the next two weeks.
Portfolio
- Ideally high expected return and low standard deviation of return
Young private firms typically issue convertible preferred stock rather than common stock to outside investors.
- If the company performs well ,the convertible preferred stock converts into common stock, receiving the same financial payoff and voting rights as inside shareholders. - If the company performs poorly, preferred stock has seniority in a liquidation event (i.e. sale of the company) , so outside investors get paid before common shareholders.
Indirect costs
- Impaired ability to conduct business - ex. lost sales, compromised supply chain
Advantages of IRR
- Knowing a return is intuitively appealing - It is a simple way to communicate the value of a project to someone who doesn't know all the estimation details - If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task
Put Options
- Put options give the holder the right, but not the obligation, to sell a given quantity of an asset on or before some time in the future, at prices agreed upon today. - When exercising a put, you "put" the asset to someone.
Agency costs
- Selfish strategy 1: Incentive to take large risks - Selfish Strategy 2: Incentive toward underinvestment - Selfish Strategy 3: Milking the property
Diversification
- Spreading an investment across many diverse assets will lower a portfolio's level of risk. - Primary purpose of portfolio diversification: eliminate asset-specific risk. - Well diversified portfolios have negligible unsystematic risks
portfolio expected return considers
- The amount of money currently invested in each individual security - Various levels of economic activity - The performance of each stock given various economic scenarios - The probability of various states of the economy occurring
Diversifiable Risk
- The risk that can be eliminated by combining assets into a portfolio - Often considered the same as unsystematic, unique, or asset-specific risk - If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away.
Intrinsic Value
- The value of an option if it were to immediately expire, that is, its lower pricing bound, - Call: Max[ST - E, 0] - Put: Max[E - ST , 0]
What causes the tax shield to vary over time? Equivalently, what affects its risk?
- There is a risk the company will default, or will not be able to make interest payments. - The company could change its debt policy after its current debt matures. - The tax code could change, increasing or decreasing the tax shield for each dollar of interest.
what factors determine the price of an option
- Value of the underlying asset: Higher asset value relative to the strike increases the payoff. - Time to expiration: Longer time to expiration means more time to move into the money. - Risk-free rate: Higher discount rate means the present value of the strike price is lower. - Volatility: Higher volatility means a better chance of being in the money.
Global Enterprises has spent $134,000 on research developing a new type of shoe. For this shoe to now be manufactured, the firm will need to expand into an empty building that it currently owns. The firm was offered $229,000 last week for that building. An additional $342, 000 will be required for new equipment and building improvements. Labor and material costs are estimated at $4.98 per pair of shoes. Interest expense on the loan needed to finance the production of this new shoe will be $17,800 a year. Which one of these correctly identifies the sunk costs? -$229,000 value of the building -$134,000 for research -$229,000 value of the building plus -$342,000 for new equipment and improvements -$17,800 for interest plus $134,000 for research -$229,000 for the building plus $134,000 for research
-$134,000 for research
What is the net present value of a project with the following cash flows and a required return of 12%? Year Cash Flow 0 -$28,900 1 $12,450 2 $19,630 3 $2,750
-$177.62
A project requires an initial investment of $21,600 and will produce cash inflows of $4,900, $14,200, and $8,700 over the next three years, respectively. What is the project's NPV at a required return of 14 percent? -$287.22 -$503.06 $6,200.00 $21,096.94 $42,696.94
-$503.06
A project requires an initial investment of $59,600 and will produce cash inflows of $21,200, $44,500, and $11,700 over the next 3 years, respectively. What is the project's NPV at a required return of 16 percent?
-$757.69
Phil's Carvings, Inc. wants to have a weighted average cost of capital of 9%. The firm has an after-tax cost of debt of 5% and a cost of equity of 11%. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital?
.50
A new product has startup costs of $338,200 and projected cash flows of $102,000, $187,500, and $245,000 for Years 1 to 3, respectively. What is the profitability index given a 9 percent required return? .71 .77 1.16 1.30 1.41
1.30
The Consolidated Transfer Co. is an all-equity financed firm. The beta is .75, the market risk premium is 8% and the risk-free rate is 4%. What is the expected return of Consolidated?
10%
Which one of these bonds is the most interest-rate sensitive?
10-year zero coupon bond
Reliable Cars has sales of $3,830, total assets of $3,150, and a profit margin of 5 percent. The firm has a total debt ratio of 41 percent. What is the return on equity?
10.30 percent Return on equity = (0.05 x $3,830)/[$3,150 x (1 - .41)] = 10.3 percent
ack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5%. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4% and the market risk premium is 8%. Jack's tax rate is 35%. What is Jack's weighted average cost of capital? Multiple Choice 7.10 % 7.39 % 10.38 % 10.65 % 11.37 %
10.38 %
Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5%. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4% and the market risk premium is 8%. Jack's tax rate is 35%. What is Jack's weighted average cost of capital?
10.38%
As you get closer to retirement, shift from risky to safe assets
100-age rule for stocks as an example
The common stock of Auto Deliveries sells for $27.71 a share. The stock is expected to pay $2.10 per share next month when the annual dividend is distributed. Auto Deliveries has established a pattern of increasing its dividends by 4.5 percent annually and expects to continue doing so. What is the market rate of return on this stock?
12.08 percent 27.71 = 2.1/ (R-.045)
A firm has sales of $1,310, net income of $241, net fixed assets of $501, and current assets of $301. The firm has $97 in inventory. What is the common-size statement value of inventory? 12.1 percent
12.1 percent Common-size inventory = $97/($501 + $301) = 12.1 percent
What is the internal rate of return on an investment that has an initial cost of $38,400 and projected cash inflows of $11,200, $19,600, and $18,100 for Years 1 to 3, respectively? 11.86% 12.37% 11.08% 13.92% 12.15%
12.15%
Calculate the Accounting Rate of Return (ARR) for the project with the following net income. Initial Investment $3,000 Net Income in Year 1 $1,500 Net Income in Year 2 $2,000 Net Income in Year 3 $2,200 Net Income in Year 4 $2,500
136.67%.
The cost of capital of Firm A is 11.2 percent compared to 14.1 percent for Firm B. The market rate of return is 10.8 percent and the risk-free rate is 4 percent. Firm A is considering the acquisition of Firm B. Should this acquisition occur, it will be financed with debt at an interest cost of 8.7 percent. Which of these rates is most appropriate to use as the discount rate when analyzing the acquisition of Firm B by Firm A?
14.1% (cost of capital for firm B)
The risk-free rate of return is 4 percent and the market risk premium is 8 percent. What is the expected rate of return on a stock with a beta of 1.28?
14.24 percent This is the CAPM. E(r) = 0.04 + (1.28 * 0.08) = 0.1424 = 14.24 percent
What is the return on equity for 2009?
15 percent Return on equity = $547/($2,930 + $766) = 15 percent
Given the following cash flows for project A: CF0 = -2,000 CF1 = +500 CF2 = +1,500 CF3 = +5,000 calculate the payback period.
2 years.
It will cost $3,000 to acquire a small ice cream cart. Cart sales are expected to be $1,400 a year for three years. After the three years, the cart is expected to be worthless as that is the expected remaining life of the cooling s7stem. What is the payback period of the ice cream cart?
2.14 years
An investment project has the cash flow stream of -$3250, $80, $200, $75, and $90. The cost of capital is 12%. What is the discounted payback period?
2.24 years
Refer to the cash flows in #1. Assume the discount rate is 25%, calculate the discount payback period.
2.25 years
It will cost $3,500 to acquire a small hot dog cart. Cart sales are expected to be $1,500 a year for three years. After the three years, the cart is expected to be worthless as that is the expected remaining life of the cart. What is the payback period?
2.33 years
Bill is analyzing a security. One-year Treasury rates are currently 4.30 percent. What is the following investment's expected return? Probability Associated return .15 -2% .37 3% .30 4% .18 5%
2.9 percent
Redesigned Computers has 8 percent coupon bonds outstanding with a current market price of $879.64. The yield to maturity is 9.34 percent and the face value is $1,000. Interest is paid semiannually. How many years is it until this bond matures?
