FIN 301 Test 3

3. The cost of capital may also be called a hurdle rate or minimum required rate of return on long-term capital investments

True

9. Target weights used in calculating a firm's cost of capital are weights the firm has estimated will provide the minimum cost of capital for the firm.

True

When a bond's yield to maturity is less than the bond's coupon rate, the bond

is selling at a premium

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if

risk-free rate decreases

. Generally speaking, bonds issued in the U.S. pay interest on a(n) _____ basis.

semi-annual

17. The cost of long-term bond financing is also defined as the bond's yield to maturity

: False, the yield to maturity is the return required by investors, the cost of capital for the bonds is determined by finding the after-tax equivalent of the pre-tax yield to maturity adjusted for flotation costs.

If the financial markets are efficient then:

stock prices should only respond to unexpected news and events.

Delfino's expects to pay an annual dividend of $1.50 per share next year. What is the anticipated dividend for year 5 if the firm increases its dividend by 2 percent annually?

$1.50 (1.02)4

The Printing Company stock is selling for $32.60 a share based on a 14 percent rate of return. What is the amount of the next annual dividend if the dividends are increasing by 2.5 percent annually?

$32.60 (0.14 - 0.025) = $3.75

1. Twenty years ago Alley Cat Enterprises, Inc. issued $1,000 bonds which will mature in 10 years. The bonds pay 9% interest semi-annually and are currently priced to provide a yield of 14%. What is the price must a new investor pay to purchase the bonds?

$735.15 N= 20; I/YR= 7; PMT=45; FV= 1000

Donuts Delite just paid an annual dividend of $1.10 a share. The firm expects to increase this dividend by 8 percent per year the following 3 years and then decrease the dividend growth to 2 percent annually thereafter. Which one of the following is the correct computation of the dividend for year 7?

($1.10) (1.08)3 (1.02)4

Which statement is correct, all else held constant?

. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options.

Dividends are which one of the following?

. Paid out of aftertax profits

The weighted average cost of capital is defined as the weighted average of a firm's:

. cost of equity, cost of preferred, and its aftertax cost of debt.

6. Allie Cats, Inc. a pet store chain has issued convertible bonds. The bonds have a face value of $1,000 and are convertible at $23.00 per share. The bond is now priced at $945 and has a coupon rate of 6%. What is the conversion ratio for the bond?

1000/23 = $43.48

3. Your broker has contacted you with an opportunity to purchase some $1,000 bonds issued by the HelpYouOut, Inc. manufacturing firm. The firm has structured the bonds as consuls with a 7% coupon rate. If the AA rated bonds have a required return of 9%:

70/.09 = $777.77

Which one of the following bonds is the least sensitive to changes in market interest rates?

8 percent annual coupon, 4 year

Dan is a chemist for ABC, a major drug manufacturer. Dan cannot earn excess profits on ABC stock based on the knowledge he has related to his experiments if the financial markets are:

strong form efficient

. Investors receive a total return of 13.7 percent on the common stock of Dexter International. The stock is selling for $41.68 a share. What is the dividend growth rate if the company plans to pay an annual dividend of $2.10 a share next year?

Capital gains yield = 0.137 - ($2.10/$41.68) = 8.66 percent

Which one of the following types of securities has no priority in a bankruptcy proceeding?

Common Stock

Western Electric has 21,000 shares of common stock outstanding at a price per share of $61 and a rate of return of 15.6 percent. The firm has 11,000 shares of $8 preferred stock outstanding at a price of $48 a share. The outstanding debt has a total face value of $275,000 and currently sells for 104 percent of face. The yield to maturity on the debt is 8.81 percent. What is the firm's weighted average cost of capital if the tax rate is 35 percent? (Hint: use market value weights)

Common stock: 21,000 × $61 = $1,281,000 Preferred stock: 11,000 × $48 = $528,000 Debt: 1.04 × $275,000 = $286,000 Value = $1,281,000 + 528,000 + 286,000 = $2,095,000 WACC = ($1,281,000/$2,095,000)(.156) + ($528,000/$2,095,000)($8/$48) + ($286,000/$2,095,000)(.0881)(1 -.35) = .1452, or 14.52 percent

The annual interest divided by the face value of a bond is referred to as the:

Coupon Rate

A 6 percent bond has a yield to maturity of 6.5 percent. The bond matures in 7 years, has a face value of $1,000, and pays semiannual interest payments. What is the amount of each coupon payment?

