Principles of Finance - Exam 2

As a general rule, which of the following are true of debt and equity?

-Equity represents an ownership interest -The maximum reward for owning debt is fixed

The three attributes of NPV are that it:

1. uses all the cash flows of a project 2. uses cash flows 3. discounts the cash flows properly

The _____ step is to determine whether cash flows are relevant.

first

In capital budgeting, the net ______ determines the value of a project to the company.

present value

Bond ratings are based on the probability of default risk, which is the risk that ___.

the bond's issuer may not be able make all the required payments

When the stock being valued does not pay dividends,

the dividend growth model can still be used.

If you own corporate bonds, you will be concerned about interest rate risk as it affects ____.

the market price of the bonds

True or false: Cash flows should always be considered on an aftertax basis.

true

True or false: IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects.

true

Three special case patterns of dividend growth include _____.

zero growth nonconstant growth constant growth

Which six factors determine the yield on a bond?

-real rate of return -interest rate risk -expected future inflation -liquidity -default risk -taxability

A benchmark PE ratio can be determined using:

-the PEs of similar companies -a company's own historical PEs

Arrange the steps involved in the discounted payback period in order starting with the first step.

1. Discount the cash flows using the discount rate. 2. Add the discounted cash flows. 3. Accept if the discounted payback period is less than some pre-specified number of years.

The internal rate of return is defined as the:

Discount rate which causes the net present value of a project to equal zero.

Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

Discounted payback period

Which of the following are expected cash flows to investors in stocks?

Dividends Capital gains

Which one of the following is true about dividend growth patterns?

Dividends may grow at a constant rate.

Which of the following is not a difference between debt and equity?

Equity is publicly traded while debt is not

For investors in the stock market, dividends from stocks are fixed and guaranteed, while capital gains are variable and not guaranteed.

False

True or false: A bond's value is not affected by changes in the market rate of interest.

False

True or false: The real rate of return will generally be higher than the nominal rate of return.

False

Why does a bond's value fluctuate over time?

The coupon rate and par value are fixed, while market interest rates change.

True or false: Equity represents an ownership interest.

True

True or false: Interest earned on Treasury notes and bonds is taxable

True

True or false: The crossover rate is the rate at which the NPVs of two projects are equal.

True

Which shape does the term structure of interest rates usually have?

Upward sloping

The NYSE differs from the Nasdaq primarily because the NYSE has _____.

a physical location specialists an auction market

The internal rate of return is a function of ____.

a project's cash flows

The option that is forgone so that an asset can be utilized by a specific project is referred to as which one of the following?

opportunity cost

The amount of time needed for the cash flows from an investment to pay for its initial cost is the _____ period.

payback

For a project with conventional cash flows, the NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.

positive, negative

A stock with dividend priority over common stock is called a _____ stock

preferred

Initial public offerings of stock occur in the ____ market.

primary

In a _____ board, only a fraction of the directorships are up for election at any one time.

staggered

Mota Motors has eight directors on its board, two of whom go up for election each year. This is an example of a:

staggered board

The _____-alone principle is the assumption that evaluation of a project may be based on the project's incremental cash flows.

stand

According to the _________ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."

stand-alone

The fact that a proposed project is analyzed based on the project's incremental cash flows is the assumption behind which one of the following principles?

stand-alone principle

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

suggests accepting

Which one of the following types of costs was incurred in the past and cannot be recouped?

sunk cost

Which of the following is an example of a sunk cost? -Test marketing expenses -Cost of new equipment -Bonus to top management -Salvage value of equipment

test marketing expenses

Pro forma financial statements can best be described as financial statements:

that state projected values for future time periods

The dividend yield is determined by dividing the expected dividend (D1) by _____.

the current price (P0)

If a project has a net present value equal to zero, then:

the project earns a return exactly equal to the discount rate.

The degree of interest rate risk depends on ____.

the sensitivity of the bond's price to interest rate changes

True or false: When developing cash flows for capital budgeting, it is easy to overlook important items.

true

True or false: With more than one class of common stock, it is easier for insiders such as founding families to maintain control of the company.

true

Net _____ value is a measure of how much value is created or added today by undertaking an investment.

present

If a zero-dividend stock is purchased for $80 and sold one year later for $84, the 1-year return can be found using the formula ______.