20 years Enter 9.34/2 -879.64 80/2 1,000 N I/Y PV PMT FV Solve for 40 The number of six-month periods is 40. The number of years is 20 years.
Refer to the cash flows in #4. Determine the modified internal rate of return (MIRR) if the cost of capital is 10%.
28.61%.
You are considering a project with an initial cost of $4,300. What is the payback period for this project if the cash inflows are $550, $970, $2,600, and $500 a year over the next four years?
3.36 years
An investment project has the cash flow stream of -$250, $75, $125, $100, and $50. The cost of capital is 12%. What is the discounted payback period?
3.38 years
An investment project has the cash flow stream of $-250, $75, $125, $100, and $50. The cost of capital is 12%. What is the discounted payback period?
3.38 years $75/1.12 = $66.96, $125/1.12^2 = $99.65, $100/1.12^3 = $71.18, $50/1.12^4 = $31.78 3 yr. CF: $250 - $66.96 - $99.65 - $71.18 = $12.21 Fraction = $12.21/$31.78 = .38 Discounted Payback: 3 + .38 = 3.38 years
Homer is considering a project which will produce cash inflows of $950 a year for 4 years. The project has a 9% required rate of return and an initial cost of $2,900. What is the discounted payback period?
3.74 years
An investment with an initial cost of $15,000 produces cash flows of $5,000 annually for 5 years. If the cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback period is _____ years.
3.75 Discounted Payback: n = $15,000/$5,000 = 3. PMT = 1 PV = -3 FV = 0 I/YR = 10 N = ? = 3.75
What is the internal rate of return on an investment with the following cash flows? Year Cash Flows 0 -$123,400 1 $36,200 2 $54,800 3 $48,100
5.96%
Latcher's is a relatively new firm that is still in a period of rapid development. The company plans on retaining all of its earnings for the next six years. Seven years from now, the company projects paying an annual dividend of $.25 a share and then increasing that amount by 3 percent annually thereafter. To value this stock as of today, you would most likely determine the value of the stock _____ years from today before determining today's value.
6
Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5 percent and the market rate of return is 10 percent. What is the amount of the risk premium on Zelo stock?
6.77 percent Risk premium = 1.23 * (0.10 - 0.045) = 0.06765 = 6.77 percent
Jake's Sound Systems has 210,000 shares of common stock outstanding at a market price of $36 a share. Last month, Jake's paid an annual dividend in the amount of $1.593 per share. The dividend growth rate is 4%. Jake's also has 6,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7 % coupon, pay interest annually, and mature in 4.89 years. The bonds are selling at 99% of face value. The company's tax rate is 34%. What is Jake's weighted average cost of capital? a. 5.3% b. 5.8% c. 6.3% d. 6.9% e. 7.2%
6.9% E = 210,000*36 = 7.56m D1 = $1.593 x 1.04 = $1.65672 To get r e 36 = 1.65672 / r e- g r e = (1.65672 / 36) + g = 0.08602 = 8.602%
Peter's Audio Shop has a cost of debt of 7%, a cost of equity of 11%, and a cost of preferred stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter's Audio Shop?
9.14%
Peter's Audio Shop has a cost of debt of 7%, a cost of equity of 11%, and a cost of preferred stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter's Audio Shop? Multiple Choice 6.14% 6.54% 8.60% 9.14% 9.45%
9.14%
The NuPress Valet Co. has an improved version of its hotel stand. The investment cost is expected to be $72 million and will return $13.5 million for 5 years in net cash flows. The ratio of debt to equity is 1 to 1. The cost of equity is 13%, the cost of debt is 9%, and the tax rate is 34%. The appropriate discount rate, assuming average risk, is:
9.47%
The NuPress Valet Co. has an improved version of its hotel stand. The investment cost is expected to be $72 million and will return $13.5 million for 5 years in net cash flows. The ratio of debt to equity is 1 to 1. The cost of equity is 13%, the cost of debt is 9%, and the tax rate is 34%. The appropriate discount rate, assuming average risk, is: Multiple Choice 8.65% 9% 9.47% 10.5% 13%
9.47% WACC = .09(1-.34)(.5) + .13(.5) = .0297 + .065 = .0947 = 9.47%
Al's Sport Store has sales of $2,750, costs of goods sold of $2,090, inventory of $536, and accounts receivable of $441. How many days, on average, does it take the firm to sell its inventory assuming that all sales are on credit?
93.6 Inventory turnover = $2,090/$536 = 3.8993 Days in inventory = 365/3.8993 = 93.61 days
The present value created per dollar invested is called the:
Profitability index.
The present value of an investment's future cash flows divided by its initial cost is the:
Profitability index.
Market risk =
also called nondiversifiable risk. this risk can't be diversified away
V(firm) = sum of FCFFt / (1 + WACC)^t
numerator matches denominator result = firm value
The discounted payback period of a project will decrease whenever the:
amount of each project cash inflow is increased.
The payback period rule:
requires an arbitrary choice of a cutoff point.
The differential growth model:
requires g2 to be less than the discount rate.
rights offer
the firm offers the new shares only to existing shareholders.
On average, shareholders of...
the target firm benefit from mergers.
An option that may be exercised only on the expiration date is called a(n) _____ option. A. European B. American C. Bermudan D. futures E. Asian
A
Generous compensation packages paid to a firm's top management in the event of a takeover are referred to as: A. golden parachutes. B. poison puts. C. white knights. D. shark repellents. E. bear hugs.
A. golden parachutes.
PI decision criteria
Accept project when PI>1
Which of the following decision rules has the advantage that the information needed for the calculation is readily available?
Average accounting return
The lower bound on a call's value is defined as the: A. greater of the strike price or zero. B. greater of the stock price minus the exercise price or zero. C. lesser of the strike price or the stock price. D. lesser of the strike price or zero. E. lesser of the stock price minus the exercise price or zero.
B. greater of the stock price minus the exercise price or zero.
What is the most valuable investment given up if an alternative investment is chosen?
an opportunity cost
a rate commensurate with the risk level of the project.
Diversified Industries is a multi-product firm operating in a number of industries. Assume the firm is analyzing a new project that has risks unrelated to those of the current firm's product. When computing the net present value of the new project the cash flows should be discounted using:
Which one of the following values cannot be negative?
Dividend yield
cash flow rule #3
Do not include financing costs in cash flows. Financing costs will be included in the discount rate Deducting interest expense from cash flows would constitute double counting We are interested in the cash flow generated by a project available to pay all claimholders, including debtholders. Remember our plan of attack: 1. estimate cash flows, 2. discount cash flows. We will address financing costs in step 2
15.88%
Dybvig Corporation's common stock has a beta of 1.8. If the risk-free rate is 4.9 percent and the expected return on the market is 11 percent, what is the company's cost of equity capital?
A purely financial merger: A. increases shareholder value but does not affect bondholders. B. decreases both bondholder and shareholder values. C. transfers bondholder value to shareholders. D. increases bondholder value but does not affect shareholder value. E. reduces shareholder value while increasing bondholder value.
E
In the Black-Scholes option pricing formula, N(d) is the probability that a standardized, normally distributed random variable is: A) greater than or equal to d. B) less than one. C) equal to one. D) equal to d. E) less than or equal to d.
E
The lower bound of a call option: A. can be a negative value regardless of the stock or exercise prices. B. can be a negative value but only when the exercise price exceeds the stock price. C. can be a negative value but only when the stock price exceeds the exercise price. D. must be greater than zero. E. can be equal to zero.
E
You own stock in a firm that has a pure discount loan due in six months. The loan has a face value of $50,000. The assets of the firm are currently worth $62,000. The stockholders in this firm basically own a _____ option on the assets of the firm with a strike price of ______ A. put; $62,000. B. put; $50,000. C. warrant; $62,000. D. call; $62,000. E. call; $50,000.