Coupon payment = ($1,000 0.06)/2 = $30

The current yield on a bond is equal to the annual interest divided by which one of the following?

Current Market Price

15. Because of your interest in Humana, Inc. bonds, your broker informs you that the bonds are currently selling at a premium. This means the bonds are now a good investment

False, selling at a premium simply means the bond's price is higher than its maturity value.

A preferred stock sells for $48.20 a share and has a market return of 15.65 percent. What is the dividend amount?

Dividend = 0.1565 $48.20 = $7.54

What is the name given to the model that computes the present value of a stock by dividing next year's annual dividend amount by the difference between the discount rate and the rate of change in the annual dividend amount?

Dividend growth model

Donovan Brothers, Inc. would like to increase its rate of growth. Decreasing which one of the following will help the firm achieve its goal?

Dividend payout ratio

. What is the principal amount of a bond that is repaid at the end of the loan term called?

Face Value

14. Anna's Dancewear, Inc. has an outstanding consul bond with a 5% coupon rate and face value of $1,000. If the bond is priced to provide an 8% required rate of return, the future value of the bond can be determined if we are provided with additional information

False

17. Debentures are the contracts that accompany bonds and which specify all the characteristics of the bonds.

False

3. The terms market value and terminal value all have the same meaning in the bond markets.

False

5. When a convertible bond is converted into the stock of the issuer, the bond is not retired but becomes available for issue once again in form of issue called a seasoned issue

False Answer: When a bond is converted into stock, it is not made available for reissue

19. An annual bond issued with a par value of $10,000 and a coupon rate of 12% will be priced above the $10,000 par value if it matures in 10 years and the required return for the bond is 14%.

False, it will be priced at $8,957 and will be priced below the par value because the required return is greater than the coupon rate.

12. Book value weights used in calculating a firm's cost of capital are preferred to marginal value weights because they represent current costs.

False, marginal weights represent current costs.

16. Because of your interest in Humana, Inc. bonds, your broker informs you that the bonds are currently selling at a discount. This means the bonds are now a good investment

False, selling at a discount simply means the bond's price is lower than its maturity value.

6. Convertible bonds are bonds which may be converted into the stock of the issuer at the discretion of the issuer during a specified period of time.

False, the bonds may be converted into the stock of the issuer at the discretion of the investor, not the issuer.

4. A bond's call provision provides a protection to investor's because it allows the issuer to call back the bonds providing the investor with an early return of investment capital.

False, the call provision is a benefit to the issuer as it allows the bond to be recalled at a time that is beneficial to the issuer not the investor

8. Retained earnings has a cost of capital which is higher than that of the cost of capital for new issues of common stock because it includes a required return for the lack of dividend payments.

False, the cost of retained earnings capital is identical to that for new issues of common stock less flotation costs

5. Dividends may be paid to stockholders only when the firm has net earnings and cannot be paid if the firm has a net loss.

False, the firm may pay dividends even if they have a net loss for the period

4. A tender offer is an open offer to all shareholders to buy their stock at a discounted price below the current market price.

False, the offer to buy will be at a premium price, above the current market price.

23. A $1,000 semiannual bond with an 8% coupon provides payments of $80 to the owner of the bond every six months.

False, the payments would be $80 per year ($1,000 X .08) paid in two semiannual installments of $40 each.

The dividend growth model can be used to value the stock of firms which pay which type of dividends? I. constant annual dividend II. annual dividend with a constant increasing rate of growth III. annual dividend with a constant decreasing rate of growth IV. zero dividend

I, II, and III only

Which one of the following will decrease the aftertax cost of debt for a firm?

