FRL 301 Final Review

The Corner Bakery has a debt-equity ratio of .62. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes? A) 11.14 percent B) 7.10 percent C) 18.40 percent D) 10.68 percent E) 17.56 percent

A) 11.14 percent RE = 0.161 = 0.142 + (0.142 - Rd) × 0.62; Rd = 11.14 percent

Which one of the following formulas correctly describes the relative purchasing power parity relationship? A. E(St) = S0 × [1 + (hFC - hUS)]^t B. E(St) = S0 × [1 - (hFC - hUS)]^t C. E(St) = S0 × [1 + (hUS + hFC)]^t D. E(St) = S0 × [1 - (hUS - hFC)]^t E. E(St) = S0 × [1 + (hUS - hFC)]^t

A. E(St) = S0 × [1 + (hFC - hUS)]^t

Which one of the following measures the amount of systematic risk present in a particular risky asset relative to the systematic risk present in an average risky asset? A. beta B. reward-to-risk ratio C. risk ratio D. standard deviation E. price-earnings ratio

A. beta

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

A. can be effectively eliminated by portfolio diversification.

Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings? A. interest tax shield B. interest credit C. financing shield D. current tax yield E. tax-loss interest

A. interest tax shield

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

A. investors panic causing security prices around the globe to fall precipitously

The standard deviation of a portfolio: A. is a weighted average of the standard deviations of the individual securities held in the portfolio. B. can never be less than the standard deviation of the most risky security in the portfolio. C. must be equal to or greater than the lowest standard deviation of any single security held in the portfolio. D. is an arithmetic average of the standard deviations of the individual securities which comprise the portfolio. E. can be less than the standard deviation of the least risky security in the portfolio.

A. is a weighted average of the standard deviations of the individual securities held in the portfolio.

Which one of the following correctly describes the dividend yield? A. next year's annual dividend divided by today's stock price B. this year's annual dividend divided by today's stock price C. this year's annual dividend divided by next year's expected stock price D. next year's annual dividend divided by this year's annual dividend E. the increase in next year's dividend over this year's dividend divided by this year's dividend

A. next year's annual dividend divided by today's stock price

Last year, T-bills returned 2 percent while your investment in large-company stocks earned an average of 5 percent. Which one of the following terms refers to the difference between these two rates of return? A. risk premium B. geometric return C. arithmetic D. standard deviation E. variance

A. risk premium

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: A. the static theory of capital structure. B. M & M Proposition I. C. M & M Proposition II. D. the capital asset pricing model. E. the open markets theorem.

A. the static theory of capital structure.

The Pancake House has sales of $1,642,000, depreciation of $27,000, and net working capital of $218,000. The firm has a tax rate of 35 percent and a profit margin of 6 percent. The firm has no interest expense. What is the amount of the operating cash flow? A. $98,520 B. $125,520 C. $147,480 D. $268,480 E. $343,520

B. $125,520 OCF = ($1,642,000 × 0.06) + $27,000 = $125,520

A project will produce an operating cash flow of $14,600 a year for 7 years. The initial fixed asset investment in the project will be $48,900. The net aftertax salvage value is estimated at $12,000 and will be received during the last year of the project's life. What is the net present value of the project if the required rate of return is 12 percent? A. $22,627.54 B. $23,159.04 C. $34,627.54 D. $39,070.26 E. $41,040.83

B. $23,159.04

Delta Lighting has 30,000 shares of common stock outstanding at a market price of $15.00 a share. This stock was originally issued at $31 per share. The firm also has a bond issue outstanding with a total face value of $280,000 which is selling for 86 percent of par. The cost of equity is 13 percent while the aftertax cost of debt is 6.9 percent. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of capital? A. 10.07 percent B. 10.87 percent C. 12.36 percent D. 13.29 percent E. 13.47 percent

B. 10.87 percent Comm: 30,000 * 15 = 450,000 Debt: 280,000 * 0.86 = 240,800 Total = 690,800 WACC = (450,000/690,800 * .13) + (240,800/690,800 * .069) = 10.87 percent

Nelson's Landscaping has 1,200 bonds outstanding that are selling for $990 each. The company also has 2,500 shares of preferred stock at a market price of $28 a share. The common stock is priced at $37 a share and there are 28,000 shares outstanding. What is the weight of the common stock as it relates to the firm's weighted average cost of capital? A. 43.08 percent B. 45.16 percent C. 47.11 percent D. 54.00 percent E. 55.45 percent

B. 45.16 percent Debt: 1,200 * $990 = 1,188,000 Pref: 2,500 * $28 = 70,000 Comm: 28,000 * $37 = 1,036,000 Total = 2,294,000 WeightCommon = 1,036,000/2,294,000 = 45.16%

Last year, you purchased a stock at a price of $47.10 a share. Over the course of the year, you received $2.40 per share in dividends while inflation averaged 3.4 percent. Today, you sold your shares for $49.50 a share. What is your approximate real rate of return on this investment? A. 6.30 percent B. 6.79 percent C. 7.18 percent D. 9.69 percent E. 10.19 percent

B. 6.79 percent Nominal return = ($49.50 - $47.10 + $2.40)/$47.10 = 10.19 percent Approximate real return = 0.1019 - 0.034 = 6.79 percent

Which one of the following statements is correct concerning unsystematic risk? A. An investor is rewarded for assuming unsystematic risk. B. Eliminating unsystematic risk is the responsibility of the individual investor. C. Unsystematic risk is rewarded when it exceeds the market level of unsystematic risk. D. Beta measures the level of unsystematic risk inherent in an individual security. E. Standard deviation is a measure of unsystematic risk.