E
30. If you want to review a project from a benefit-cost perspective, you should use the _______ method of analysis. A. net present value B. payback C. internal rate of return D. discounted payback E. profitability index
E. profitability index
The length of time required for a project's discounted cash flows to equal the initial cost of the project is called the: A. net present value. B. discounted net present value. C. payback period. D. discounted profitability index. E. discounted payback period.
E. discounted payback period.
You are trying to determine whether to accept Project A or Project B. These projects are mutually exclusive. As part of your analysis, you should compute the incremental IRR by determining the: A. internal rate of return for the cash flows of each project. B. net present value of each project using the internal rate of return as the discount rate. C. discount rate that equates the discounted payback periods for each project. D. discount rate that makes the net present value of each project equal to one. E. internal rate of return for the differences in the cash flows of the two projects.
E. internal rate of return for the differences in the cash flows of the two projects.
You are trying to determine whether to accept Project A or Project B. These projects are mutually exclusive. As part of your analysis, you should compute the incremental IRR by determining the: A. internal rate of return for the cash flows of each project. B. net present value of each project using the internal rate of return as the discount rate. C. discount rate that equates the discounted payback periods for each project. D. discount rate that makes the net present value of each project equal to one. E. internal rate of return for the differences in the cash flows of the two projects.
E. internal rate of return for the differences in the cash flows of the two projects.
The value of an option if it were to immediately expire, that is, its lower pricing bound, is called an option's _____ value. A. strike B. market C. volatility D. time E. intrinsic
E. intrinsic
In the Black-Scholes option pricing formula, N(d1) is the probability that a standardized, normally distributed random variable is: A. less than or equal to N(d2). B. less than one. C. equal to one. D. equal to d1. E. less than or equal to d1.
E. less than or equal to d1.
A purely financial merger: A. increases shareholder value but does not affect bondholders. B. decreases both bondholder and shareholder values. C. transfers bondholder value to shareholders. D. increases bondholder value but does not affect shareholder value. E. reduces shareholder value while increasing bondholder value.
E. reduces shareholder value while increasing bondholder value.
The discounted payback rule may cause: A. projects with discounted payback periods in excess of the project's life to be accepted. B. the most liquid projects to be rejected in favor of less liquid projects. C. projects to be incorrectly accepted due to ignoring the time value of money. D. some projects with negative net present values to be accepted. E. some positive net present value projects to be rejected.
E. some positive net present value projects to be rejected.
Which one of these is least associated with takeovers? A. leveraged buyouts B. management buyouts C. proxy contests D. acquisition of assets E. spin-offs
E. spin-offs
What is the primary shortcoming of the average accounting rate of return from a financial perspective? A. The lack of use in the business world B. The lack of a clear-cut decision rule C. The degree of the calculation difficulty D. The degree of estimation involved with the initial cost E. The use of net income rather than cash flows
E. The use of net income rather than cash flows
Which one of the following statements correctly describes your situation as the owner of an American call option?
E. You have the right to buy at a set price at any time up to and including the expiration date.
Net cash flow (Free Cash Flow) is calculated as:
EBIT - tax + depreciation - capital spending - increases in net working capital.
Why does net working capital increase?
Essentially, you are making an investment in working capital (negative cash flow) At end of project - usually assumed to be completely recovered Increases then decreases
Generally, the most difficult part of utilizing the net present value concept is:
Estimating the future cash flows given the initial investment in the project.
An option that may be exercised only on the expiration date is called a(n) _____ option.
European
The two fatal flaws of the internal rate of return rule are:
Failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem.
An anchor currency provides the base for a floating exchange rate system
False; fixed
a. 0.1667 and 0.8333 b. 0.7396 and 0.2604 c. Market Value
Filer Manufacturing has 4 million shares of common stock outstanding. The current share price is $70, and the book value per share is $5. Filer Manufacturing also has two bond issues outstanding. The first bond issue has a face value of $60 million and a coupon rate of 5 percent and sells for 95 percent of par. The second issue has a face value of $40 million and a coupon rate of 6 percent and sells for 104 percent of par. The first issue matures in 20 years, the second in 4 years.
Which one of these statements is correct?
Financial leverage refers to a firm's use of debt and its related fixed costs of finance.
Types of markets
Financial markets, commodities markets
Firm A acquired Firm B in a cash acquisition. The merger was a success and value was created. This incremental value was beneficial to the shareholders of:
Firm A only.
a. 6.84% b. 12.28%
Floyd Industries stock has a beta of 1.2. The company just paid a dividend of $.50, and the dividends are expected to grow at 6 percent per year. The expected return on the market is 11 percent, and Treasury bills are yielding 4.6 percent. The most recent stock price for Floyd is $63.
When is it appropriate to use WACC in an NPV decision?
For when we are extending the firm.
MACRS table
Get more tax benefit up front with MACRS method Common (and legal) to keep two sets of books: one for IRS and one for stock holders (using straight-line) get both benefits This table assumes implementation mid-year. Hence a 3 year asset is depreciated over 4 years with depreciation lower in the first year than in the second.
The beta of a firm is more likely to be high under which two conditions?
High cyclical business activity and high operating leverage
If the discount rate is _____ than both projects IRR's reject both
Higher
a pioneer in managing small accounts
Homestead funds
The acquisition of a firm in the same industry as the bidder is called a:
Horizontal acquisition.
Which of the following uses an arbitrary cutoff number in its decision rule? I. Payback period II. AAR III. IRR
I and II only
Analysis using the profitability index:
I'd useful as a decision tool when investment funds are limited.
Synergistic benefits can often be realized by merging with a firm that: I. has an ineffective marketing program. II. has unused debt capacity. III. uses complementary resources. IV. has net operating losses.
I, II, III, and IV
Which of the following statements is (are) true concerning the internal rate of return (IRR)? I. The IRR is the most widely used capital budgeting technique. II. The IRR method can produce multiple rates of return if the cash flows are nonconventional. III. If the IRR rate is used as the discount rate, then the resulting profitability index must equal 1.0. IV. The crossover point occurs where the IRR of two projects are equal
I, II, and III only
Which of the following are advantages of using net present value when evaluating projects? I. NPV lets you know in today's dollars how much better off or worse off you will be if you accept a project. II. NPV includes time value of money considerations. III. The NPV method quickly determines the discount rate that changes an accept decision into a reject decision and vice versa. IV. NPV indicates the expected impact on the owners of the firm.
I, II, and IV only
Rank the following decision rules from worst to best in terms of their overall usefulness in capital budgeting analysis. I. NPV II. Payback III. IRR
II, III, I
The internal rate of return on a project is 11.24%. Which of the following (is) are true if the project is assigned a 9.5% discount rate? I. The project will have a negative net present value. II. The profitability index will be greater than 1.0. III. The initial investment is less than the market value of the project. IV. The project will have a positive effect on shareholders if it is accepted.
II, III, and IV only
Which of the following should be included in the analysis of a project?
II. Opportunity costs III. Erosion costs IV. Incremental costs
The investment timing decision relates to:
when a project should commence.
Which of the following calculations takes the time value of money into account? I. Payback II. Average accounting return III. Profitability index
III only
Which of the following types of acquisitions is (are) least likely to result in synergistic increases in value? I. Horizontal acquisitions II. Vertical acquisitions III. Conglomerate acquisitions
III only
Which of the following would be listed as an argument against using an acquisition by tender offer as opposed to a merger? I. No shareholder meetings need to be held. II. The target firm's management and board of directors can be bypassed. III. A significant number of minority shareholders may hold out.
III only
is better than payback or average accounting return
IRR
Consider a project with an initial investment and positive future cash flows. As the discount rate is increased the ____________
IRR remains constant while the NPV decreases
What method is this? Single rate of return aids people in discussing/thinking about projects. Most people know/understand the flaws of IRR and take them into account
IRR, reason why they are still using it.