Increase in Tax Rates

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, an aftertax cost of debt of 5.2 percent, and a tax rate of 35 percent. Given this, which one of the following will increase the firm's weighted average cost of capital?

Increasing the firm's beta

4. When the cost of capital is adjusted to a higher minimum required rate of return to account for possible error in forecasting related to capital budgeting projects and the determination of the cost of capital, the new rate and all other adjusted-for-risk rates are called hurdle rates.

True

On which one of the following dates is the principal amount of a bond repaid?

Maturity Date

The $1,000 face value bonds of Jasper International have a 7.5 percent coupon and pay interest annually. Currently, the bonds are quoted at 98.27 and mature in 3.5 years. What is the yield to maturity?

N= 3.5; PV= -982.7; PMT=75; FV=1000

Best Lodging has $1,000 face value bonds outstanding. These bonds pay interest semiannually, mature in 5 years, and have a 6 percent coupon. The current price is quoted at 101. What is the yield to maturity?

N=10; PV= -1010; PMT=30; FV=1000 2.885* 2= 5.77

2. Twenty years ago Alley Cat Enterprises, Inc. issued $1,000 bonds which will mature in 5 years. The bonds pay 9% interest semi-annually and currently is priced at 90. What yield to maturity is being required in the market?

N=10; PV= -900; PMT= 45; FV=1000 YTM = Periodic rate X 2 = 5.8490% X 2 = 11.6979

AB Builders, Inc. has 12-year bonds outstanding with a face value of $1,000 and a market price of $974. The bonds pay interest annually and have a yield to maturity of 4.03 percent. What is the coupon rate?

N=12; I/YR=4.03; PV= -974; FV=1000

A $1,000 face value bond currently has a yield to maturity of 6.69 percent. The bond matures in 3 years and pays interest annually. The coupon rate is 7 percent. What is the current price of this bond?

N=3; I/YR= 6.69; PMT=7-; FV= 1000

One year ago, you purchased a 7.5 percent annual coupon bond for a clean price of $980. The bond now has 7 years remaining until maturity. Today, the yield to maturity on this bond is 6.87 percent. How does today's clean price of this bond compare to your purchase price?

N=7; I/YR=6.87; PMT=75; FV=1000 Percent price change = ($1,034.11 - $980)/$980 = 5.52 percent

The Pancake House pays a constant annual dividend of $1.25 per share. How much are you willing to pay for one share if you require a 15 percent rate of return?

P = $1.25/0.15 = $8.33

The Cart Wheel plans to pay an annual dividend of $1.20 per share next year, $1.00 per share a year for the following two years, and then cease paying dividends altogether. How much is one share of this stock worth to you today if you require a 17 percent rate of return?

P0 = ($1.20/1.171) + ($1/1.172) + ($1/1.173) = $2.38

Healthy Foods just paid its annual dividend of $1.45 a share. The firm recently announced that all future dividends will be increased by 2.8 percent annually. What is one share of this stock worth to you if you require a 14 percent rate of return?

P0 = ($1.45 1.028)/(0.14 - 0.028) = $13.31

5. Flotation costs are generally higher for common stock than for debt financing.

True

7. A bond's yield to maturity may also be called its' internal rate of return.

True

7. Dividends may be paid to stockholders when the firm has net losses.

True

A firm expects to increase its annual dividend by 20 percent per year for the next two years and by 15 percent per year for the following two years. After that, the company plans to pay a constant annual dividend of $3 a share. The last dividend paid was $1.00 a share. What is the current value of this stock if the required rate of return is 12 percent?

P0 = [(1 1.2)/1.12] + [(1 1.22)/1.122] + [(1 1.22 1.15)/1.123] + [(1 1.22 1.152)/1.124] + [($3/0.12)/1.124 = $20.50

. New Gadgets is growing at a very fast pace. As a result, the company expects to pay annual dividends of $0.55, 0.80, and $1.10 per share over the next three years, respectively. After that, the dividend is projected to increase by 5 percent annually. The last annual dividend the firm paid was $0.40 a share. What is the current value of this stock if the required return is 16 percent?