($84/$80) − 1

Which of these are required to calculate the current value of a bond?

-Coupon rate -Par value -Time remaining to maturity -Applicable market rate

Which of the following is true about interest rate risk?

-All else equal, the longer the time to maturity, the greater the interest rate risk. -All else equal, the lower the coupon rate, the greater the interest rate risk.

What are three important features of Treasury notes and bonds?

-Default-free -Highly liquid -Taxable

Which of the following are reasons why it is more difficult to value common stock than it is to value bonds?

-The life of a common stock is essentially forever. -The rate of return required by the market is not easily observed. -Common stock cash flows are not known in advance

What are the advantages of the payback period method for management?

-The payback period method is ideal for short projects. -The payback period method is easy to use. -It allows lower level managers to make small decisions effectively.

Which of the following are usually included in a bond's indenture?

-The repayment arrangements -The total amount of bonds issued

Which of the following are mutually exclusive investments?

-Two different choices for the assembly lines that will make the same product. -A restaurant or a gas station on the same piece of land.

What are some reasons why the bond market is so big?

-Various state and local governments also participate in the bond market. -Federal government borrowing activity in the bond market is enormous. -Many corporations have multiple bond issues outstanding.

A stock currently sells for $41. The dividend yield is 3.8 percent and the dividend growth rate is 5.1 percent. What is the amount of the dividend to be paid in one year?

1.56

The bonus depreciation in 2019 was _____ percent.

100

The rules for depreciating assets for tax purposes are based upon provisions in the ___.

1986 Tax Reform Act

A zero-growth stock pays a dividend of $2 per share and has a discount rate of 10%. What will the stock's price be?

20.00

According to the 2017 Tax Cuts and Jobs Act, bonus depreciation is phased out after _____.

2026

What information do we need to determine the value of stock using the zero-growth model?

Annual dividend amount Discount rate

Match each one of these bonds with their characteristic.

CAT bond: protects insurance companies from natural disasters Convertible bond: can be exchanged for shares of stock Put bond: owner can force issuer to repay prior to maturity at a stated price Structured note: based on financial securities, commodities, or currencies

_____ budgeting is the decision-making process for accepting and rejecting projects.

Capital

As an investor in the bond market, why should you be concerned about changes in interest rates?

Changes in interest rates cause changes in bond prices.

What is the coupon rate on a bond that has a par value of $1,000, a market value of $1,100, and a coupon interest payment of $100 per year?

Coupon Rate=$100/$1000=10%

What is a bond's current yield?

Current yield = annual coupon payment / current price

Which one of the following rights is never directly granted to all shareholders of a publicly held corporation?

Determining the amount of the dividend to be paid per share

A decrease in which of the following will increase the current value of a stock according to the dividend growth model?

Discount Rate

What is a discount bond?

Discount bonds are bonds that sell for less than the face value

Once cash flows have been estimated, which of the following investment criteria can be applied to them?

IRR NPV payback period

_____ cash flows come about as a direct consequence of taking a project under consideration.

Incremental

Which of the following are features of common stock?

It generally has voting rights. It has no special preference in bankruptcy. It has no special preference in receiving dividends.

Which of the following variables are required to calculate the value of a bond?

Market yield Coupon rate Remaining life of bond

Which one of the following should not be included in the analysis of a new product?

Money already spent for research and development of the new product.

The two most important stock markets in the United States are the New York Stock Exchange and ______.

Nasdaq

Which of the following occurs in the primary market?

Newly-issued stocks are initially sold

Is a company required to pay preferred dividends?

No; the company may defer dividends on preferred stock; however they can not pay dividends to common shareholders until preferred dividends are paid.

Chemical Mines has 5,000 shareholders and is preparing to elect two new board members. You do not own enough shares to personally control the elections but are determined to oust the current leadership. Likewise, no other single shareholder owns sufficient shares to personally control the outcome of the election. Which one of the following is the most likely outcome of this situation given that some shareholders are happy with the existing management?