A. Mutually Exclusive
If a firm accepts Project A it will not be feasible to also accept Project B because both projects would require the simultaneous and exclusive use of the same piece of machinery. These projects are considered to be: A. Mutually Exclusive B. Economically Scaled C. Independent D. Interdependent
C. The project's internal rate of return is exactly equal to the discount rate
If a project has a net present value equal to zero, then: A. A decrease in the project's initial cost will cause the project to have a negative NPV. B. The total of the cash inflows must equal the initial cost of the project. C. The project's internal rate of return is exactly equal to the discount rate D. The project's profitability index must also be equal to zero
________________, it is impossible for a tax-free acquisition to take place.
If an acquisition is being undertaken with cash
NPV Decision Rule
If the computed NPV is greater than zero, accept.
MM Dividend Irrelevance
In perfect capital markets, holding fixed the investment policy of a firm, the firm's choice of dividend policy is irrelevant and does not affect the initial share price.
MM Payout Irrelevance
In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm's choice of payout versus retention is irrelevant and does not affect the initial value of the firm.
FCF = EBIT * (1-t) + depr. - CAPX - Change in NWC
In the language of the textbook, this is cash flow from operations + cash flow from investment in PP&E + cash flow from investment in working capital Note that other formulas work also, but this one is perhaps the most useful and most general
Project analysis is focused on _____ costs.
Incremental
Several factors affect the dividend and capital gains tax exposure of investors: - Investment Horizon: Short-term investors pay income tax rates, long- term investors pay the respective tax rates, and investors giving stock to their heirs do not pay capital gains tax at all. - Type of Investor: Retirement accounts are subject to neither dividend nor capital gains taxes. Pension funds and non-profit endowments are also exempt from taxation.
Long-term investors prefer share repurchases, to avoid higher dividend tax rates. Tax-exempt investors prefer whatever payout policy matches their cash needs, which often means they prefer dividends to avoid transaction costs involved in selling shares.
Cash flow rule #1
Look only at changes in cash flow directly attributable to the project Sunk costs should be ignored (sunk costs remain the same whether or not you accept the project; therefore, they do not affect NPV) Opportunity costs should be included (opportunity costs = the value, benefit, or cash flow foregone as a result of the project) Allocated costs should be included only after careful thought (allocated overhead is an example of allocated costs) Excess capacity should be included only if it's an actual cost to the whole company When in doubt, remember the with-without principle. Imagine two worlds, one with the project, and one without. Any cash flows different in those two worlds are relevant.
Cost of capital example: Geothermal Inc has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the company cost of capital?
Market value debt $194 40% Market value equity $453 70% Market value assets $647 100% Portfolio return = (0.3 * 8%) + (.7 * 14%) = 12.2%
PI disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive investments
A project initially costs $40,500 and will not produce any cash flows for the first 2 years. Starting in year 3, it will produce cash flows of $34,500 a year for 2 years. In year 6, the project will end and should produce a final cash inflow of $12,000. What is the net present value of this project if the required rate of return is 18.5 percent?
NPV = -$40,500 + $34,500 / 1.185^3 + $34,500 / 1.185^4 + $12,000 / 1.185^6 = $2,063.19
A project is expected to create operating cash flows of $24,500 a year for three years. The initial cost of the fixed assets is $55,000. These assets will be worthless at the end of the project. An additional $4,000 of net working capital will be required throughout the life of the project. What is the project's net present value if the required rate of return is 10 percent?
NPV = -$55,000 - 4,000 + $24,500[(1 - 1/1.103)/.10] + $4,000/1.103 = $4,933.13
Which of the following does not characterize NPV?
NPV does not explicitly incorporate risk into the analysis.
The principle that an investment should be accepted if the difference between the investment's market value and its cost is positive and rejected if the difference is negative is referred to as the:
Net present value rule.
Jack is considering adding toys to his general store. He estimates that the cost of inventory will be $4,200. The remodeling and shelving costs are estimated at $1,500. Toy sales are expected to produce net cash inflows of $1,200, $1,500, $1,600, and $1,750 over the next four years, respectively. Should Jack add toys to his store if he assigns a three-year payback period to this project?
No; because the payback period is 3.80 years.
The internal rate of return should
Not be used for ranking mutually exclusive projects.
Kurt's Kabinets is looking at a project that will require $80,000 in fixed assets and another $20,000 in net working capital. The project is expected to produce sales of $138,000 with associated costs of $74,000. The project has a 4-year life. The company uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 34 percent. What is the operating cash flow for this project?
OCF = ($138,000 - 74,000)(1 - .34) + ($80,000/4)(.34) = $49,040
The payback method assumes that the cash flows:
Occur evenly throughout the year.
A security that is fairly priced will have a return that lies _____ the security market line.
On
Disadvantage to a merger
One disadvantage of a merger is that it requires the approval of both the target and bidder firm's shareholders.
Which of the following statement is true?
One must know the discount rate to compute the NPV of a project but one can compute the IRR without referring to the discount rate.
Which of the following statements is true?
One must know the discount rate to compute the NPV of a project but one can compute the IRR without referring to the discount rate.
Your proposed project will require the use of machinery that the company owns that is only being used at 50% capacity. Since you will use the other 50% capacity, half of the annual maintenance expenses will be charged to your project. Is this appropriate?
Only incremental maintenance costs should be added. If the maintenance costs are incurred whether or not you do your project or not, don't count it.
5 Capital Budgeting Methods
Payback Period, Discounted payback period, NPV, Profitability Index, Internal Rate of Return
Which of the following methods of project analysis are biased towards short-term projects?
Payback and Discount payback
Which methods of project analysis are most biased towards short-term projects?
Payback and discounted payback
If the discounted payback method is preferable to the payback method, then why is the payback method ever used?
Payback is easier to compute than discounted payback
If the discounted payback method is preferable to the payback method, then why is the payback method ever used?
Payback is easier to compute than discounted payback.
The length of time required for an investment to generate cash flows sufficient to recover its initial cost is the:
Payback period
Cash Dividend
Payment of cash by the firm to its shareholders.
You are considering two independent projects. The required rate of return is 13.75 percent for Project A and 14.25 percent for Project B. Project A has an initial cost of $51,400 and cash inflows of $21,400, $24,900, and $22,200 for years 1 to 3, respectively. Project B has an initial cost of $38,300 and cash inflows of $23,000 a year for 2 years. Which project(s), if either, should you accept?
Project A NPV = -$51,400 + ($21,400 / 1.1375) + ($24,900 / 1.1375^2) + ($22,200 / 1.1375^3) = $1,740.62; Accept Project B NPV = -$38,300 + $23,000 / 1.1425 + $23,000 / 1.1425^2 = -$548.32; Reject
You are considering the following two mutually exclusive projects that will not be repeated. The required rate of return is 11.25% for project A and 10.75% for project B. Which project should you accept and why? Year Project A Project B 0 -$48,000 -$126,900 1 $18,400 $69,700 2 $31,300 $80,900 3 $11,700 $ 0
Project A; because its NPV is about $335 more than the NPV of project B.
Matt is analyzing two mutually exclusive projects of similar size. Both projects have 5-year lives. Project A has an NPV of $18,389, a payback period of 2.38 years, an IRR of 15.9 percent, and a discount rate of 13.6 percent. Project B has an NPV of $19,748, a payback period of 2.69 years, an IRR of 13.4 percent, and a discount rate of 12.8 percent. He can afford to fund either project, but not both. Matt should accept:
Project B based on its NPV.
market risk premium equation
Rm - Rf
Based on the NPV of the investment, should Klamath undertake this project?
So far CF (cash flow) numbers have been given. Now we will learn to estimate cash flows
Proposition II (with taxes)
Some of the increase in equity risk and return is offset by the interest tax shield RS = R0 + (B/S)×(1-tC)×(R0 - RB) RB is the interest rate (cost of debt) RS is the return on equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of equity
a. 575% b. $19,101,124
Suppose your company needs $18 million to build a new assembly line. Your target debt-equity ratio is .7. The flotation cost for new equity is 7 percent, but the flotation cost for debt is only 4 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small. a. What is your company's weighted average flotation cost, assuming all equity is raised externally? b. What is the true cost of building the new assembly line after taking flotation costs into account?