P3 = ($1.10 1.05)/(0.16 - 0.05) = $10.50 P0 = [$0.55/1.16] + [$0.80/1.162] + [($1.10 + $10.50)/1.163] = $8.50

Business Services, Inc. is expected to pay its first annual dividend of $0.80 per share three years from now. Starting in year six, the company is expected to start increasing the dividend by 2 percent per year. What is the value of this stock today at a required return of 12 percent?

P5 = ($0.80 1.02)/(0.12 - 0.02) = $8.16 P0 = [$0.80/1.123] + [$0.80/1.124] + [($0.80 + $8.16)/1.125] = $6.16

River Rock, Inc. just paid an annual dividend of $2.80. The company has increased its dividend by 2.5 percent a year for the past ten years and expects to continue doing so. What will a share of this stock be worth six years from now if the required return is 16 percent?

P6 = ($2.80 1.0257)/(0.16 - 0.025) = $24.65

8. Zero coupon or pure discount bonds

Pay no interest

1. Preferred stock holders are called preferred owners because they hold more rights and privileges than the common stockholders. This includes, for example, more voting rights than those held by common stockholders.

Preferred stockholders are provided preference in cash payouts for dividends and in liquidation but do not generally have other rights that provide more benefits than those accorded to the common stockholders.

Piedmont Hotels is an all-equity firm with 48,000 shares of stock outstanding. The stock has a beta of 1.19 and a standard deviation of 14.8 percent. The market risk premium is 7.8 percent and the risk-free rate of return is 4.1 percent. The company is considering a project that it considers riskier than its current operations so has assigned an adjustment of 1.35 percent to the project's discount rate. What should the firm set as the required rate of return for the project?

Project cost of capital = .041 + 1.19(.078) + .0135 = .1473, or 14.73 percent

Shoreline Foods pays a constant annual dividend of $1.60 a share and currently sells for $28.50 a share. What is the rate of return?

R = $1.60/$28.50 = 5.61 percent

The Donut Hut has sales of $68,000, current assets of $11,300, net income of $5,100, net fixed assets of $54,900, total debt of $23,800, and dividends of $800. What is the growth rate?

ROE = {[$5,100/($11,300 + $54,900 - $23,800)] = 0.120283; Retention rate = [($5,100 - $800)/$5,100] = 0.843137; Growth rate = 0.120283 * 0.843137 = 10.14%

Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share, and the flotation cost is 10%?

Re= ($1.48 × 1.022) /[$ 29.60 * (1 - 10%)] + .022 = .0788, or 7.88 percent

Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share?

Re= [($1.48 × 1.022) /$29.60] + .022 = .0731, or 7.31 percent

The next dividend payment by Swenson, Inc., will be $1.80 per share. The dividends are anticipated to maintain a 5.5 percent growth rate, forever. If the stock currently sells for $48.50 per share, what is the required return?

Required return = ($1.80/$48.50) + 0.055 = 9.21 percent

. Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision?

Risk level of the project

What is the market called that allows shareholders to resell their shares to other investors?

Secondary

7. The minimum rate of return on all long-term capital budgeting projects should be the firm's risk-adjusted cost of capital

True

2. Because of the tax effect, the cost of debt capital is generally lower than the cost of equity capital

TRue

8. Low coupon bonds are more volatile or sensitive to interest rate changes than high coupon bonds

True

8. Treasury stock is stock which has been issued and sold by a firm and has subsequently been repurchased by the firm.

True

1. Bonds are long-term liabilities of the issuer of the bonds

True

10. A proxy provides the holder or owner of the proxy the right to vote on behalf of a stockholder.

True

10. Longer term to maturity bonds are more volatile or sensitive to interest rate changes than shorter term to maturity bonds.

True

11. Target weights used in calculating a firm's cost of capital are weights the firm has estimated will maximize the value of the firm.