Proxy fight for control of the board

Using the payback period rule will bias toward accepting which type of investment?

Short-term investment

In which of the following scenarios would IRR always recommend the wrong decision?

Starting cash flow: 1000 Ending cash flow: -2000

A project should be __________ if its NPV is greater than zero.

accepted

Cash flows should always be considered on a(n) ___________ basis.

after-tax

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

arbitrary

The main reason it is important to distinguish between debt and equity is that the benefits and risks _____.

are different

Opportunity costs are ____.

benefits lost due to taking on a particular project

The price that represents what a dealer is willing to pay for a security is the _____.

bid price

When an asset is sold, there will be a tax savings if the _____ value exceeds the sales price.

book

What are the distributions of either cash or stock to shareholders by a corporation called?

coupon payments

The _____ rate is the rate at which the NPVs of two projects are equal.

crossover

If preferred dividends are _____ and are not paid in a given year, they will be carried forward as an arrearage.

cumulative

The _____ yield is the bond's annual coupon divided by its price.

current

What is net working capital?

current assets - current liabilities

Someone who maintains an inventory of stocks and buys and sells those stocks is known as a ____.

dealer

When interest rates in the market rise, we can expect the price of bonds to ____.

decrease

All else constant, the dividend yield will increase if the stock price ____.

decreases

To calculate the OCF using the bottom-up approach, add _____ to net income.

depreciation

Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration.

direct

The value of a share of common stock in a corporation is _____ to the general rights of shareholders.

directly related

NPV ______ cash flows properly.

discounts

Preferred stock has preference over common stock in the _____.

distribution of corporate assets payment of dividends

Interest expenses incurred on debt financing are ______ when computing cash flows from a project.

ignored

With cost-cutting proposals, when costs decrease, operating cash flows (decrease/increase).

increase

A humped term structure of interest rates indicates that interest rates are expected to _____ as the time to maturity increases.

increase and then decline

The difference between a company's future cash flows if it accepts a project and the company's future cash flows if it does not accept the project is referred to as the project's:

incremental cash flows

The written agreement between the corporation and the lender detailing the terms of the debt issue is the:

indenture

A(n) ______ project does not rely on the acceptance or rejection of another project.

independent

The length of time a firm must wait to recoup the money it has invested in a project is called the:

internal return period

The internal rate of return:

is easy to understand

In general, a corporate bond's coupon rate ____,

is fixed until the bond matures

Net present value:

is the best method for analyzing mutually exclusive projects

The federal government can raise money from financial markets to finance its deficits by ___.

issuing bonds

If a $1,000 par value bond is trading at a discount, it means that the market value of the bond is ______ $1,000.

less than

The reason that interest rate risk is greater for ____ term bonds than for ____ term bonds is that the change in rates has a greater effect on the present value of the ____ than on the present value of the ____.

long; short; face value; coupon payments

A zero coupon bond is a bond that ____.

makes no interest payments

A share of common stock is (less/more) difficult to value in practice than a bond.

more

Most voting in large corporations is done by proxy because _____.

most small shareholders do not attend the annual meeting

By ignoring time value, the payback period rule may incorrectly accept projects with a (positive/negative) NPV.

negative

There is a(n) ______ relationship between market interest rates and bond values.

negative

Which one of the following methods predicts the amount by which the value of a firm will change if a project is accepted?

net present value

The difference between a firm's current assets and its current liabilities is known as the _____.

net working capital

A _____ is the grant of authority by a shareholder to someone else to vote his or her shares.

proxy

The two major forms of long-term debt are _____ issue and privately placed.

public

What are the two major forms of long-term debt?

public issue and private issue

The accelerated cost _____ system is a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.

recovery

Erosion will ______ the sales of existing products.

reduce

Opportunity costs are classified as ______ costs in project analysis.

relevant

The first step in estimating cash flow is to determine the _________ cash flows.

relevant

If the IRR is greater than the _______ ________, we should accept the project.

required return

Internal rate of return (IRR) must be compared to the ________ in order to determine the acceptability of a project.

required return

A calculated NPV of $15,000 means that the project is expected to create a positive value for the firm and _____.

should be accepted if there is no capital rationing constraint

The payback period method allows lower management to make (smaller/larger), everyday financial decisions effectively.

smaller

Which of the following entities declares a dividend?