When new product increases the cash flows of existing projects
Synergy (Incremental IRR side effect)
Studies of acquisitions and mergers suggest that shareholders of the:
Target firm have the most to gain from a merger.
the common stock of an unlevered firm.
The asset beta is defined as the beta of:
Bloomfield's has some equipment sitting idle in a warehouse. The equipment is fully paid for and also fully depreciated. If the firm decides to use this equipment for a new project, what cost, if any, should the firm include in its startup costs for the project?
The current market value of the equipment should be included in the startup costs.
Ex-dividend Date
The date before which a new purchaser of stock is entitled to receive a declared dividend, but on or after which she does not receive the dividend
Declaration date
The date on which the board of directors passes a resolution authorizing payment of a dividend to the shareholders
Net Present Value
The difference between the market value of a project and its cost (best method)
Which of the following is true about using discounted payback analysis for projects which have only positive cash flows after the initial outlay and for which the discount rate is positive?
The discounted payback period will be longer than the regular payback period
Delta
The effect on an option's value of a small change in the value of the underlying asset
Which of the following is an example of diversifiable risk?
The employees of Textile, Inc. just voted to go on strike. Textile, Inc. is an individual firm. The risk of an individual firm can be diversified by forming a portfolio of stocks along with textile.
Direct Bankruptcy Costs
The explicit costs, such as the legal expenses, associated with corporate default
expiration date
The future date at which the option can be exercised
Given that the net present value (NPV) is general considered to be the meat method of analysis, why should you still use the other methods?
The other methods help validate whether or not the results from the net present value analysis are reliable.
A) it provides a quick estimate of how rapidly an initial investment will be recouped.
The payback method is a convenient and useful tool because A) it provides a quick estimate of how rapidly an initial investment will be recouped. B) it considers all of a project's relevant cash flows. C) it considers the time value of money. D) the required payback period for all of a firm's projects must be identical. E) it only considers the cash flows within the current period of 12 months.
strike price
The price at which the holder exercises
What is the key reason why a positive NPV project should be accepted? The project is expected to increase shareholder value. The present value of the expected cash flows equal the project's cost. The firm will earn a return equal to the NPV value at the end of the project. The project will have a payback period equal to its life. The project's PI will be less than 1, which also indicates acceptance.
The project is expected to increase shareholder value.
MM1 with Taxes:
The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt: VL = Vu + PV(tax shield)
A) internal rate of return and net present value methods.
The two most commonly used methods of capital budgeting analysis are the A) internal rate of return and net present value methods. B) net present value and payback methods. C) profitability index and the internal rate of return methods. D) net present value and discounted payback methods. E) average accounting return and discounted payback methods.
What is the primary shortcoming of the average accounting rate of return from a financial perspective?
The use of net income rather than cash flows
Which one of the following statements is correct concerning in-the-money option values?
The value of a call decreases as the exercise price increases.
Total Risk
Total risk = systematic risk + unsystematic risk - The standard deviation of returns is a measure of total risk. - For well-diversified portfolios, unsystematic risk is very small. - Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.
Which one of the following statements is correct concerning acquisition considerations?
Transaction costs and related expenses must be included in the acquisition analysis
A managed float regime is when countries intervene in foreign exchange markets in an attempt to influence their exchange rates by buying and selling foreign assets
True
You have been hired to value a firm that is not publicly traded. The firm has earnings of $300,000 per year on sales of $3 million a year. After some research, you determine that a fair PE ratio is 15x, the market-to-book ratio is 1.4, and the discount rate is 15 percent. What is the value of this firm using a comparable firm approach?
Using this method, we take earnings of $300,000 and we multiply it by the PE ratio of 15. $300,000 * 15 = $4,500,000
Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information Month Market return% Turbo return % 1 +1 +.08 2 +1 +1.8 3 +1 -0.2 4 -1 -1.8 5 -1 +0.2 6 -1 -0.8
When the market was up 1%, Turbo average % change was +0.8% When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6% (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8. B = 1.6 / 2 = 0.8
Retention ratio × Return on equity
Which one of these formulas will provide an estimate of the growth rate of a security's dividends?
risk-shifting or excessive risk- taking, a form of moral hazard
Why not roll the dice on the risky project? - If the project fails, you're no worse off, since you were going to default anyway. - If the project succeeds, you avoid default and retain ownership of the firm. - "Gambling for resurrection" at the expense of creditors, who bear the downside risk.
Why don't firms increase leverage to 99% (or100%) to increase firm value?
With higher leverage,the firm is less likely to be able to make interest payments, or more likely to default on its debt obligations
According to the text, which is not a primary method of computing the cost of common stock?
YTM
Do some firms have more market risk than others?
Yes. For example, an economic slow-down affects all firms, but which would be more affected? A- Harley Davidson; or B- American Electric Power. Answer is A, because people tend to postpone the purchase of luxury items during hard times.
Which one of the following statements correctly describes your situation as the owner of an American call option?
You have the right to buy at a set price at any time up to and including the expiration date.
Which one of the following will decrease net working capital of a firm?
a decrease in accounts receivable
poison pill
a rights offering that gives target shareholders the right to buy shares at a deeply discounted price once the acquirer owns a certain percentage of the target's shares The acquirer is excluded from the offering, so the value of the acquirer's shares is severely diluted, making the cost of the takeover prohibitively expensive.
The acquisition of a firm whose business is not related to that of the bidder is called a _____ acquisition. a. conglomerate b. forward c. backward d. horizontal e. vertical
a. conglomerate
In a merger or acquisition, a firm should be acquired if it: a. generates a positive net present value to the shareholders of an acquiring firm. b. is a firm in the same line of business, in which the acquirer has expertise. c. is a firm in a totally different line of business which will diversity the firm. d. pays a large dividend which will provide cash pass through to the acquiror. e. None of the above.
a. generates a positive net present value to the shareholders of an acquiring firm.
Generous compensation packages paid to a firm's top management in the event of a takeover are referred to as: a. golden parachutes. b. poison puts. c. white knights. d. shark repellents. e. bear hugs.
a. golden parachute
Suppose that Verizon and Sprint were to merge. Ignoring potential antitrust problems, this merger would be classified as a: a. horizontal merger. b. vertical merger. c. conglomerate merger. d. monopolistic merger. e. None of the above.
a. horizontal merger.
In a merger the: a. legal status of both the acquiring firm and the target firm is terminated. b. acquiring firm retains its name and legal status. c. acquiring firm acquires the assets but not the liabilities of the target firm. d. stockholders of the target firm have little, if any, say as to whether or not the merger occurs. e. target firm continues to exist as a subsidiary of the acquiring firm.
a. legal status of both the acquiring firm and the target firm is terminated.
the complete absorption of one company by another, where in the acquiring firm retains its identity and the acquired firm ceases to exist as a separate entity, is called a: a. merger b. Consolidation c. tender off d. spinoff e. divestiture
a. merger
firm-specific risk =
also called diversifiable risk. this risk can be reduced through diversification
Payback Period (Discounted Payback Period) method decision criteria
accept project if project period is less than policy payback period, reject otherwise
In a merger the
acquiring firm retains its name and legal status
The incremental cash flows of a project are best defined as
any change in a firm's cash flows resulting from the addition of the project including opportunity costs.
The incremental cash flows of a project are best defined as...
any change in a firm's cash flows resulting from the addition of the project including opportunity costs.
A trading opportunity that offers a riskless profit is called a(n):
arbitrage.
Given the following information, what is the value of d2 as it is used in the Black-Scholes Option Pricing Model? Stock price $42 Time to expiration .25 Risk-free rate .055 Standard deviation .50 d1 .375161 a. .021608 b. .125161 c. .175608 d. .200161 e. .250161
b
The market price of ABC stock has been very volatile and you think this volatility will continue for a few weeks. Thus, you decide to purchase a one-month call option contract on ABC stock with a strike price of $25 and an option price of $1.30. You also purchase a one-month put option on ABC stock with a strike price of $25 and an option price of $.50. What will be your total profit or loss on these option positions if the stock price is $24.60 on the day the options expire? a. -$180 b. -$140 c. -$100 d. $0 e. $180
b
Three months ago, you purchased a put option on WXX stock with a strike price of $60 and an option price of $.60. The option expires today when the value of WXX stock is $62.50. Ignoring trading costs and taxes, what is your total profit or loss on your investment? a. -$310 b. -$60 c. $0 d. $60 e. $190
b
Two stock market based costs of liquidity that affects the cost of capital are the: A. bid-ask spread and the specialist spread.
bid-ask spread and the market impact costs.