True

13. Bond prices can be expected to rise if interest rates fall.

True

13. Marginal value weights used in calculating a firm's cost of capital are preferred to book value weights because they represent current costs.

True

15. A firm's financial structure is comprised of the total of short-term and long-term financing

True

18. Flotation costs incurred to raise new external capital increase the firm's cost of capital.

True

2. The terms face value, par value, maturity value, and terminal value all have the same meaning in the bond markets

True

20. A bond with a bond rating of B is less likely to default on payments than a bond with a bond rating of C

True

21. A bond with a BBB bond rating is considered as an investment grade bond

True

2. The preemptive right accorded common stock investors provides them with protection from dilution by requiring the issuer of the stock to provide them with the right to purchase enough stock from an additional issue of the same stock to maintain their percentage of ownership. 3. The preemptive right provides the owner of stock with protection from dilution of ownership by preventing a firm from reducing the shareholder's level of control or ownership by issuing additional shares to other investors without first providing a right to purchase additional shares to maintain their ownership percentage to current owners.

TrueTrue

USA Manufacturing issued 30-year, 7.5 percent semiannual bonds 6 years ago. The bonds currently sell at 101 percent of face value. What is the firm's aftertax cost of debt if the tax rate is 35 percent?

Use calculator; N = 24 * 2 = 48; PMT = 7.5%*1000/2 = 37.5; FV = 1000; PV = -1010 Get I/Y = 3.7051, so RD = 3.7051 * 2 = 7.4102 percent Aftertax cost of debt = 7.4102 percent ×(1 -.35) = 4.82 percent

Country Cook's cost of equity is 16.2 percent and its aftertax cost of debt is 5.8 percent. What is the firm's weighted average cost of capital if its debt-equity ratio is .42 and the tax rate is 34 percent?

WACC = (1/1.42)(.162) + [(.42 /1.42)(.058)] = .1312, or 13.12 percent

A firm wants to create a WACC of 11.2 percent. The firm's cost of equity is 16.8 percent and its pretax cost of debt is 8.7 percent. The tax rate is 35 percent. What does the debt-equity ratio need to be for the firm to achieve its target WACC?

WACC = .112 = (1 -x)(.168) + (x)(.087)(1 -.35)] x = .5025 Debt-equity ratio = .5025 /(1 -.5025) = 1.01

Which one of the following represents the minimum rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

Weighted average cost of capital

Which one of the following terms applies to a bond that initially sells at a deep discount and pays no interest payments?

Zerro Coupon

The results of the dividend growth model:

are sensitive to the rate of dividend growth.

All of the following are features of bonds except

c. May be paid dividends on a semi-annual or annual basis

Dividends are best defined as:

cash or stock payments to shareholders

An increase in a levered firm's tax rate will

decrease the firm's cost of capital

Delphin's Marina is expected to pay an annual dividend of $0.58 next year. The stock is selling for $8.53 a share and has a total return of 12 percent. What is the dividend growth rate?

g = 0.12 - ($0.58/$8.53) = 5.20 percent

Joshua's Antiques has a total asset turnover rate of 1.2, an equity multiplier of 1.4, a profit margin of 5 percent, a retention ratio of 0.8, and total assets of $120,000. What is the growth rate?

growth rate = [(0.05 1.2 1.4) 0.8] = 6.72 percent

The yield to maturity on a discount bond is:

is greater than both the current yield and the coupon rate.

11. A market is defined as being weak form efficient if stock prices currently reflect all market information to include stock prices and volume.

true

12. A market is defined as being semi-strong form efficient if stock prices currently reflect all market information to include stock prices and volume and all other public information.

true

A market is defined as being strong form efficient if stock prices currently reflect all information to include all market, all public, and all private information.

true

a sinking fund is a fund created for deposits by the issuer to ensure funds are available to repurchase the bonds at maturity

true

If a firm has a 100 percent dividend payout ratio, then the growth rate of the firm is:

zero percent