The board of directors

What is a real rate of return?

-it is a rate of return that has been adjusted for inflation -it is a percentage change in buying power

Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?

-Book value represents the purchase price minus the accumulated depreciation. -There will be a tax savings if the book value exceeds the sales price. -Taxes are based on the difference between the book value and the sales price.

When evaluating cost-cutting proposals, how are operating cash flows affected?

-The decrease in costs increases operating income. -There is an additional depreciation deduction.

What is a corporate bond's yield to maturity (YTM)?

-YTM is the expected return for an investor who buys the bond today and holds it to maturity. -YTM is the prevailing market interest rate for bonds with similar features.

The basic NPV investment rule is:

-accept a project if the NPV is greater than zero -reject a project if its NPV is less than zero -if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference

The IRR rule can lead to bad decisions when _____ or _____.

-cash flows are not conventional -projects are mutually exclusive

A corporate bond's yield to maturity ____.

-changes over time -can be greater than, equal to, or less than the bond's coupon rate

The IRR can lead to the wrong decision when cash (inflows/outflows) occur before cash (inflows/outflows).

1. inflows 2. outflows

Match the following terms relating to stock valuation:

P1 = Price in one year D1 = Dividend in one year R = Discount rate P0 = Price Today

What are the cash flows involved in the purchase of a 5-year zero coupon bond that has a par value of $1,000 if the current price is $800? Assume the market rate of interest is 5 percent.

Pay $800 today and receive $1,000 at the end of 5 years

This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

Payback method

Which of the following institutions issue bonds that are traded in the bond market?

State governments The federal government Public corporations

What does a bond's rating reflect?

The ability of the firm to repay its debt and interest on time

What is the asked price?

The asked price is the price at which a dealer is willing to sell.

OCF is calculated as net income plus depreciation using the _____ approach.

bottom-up

A person who brings buyers and sellers together is called a(n) ______.

broker

Capital ______ is the decision-making process for accepting and rejecting projects.

budgeting

A bond with exotic features is often called a _____ bond.

cat

Matthews Company has two classes of common stock, and each share represents the same proportion of ownership in the company. Class A has 2 votes for each share. Class B has one vote per share. Which class is more valuable?

class A

A _____ is a payment by a corporation to shareholders, made in either cash or stock.

dividend

Common stock as no special preference either in receiving _____ or in bankruptcy.

dividends

An independent project (does/doesn't) rely on the acceptance or rejection of another project.

doesn't

When developing cash flows for capital budgeting, it is _____ to overlook important items.

easy

The cash flows of a new project that come at the expense of a firm's existing projects is called _____.

erosion

A situation in which taking one investment prevents the taking of another is called a mutually _____ investment decision.

exclusive

Longer-term bonds have (smaller/greater) interest rate sensitivity because a (smaller/larger) portion of a bond's value comes from the face amount.

greater, larger

The value of a firm is the function of its _____ rate and its discount rate.

growth

The value of a firm is the function of its ______ rate and its _______ rate.

growth, discount

Sunk costs are costs that ____.

have already occurred and are not affected by accepting or rejecting a project

One common reason for having two classes of common stock with different voting rights is _____.

it is easier for insiders such as founding families to maintain control of the company

The IRR rule can lead to bad decisions when cash flows are _____ or projects are mutually exclusive.

not conventional

Which of the following is not one of the six factors used to determine the yield on a bond?

voting rights

The _____ curse says that the lowest bidder is the one who underbid the most.

winner's

Korporate Classics Corporation (KCC) won a bid to supply widgets to Pacer Corporation but lost money on the deal because they underbid the project. KCC fell victim to the _____.

winner's curse

When analyzing a proposed investment, we (will/won't) include interest paid or any other financing costs.

won't

Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is:

zero