What is the process of minimizing expenses and finding creative ways to finance a new venture called?
bootstrapping
46. Southern Home Cooking just paid its annual dividend of $.75 a share. The stock has a market price of $16.80 and a beta of 1.14. The return on the U.S. Treasury bill is 2.7 percent and the market risk premium is 7.1 percent. What is the cost of equity? A. 9.98 percent B. 10.04 percent C. 10.79 percent D. 10.37 percent E. 10.45 percent
c
48. Dee's Fashions has a growth rate of 5.2 percent and is equally as risky as the market while its stock is currently selling for $28 a share. The overall stock market has a return of 12.6 percent and a risk premium of 8.7 percent. What is the expected rate of return on this stock? A. 8.7 percent B. 9.2 percent C. 12.6 percent D. 11.3 percent E. 11.7 percent
c
A firm with high operating leverage has: A. low fixed costs in its production process. B. high variable costs in its production process. C. high fixed costs in its production process. D. high price per unit. E. low price per unit.
c
A business deal in which all publicly owned stock in a firm is replaced with complete equity ownership by a private group is called a: a. tender offer b. proxy contest c. going- private transaction d. leveraged buyout e. consolidation
c. Going private transaction
When evaluating an acquisition, you should: a. concentrate on book values and ignore market values. b. focus on the total cash flows of the merged firm. c. apply the rate of return that is relevant to the incremental cash flows. d. ignore any one-time acquisition fees or transaction costs. e. ignore any potential changes in management.
c. apply the rate of return that is relevant to the incremental cash flows.
In a tax-free acquisition, the shareholders of the target firm: a. receive income that is considered to be tax-exempt. b. gift their shares to a tax-exempt organization and therefore have no taxable gain. c. are viewed as having exchanged their shares. d. sell their shares to a qualifying entity thereby avoiding both income and capital gains taxes. e. sell their shares at cost thereby avoiding the capital gains tax.
c. are viewed as having exchanged their shares.
If Microsoft were to acquire U.S. Airways, the acquisition would be classified as a _____ acquisition. a. horizontal b. longitudinal c. conglomerate d. vertical e. complementary resources
c. conglomerate
The protective covenants contained within a loan agreement:
can increase the value of the borrowing firm.
A project that will improve the manufacturing efficiency of a firm but will generate no additional sales is referred to as a(n) _____ project.
cost-cutting
A project that will improve the manufacturing efficiency of a firm but will generate no additional sales is referred to as a(n) _____ project. -sunk cost -opportunity cost -cost-cutting -revenue-cutting -revenue-generating
cost-cutting
Beta values are highly dependent on the
covariance of a security with the market.
To calculate beta, you divide the _______ of the stock with the market portfolio by the _____ of the market portfolio.
covariance; variance
A firm should accept projects with positive net present values primarily because those projects will
create value for the firm's current stockholders.
A firm should accept projects with positive net present values primarily because those projects will...
create value for the firm's current stockholders.
27. Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should: A. Allocate more funds to Division A since it is the largest of the two divisions. B. Fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. C. Allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital. D. Assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values. E. Fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B.
d
39. When computing the adjusted cash flow from assets the tax amount is calculated as: A. EBT TC. B. (EBT - Depreciation) TC. C. (EBIT + Depreciation - Change in NWC - Capital spending) TC. D. EBIT x TC. E. (EBIT - Depreciation - Change in NWC - Capital spending) TC.
d
Firm A is acquiring Firm B for $40,000 in cash. Firm A has 2,500 shares of stock outstanding at a market value of $18 a share. Firm B has 1,500 shares of stock outstanding at a market price of $25 a share. Neither firm has any debt. The net present value of the acquisition is $2,500. What is the value of Firm A after the acquisition? a. $40,000 b. $42,500 c. $45,000 d. $47,500 e. $50,000
d. $47,500
the acquisition of a firm in the same industry as the bidder is called a a. conglomerate b. forward c. backward d. horizontal e. vertical
d. horizontal
Will Do, Inc. just purchased some equipment at a cost of $650,000. What is the proper methodology for computing the depreciation expense for year 3 if the equipment is classified as 5-year property for MACRS? MACRS 5-year property Year Rate 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76%
e. $650,000 x .192
an agreement between firms to cooperate in pursuit of joint goal is called a: a. consolidation b. merged alliance c. joint venture d. takeover project e. strategic alliance
e. strategic alliance
The yield to maturity:
equals both the current yield and the coupon rate for par value bonds.
Schottenheimer Industries has a great deal of cash but few investment opportunities. Montana, Inc., on the other hand, has many investment opportunities but finds it difficult to obtain financing. The acquisition of Montana by Schottenheifer would be made in order to ________.
exploit synergies
When an entrepreneur sells her accounts receivable at a discount price for immediate cash, what is the process called?
factoring
Two key weaknesses of the internal rate of return rule are the
failure to correctly analyze mutually exclusive projects and the multiple rate of return problem.
A financial manager who consistently underestimates the ___________ will tend to incorrectly reject projects that would actually create wealth for the stockholders
future cash inflows associated with projects
Financial derivatives include _______________.
futures
Assume a project has normal cash flows. Given this, you should accept the project...
if the NPV is positive and reject it if the NPV is negative.
The discounted payback rule states that you should accept projects:
if the discounted payback period is less than some pre-specified period of time
The payback method
ignores the time value of money.
Three categories of cash flows to consider for each project
initial outlay, terminal cash flow, annual/differential cash flows
What is tricky to evaluate when valuing a firm?
intangible assets
LBOs and MBOs
involve the firm being purchased by investors or management and investors, respectively, typically financed with a large amount of debt.
Targeted repurchase
involves private negotiation with a major shareholder. Whether the buyback occurs at a discount or a premium depends whether the shareholder wishes to exit her position or whether the firm wishes to buy out a threatening shareholder ("greenmail").
The payback method is a convenient and useful tool because...
it provides a quick estimate of how rapidly an initial investment will be recouped.
The payback method is a convenient and useful tool because:
it provides a quick estimate of how rapidly an initial investment will be recouped.
The payback method is a convenient and useful tool because: it provides a quick estimate of how rapidly an initial investment will be recouped. it considers all of a project's relevant cash flows. it considers the time value of money. the required payback period for all of a firm's projects must be identical. it only considers the cash flows within the current period of 12 months.
it provides a quick estimate of how rapidly an initial investment will be recouped.
A new company financed with funds from two existing firms for the purpose of working together on a project is called a(n):
joint venture.
In a(n) ____________, the managers of the firm purchase the shares outstanding in the open market and take the firm private
management buyout
When the existing management of a firm is involved in a going-private transaction financed primarily with borrowed funds, the transaction is frequently referred to as a:
management buyout.
Measuring market risk
market portfolio; beta
Financial analysts value items in terms of their:
market value.
Assume you are using the dividend growth model to value stocks. If you expect the market rate of return to increase across the board on all equity securities, then you should also expect the:
market values of all stocks to decrease.
Your firm needs to buy a metal stamping press. The CFO presents you with two analyses: one for a press that is automated, requiring little labour to operate, and another that is manual, requiring a significant amount of labour. This is an example of a decision involving ______________.
mutually exclusive projects
When two projects both require the total use of the same limited economic resource, the projects are generally considered to be:
mutually exclusive.
For capital budgeting purposes, *allocated cost* should be viewed as a cash outflow of a project only if it is an incremental cost of the project
n/a
Incremental cash flows (side effects, externalities) cannibalism or synergy
n/a
incremental cash flows -opportunity cost -side effects -taxes -inflation Irrelevant -sunk cost
n/a
The discount rate is referred to the ______ _________, since corporate investment in the project takes away the stockholders _________ to invest the same cash in a financial asset.
opportunity cost, opportunity
The most valuable investment given up if an alternative investment is chosen is referred to as a(n):
opportunity cost.
The price paid for an option is called the
option premium
market price 𝑆 for a strike price 𝐾 on an expiration date 𝑇 The payoff 𝐶t The payoff 𝑃t
options are a zero sum game = to make money, someone has to lose money
A put option with a $35 exercise price on ABC stock expires today. The current price of ABC stock is $36. The put is:
out of the money.
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the
payback period.
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the...
payback period.
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the:
payback period.
A firm seeks to accept projects with a high degree of liquidity, avoid the higher forecasting error associated with cash flows occurring in the distant future, and avoid projects that require a large amount of research and development expenses. This firm may be justified in using the ____________ to evaluate its projects.
payback rule
If a firm uses the _____________ as an investment criterion, one of the risks it takes is that it may ignore some future cash flows.
payback rule
Which of the following is not a way the text lists as harvesting a business?
paying a liquidating dividend to the founders
takeover defenses
poison pill recapitalization golden parachute electing board members - staggered/classified board
The present value of an investment's future cash flows divided by the initial cost of the investment is called the: average accounting return. internal rate of return. profitability index. profile period. net present value.
profitability index.
Matt is analyzing two mutually exclusive projects of similar size and has prepared the following data. Both projects have 5 year lives. Project A: NPV - $15,090 Payback period - 2.76 years Required Return 8.3% Project B: NPV - $14,693 Payback Period - 2.51 years Required Return - 8.0%
project A and reject project B based on their net present values.
You are considering the following two mutually exclusive projects that will not be repeated. The required rate of return is 11.25% for project A and 10.75% for project B. Which project should you accept and why? Year 0 PA: -$48,000 PB: -$126,900 Year 1 PA: $18,400 PB: $69,700 Year 2 PA: $31,300 PB: $80,900 Year 3 PA: $11,700 PB: $0
project A; because its NPV is about $335 more than the NPV of project B.
You are considering the following two mutually exclusive projects. The required rate of return is 10.75 percent for project A and 12 percent for project B. Which project should you accept and why?
project A; because its NPV is about $796 more than the NPV of project B
Courtney is analyzing two mutually exclusive projects of similar size and has compiled the following information based on her analysis. Both projects have four year lives. Courtney has been asked for her best recommendation given this information. Her recommendation should be to accept:
project B and reject project A based on their net present values.
An independent, financing type project has an IRR of 11.4 percent and a required rate of return of 10.6 percent. Given this, you know the
project should be rejected.
Which one of the following is a liquidity ratio?
quick ratio
• Marpor has no debt and expects to earn FCF=$16M each year. Marpor believes that if it permanently increases its debt to $40M, the risk of financial distress will cause it to lose some customers and receive less favorable terms from its suppliers. As a result, its FCF with debt will be $15M. Suppose Marpor's tax rate is 35%, the risk free rate is 5%, the expected return on the market is 15%, and Marpor's FCF beta is 1.10 (with or without debt). • Estimate Marpor's value without leverage • Estimate Marpor's value with leverage
rE = rf + B(Rm - rf) = .05 + 1.1*(.15-.05) = .16 V unlevered= FCF/ (r-g) = 16/(.16-0) = 100 tax shield = 40*.35 = 14 V levered = 15/(.16-0) + 14 = 107.75
The overall cost of capital for a retail store:
reflects the return that investors require on the total assets of the firm.
If you have returns on a security and also on the market, you can estimate beta using
regression analysis.
You are considering the following two mutually exclusive projects. Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage value. Project A: CF0: -$75,000 CF1: $19,000 CF2: $48,000 CF3: $12,000 Project B: CF0: -$70,000 CF1: $10,000 CF2: $16,000 CF3: $72,000 Required rate of return 10%, 13%; Required payback period 2.0 years, 2.0 years Based upon the payback period and the information provided in the problem, you should:
reject both project A and project B. (Neither project pays back within 2 years, thus they should both be rejected.)
Which one of the following is the best example of two mutually exclusive projects?
renting out a company warehouse or selling it outright
The book shows a house appraisal that contains two methods for valuing the house. What are they?
replacement cost and comparables
What are the three primary ways to value a firm, according to the chapter?
replacement cost, DCF, comparable trades
If stockholders want to know how much profit the firm is making on their entire investment in that firm, the stockholders should refer to the:
return on equity.
The use of WACC as the discount rate when evaluating a project is acceptable when the
risk of the project is equal to the company's overall level of risk.
The use of WACC to select investments is acceptable when the:
risk of the projects are equal to the risk of the firm.
You can realize the same value as that derived from stock ownership if you:
sell a put and buy a call on a stock as well as invest at the risk-free rate of return.
A short contract requires that the investor
sell securities in the future.
short
seller of option
Corporate charter provisions allowing existing shareholders to purchase stock at some fixed price in the event of a hostile outside takeover attempt are called ___________________.
share rights plans
A proposed project has a positive net present value. If this project is accepted, then: the firm made an incorrect accept/reject decision. shareholder wealth will increase. shareholder wealth will remain constant. the value of the firm will decrease. the value of the firm will remain constant.
shareholder wealth will increase.
A proposed project has a positive net present value. If this project is accepted, then;
shareholder wealth will increase.
suppose you're a share holder of a firm in financial distress. What would you do? 1) Continue operating as usual, so it's likely you'll eventually lose the remaining value of your shares and control of the firm will be handed to creditors. 2) Conserve funds, rather than investing in new projects. 3) Cash out by distributing as much capital as possible to shareholders before defaulting. 4) Roll the dice and invest in a risky project that has huge upside in the best scenario, but is expected to perform poorly most of the time (i.e. negative NPV).
should do 2
One advantage of the payback method of project analysis is the method's:
simplicity
One advantage of the payback method of project analysis is the method's
simplicity.
How many best-practices does the text discuss?
six
Because the poor typically don't own traditional asset-based capital, what type of collateral is typically used by MFIs?
social capital
The theory of purchasing power parity cannot fully explain exchange rate movements because
some goods are not traded between countries
The discounted payback rule may cause:
some positive net present value projects to be rejected.
The distribution of shares in a subsidiary to existing parent company stockholders is called a(n):
spin-off.
Futures differ from forwards because they are
standardized contracts
If a bidding firm wishes to bypass the board of directors of the target firm and deal directly with the shareholders of the target firm, the bidding firm should attempt to acquire the target firm via a:
stock acquisition
The lower bound on a call's value is either the:
stock price minus the exercise price or zero, whichever is greater.
Which of the following is not a financial derivative?
stocks
If a firm makes an acquisition to exploit perceived opportunities in a new industry, it is expecting ____________________ as a result of the purchase
strategic benefits
An industry is likely to have a low beta if the:
stream of revenues is stable and less volatile than the market AND market for its goods is unaffected by the market cycle.
The fixed price in an option contract at which the owner can buy or sell the underlying asset is called the option's:
strike price
The fixed price in an option contract at which the owner can buy or sell the underlying asset is called the option's:
strike price.
The risk premium is computed by ______ the average rate of return for an investment.
subtracting the average return on U.S. Treasury bills from
The CFFAs for a company is computed as the
sum of the incremental operating cash flow, net capital spending, and net working capital expenses incurred by the project.
You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost.
sunk
A cost that already occurred and cannot be changed by the decision to accept or reject the project. *not incremental cash flows, should be ignored*
sunk cost
A cost that has already been paid, or the liability to pay has already been incurred, is a(n):
sunk cost
replacement cost approach: issues
tangibles and finance costs are easy. the hard part is valuing the intangibles
tax shield =
tax rate * interest expense
A company's cost of debt will decrease when
tax rates increase.
Generally speaking, if an acquiring firm offers the target firm cash for its stock, it will be a _________ acquisition; if the acquirer offers its own shares in return for the target firm's stock, it will be a _____________ acquisition
taxable; tax-free
The relationship between nominal interest rates on default-free, pure discount securities and the time to maturity is called the:
term structure of interest rates.
The equivalent annual cost is a method used to primarily compare mutually exclusive machines:
that will be replaced and have unequal lives.
No matter how many forms of investment analysis you do: A. the actual results from a project may vary significantly from the expected results. B. the internal rate of return will always produce the most reliable results. C. a project will never be accepted unless the payback period is met. D. the initial costs will generally vary considerably from the estimated costs. E. only the first three years of a project ever affect its final outcome
the actual results from a project may vary significantly from the expected results.
No matter how many forms of investment analysis you perform:
the actual results from a project may vary significantly from the expected results.
No matter how many forms of investment analysis you perform: the actual results from a project may vary significantly from the expected results. the internal rate of return will always produce the most reliable results. a project will never be accepted unless the payback period is met. only the first three years of a project ever affect its final outcome. the initial costs will generally vary considerably from the estimated costs.
the actual results from a project may vary significantly from the expected results.
Payback Period
the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
The purchase accounting method requires that:
the assets of the target firm be recorded at their fair market value on the balance sheet of the acquiring firm
The weights used in the computation of a project's flotation costs should be based on the
the company's target debt-to-equity ratio.
A golden parachute is:
the compensation paid to senior managers when the firm they work for is acquired by another firm.
Using the DCF approach, if we assume the company has a constant growth rate after the forecast period, which model should we use to estimate the terminal value?
the constant growth Gordon Model
In comparing two projects using an NPV profile, at the point where the net present value of the projects involved are equal, _______________
the discount rate that equates them is called the crossover rate
tender offer
the firm offers to buy shares at a pre-specified price during a short time period (20 days). The price is usually at a premium (e.g. 10%) to the market price
cash offer
the firm sells new shares to investors at large.
DCF
the heart of finance. V(firm) = sum (CFt / (1+k)^t) process: estimate numerator (CF) and denominator (K) issue: apples to apples? CF and k must agree
The internal rate of return for a project will increase if:
the initial cost of the project can be reduced.
The bottom-up approach to computing the operating cash flow applies only when:
the interest expense is equal to zero.
The condition which states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency is called
the interest parity condition
You are trying to determine whether to accept project A or project B. These projects are mutually exclusive. As part of your analysis, you should compute the incremental IRR by determining:
the internal rate of return for the differences in the cash flows of the two projects.
Seven factors of the wealthy from the millionaire next door
the live well below their means; they allocate their time, energy, and money efficiently, in ways conducive to building wealth; they believe that financial independence is more important than displaying high social status; their parents did not provide economic outpatient care; their adult children are economically self-sufficient; they are proficient in targeting market opportunities; they chose the right occupation
The theory of purchasing power parity is a theory of how exchange rates are determined in
the long run
if two stocks are perfectly negatively correlated,
the portfolio is perfectly diversified
Profitability Index
the present value of an investment's future cash flows divided by its initial cost
Accepting positive NPV projects benefits the stockholders because:
the present value of the expected cash flows are greater than the cost.
The maximum value of a call option is equal to:
the price of the underlying stock.
All else constant, the net present value of a typical investment project increases when:
the rate of return decreases
All else constant, the net present value of a project increases when: a. the discount rate increases. b. each cash inflow is delayed by one year. c. the initial cost of a project increases. d. the rate of return decreases. e. all cash inflows occur during the last year of a project's life instead of periodically throughout the life of the project
the rate of return decreases *(NPV increases as rate of return decreases)
All else constant, the net present value of a typical investment project increases when
the rate of return decreases.
All else constant, the net present value of a typical investment project increases when:
the rate of return decreases.
The increase in firm value from leverage comes from
the reduction in taxes.
required return
the return that an investor requires on an asset given its risk
The intercept point of the security market line is the rate of return which corresponds to which of the following?
the risk-free rate of return.
A stock with a beta of zero would be expected to have a rate of return equal to:
the risk-free rate.
Given an exercise price E, time to maturity T and European put-call parity, the present value of the strike price E plus the call option is equal to
the share of stock plus the put option
Given an exercise price, time to maturity, and European put-call parity, the present value of the strike price plus the call option is equal to:
the share of stock plus the put option.
Which of the following does NOT correctly complete this sentence: If cash is used to finance an acquisition, then _____________________.
the shareholders of the acquiring firm will be better off than if stock were used regardless of whether or not the acquisition is a success in terms of value
What does the cost of capital depend upon?
the sources of financing for capital and the associated costs
The maximum loss the writer of a stock put option can suffer is equal to
the striking price minus the put premium
Synergy exists when:
the value of a merged firm AB is greater than the combined values of the pre-merger firms, A and B.
The value of a target firm to the acquiring firm is equal to:
the value of the target firm as a separate entity plus the incremental value derived from the acquisition.
All else equal, the contribution margin must increase as:
the variable cost per unit declines.
Toni's Tools is comparing machines to determine which one to purchase. The machines sell for differing prices, have differing operating costs, differing machine lives, and will be replaced when worn out. These machines should be compared using:
their equivalent annual costs.
CAPM
theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium
MM Proposition I with tax supports the theory that:
there is a positive linear relationship between the debt-to-equity ratio and firm value.
The problem of multiple IRRs can occur when:
there is more than one sign change in the cash flows.
The primary reason that company projects with positive net present values are considered acceptable is that:
they create value for the owners of the firm.
The elements that cause problems with the use of the IRR in projects that are mutually exclusive are:
timing and scale problems.
Rosina purchased a 15-year bond at par value when it was initially issued. The bond has a coupon rate of 7 percent and matures 13 years from now. If the current market rate for this type and quality of bond is 7.5 percent, then Rosina should expect:
to realize a capital loss if she sold the bond at today's market price.
Standard deviation measures what type of risk?
total
A capital intensity ratio of 1.03 means a firm has $1.03 in:
total assets for every $1 in sales.
The capital gains yield plus the dividend yield on a security is called the:
total return
Benefits of financial markets & intermediaries
transport cash across time, provide liquidity, allow for payments, reduce risks, provide information, estimate cost of capital
Market risk
unexpected changes in interest rates, unexpected changes in cash flows due to tax rate changes, foreign competition, and the business cycle
"Strategies for Car and House Buying,"
use a fifteen-year mortgage, not a thirty-year mortgage. The three reasons that they give as support are the following: 1) You will buy within your means. 2) You will pay more towards principal faster; that is, you will pay the debt off faster, and save tens of thousands of dollars. This will help you to invest in your future since you will have, on average, $100,000 dollars left over that you would have paid with the thirty-year mortgage. 3) You will almost always get a lower interest rate (i/y on the calculator. With your TVM skills you can see this will further save you money compared to a thirty-year loan).
The following are methods to estimate the market risk premium:
use historical data to estimate future risk premium AND use the dividend discount model to estimate risk premium.
The following are methods to estimate the market risk premium:
use historical data to estimate future risk premium and use the dividend discount model to estimate risk premium.
The discounted payback method:
uses an arbitrary cutoff period
The discounted payback method
uses an arbitrary cutoff period.
According to the text, in a lifestyle business, entrepreneurs often desire to maximize not their wealth function, but their __________ function?
utility
A general rule for managers to follow is to establish a firm's capital structure such that the firm's:
value is maximized.
Suppose General Motors buys up auto dealerships in all the major cities in Canada. This is an example of a _________________ acquisition
vertical
When a building supply store acquires a lumber mill they are doing a ______ acquisition
vertical
Kojack Film needs silver to make photographic film. To ensure that they will have an ample supply of silver at a reasonable price, the company purchases a silver mine. This is an example of a(n) ____________.
vertical acquisition
financing
weight average cost of funds
WACC
weighted average cost of capital the expected rate of return on a portfolio of all the firm's securities company cost of capital - weighted average of debt and equity returns
The weighted average of the firm's costs of equity, preferred stock, and after tax debt is the:
weighted average cost of capital (WACC)