B. Eliminating unsystematic risk is the responsibility of the individual investor.

Which one of the following states that the value of a firm is unrelated to the firm's capital structure? A. Capital Asset Pricing Model B. M & M Proposition I C. M & M Proposition II D. Law of One Price E. Efficient Markets Hypothesis

B. M & M Proposition I

The unlevered cost of capital refers to the cost of capital for a(n): A. private entity. B. all-equity firm. C. governmental entity. D. private individual. E. corporate shareholder.

B. all-equity firm.

The capital structure weights used in computing the weighted average cost of capital: A. are based on the book values of total debt and total equity. B. are based on the market value of the firm's debt and equity securities. C. are computed using the book value of the long-term debt and the book value of equity. D. remain constant over time unless the firm issues new securities. E. are restricted to the firm's debt and common stock.

B. are based on the market value of the firm's debt and equity securities.

Which one of the following is the legal proceeding under which an insolvent firm can be reorganized? A. restructure process B. bankruptcy C. forced merger D. legal takeover E. rights offer

B. bankruptcy

Assume that $1 is equal to ¥98 and also equal to C$1.21. Based on this, you could say that C$1 is equal to: C$1(¥98/C$1.21) = ¥80.99. The exchange rate of C$1 = ¥80.99 is referred to as the: A. open exchange rate. B. cross-rate. C. backward rate. D. forward rate. E. interest rate.

B. cross-rate.

To convince investors to accept greater volatility, you must: A. decrease the risk premium. B. increase the risk premium. C. decrease the real return. D. decrease the risk-free rate. E. increase the risk-free rate.

B. increase the risk premium.

Individuals who continually monitor the financial markets seeking mispriced securities: A. earn excess profits over the long-term. B. make the markets increasingly more efficient. C. are never able to find a security that is temporarily mispriced. D. are overwhelmingly successful in earning abnormal profits. E. are always quite successful using only historical price information as their basis of evaluation.

B. make the markets increasingly more efficient.

A firm should select the capital structure that: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. equates the value of debt with the value of equity.

B. maximizes the value of the firm.

Efficient financial markets fluctuate continuously because: A. the markets are continually reacting to old information as that information is absorbed. B. the markets are continually reacting to new information. C. arbitrage trading is limited. D. current trading systems require human intervention. E. investments produce varying levels of net present values.

B. the markets are continually reacting to new information.

Standard deviation is a measure of which one of the following? A. average rate of return B. volatility C. probability D. risk premium E. real returns

B. volatility

A proposed expansion project is expected to increase sales of JL Ticker's Store by $41,000 and increase cash expenses by $21,000. The project will cost $28,000 and be depreciated using straight-line depreciation to a zero book value over the 4-year life of the project. The store has a marginal tax rate of 30 percent. What is the operating cash flow of the project using the tax shield approach? A. $5,600 B. $7,800 C. $16,100 D. $13,300 E. $14,600

C. $16,100 OCF = ($41,000 - $21,000) (1 - 0.30) + ($28,000/4) (0.30) = $16,100

You recently purchased a stock that is expected to earn 30 percent in a booming economy, 9 percent in a normal economy, and lose 33 percent in a recessionary economy. There is a 5 percent probability of a boom and a 75 percent chance of a normal economy. What is your expected rate of return on this stock? A. -3.40 percent B. -2.25 percent C. 1.65 percent D. 2.60 percent E. 3.50 percent

C. 1.65 percent E(r) = (0.05 × 0.30) + (0.75 × 0.09) + (0.20 × -0.33) = 1.65 percent

Southern Home Cookin' just paid its annual dividend of $0.65 a share. The stock has a market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent and the market risk premium is 6.8 percent. What is the cost of equity? A. 9.98 percent B. 10.04 percent C. 10.12 percent D. 10.37 percent E. 10.45 percent

C. 10.12 percent Re = 0.025 + (1.12 × 0.068) = 10.12 percent

Henessey Markets has a growth rate of 4.8 percent and is equally as risky as the market. The stock is currently selling for $17 a share. The overall stock market has a 10.6 percent rate of return 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. 10.6 percent D. 11.3 percent E. 11.7 percent

C. 10.6 percent Re = (0.106 - 0.087) + (1.00 × 0.087) = 10.6 percent

Kelso's has a debt-equity ratio of 0.6 and a tax rate of 35 percent. The firm does not issue preferred stock. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.8 percent. What is the weighted average cost of capital? A. 10.46 percent B. 10.67 percent C. 10.86 percent D. 11.38 percent E. 11.57 percent

C. 10.86 percent WACC = (1/1.6) (0.145) + (0.6/1.6) (0.048) = 10.86 percent

The City Street Corporation's common stock has a beta of 1.2. The risk-free rate is 3.5 percent and the expected return on the market is 13 percent. What is the firm's cost of equity? A. 11.4 percent B. 12.8 percent C. 14.9 percent D. 17.6 percent E. 19.1 percent

C. 14.9 percent RE = 0.035 + 1.2(0.13 - 0.035) = 14.9 percent

The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage. A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, and IV only

C. I, III, and IV only

Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure? A. Capital Asset Pricing Model B. M & M Proposition I C. M & M Proposition II D. Law of One Price E. Efficient Markets Hypothesis

C. M & M Proposition II

Which one of the following statements related to risk is correct? A. The beta of a portfolio must increase when a stock with a high standard deviation is added to the portfolio. B. Every portfolio that contains 25 or more securities is free of unsystematic risk. C. The systematic risk of a portfolio can be effectively lowered by adding T-bills to the portfolio. D. Adding five additional stocks to a diversified portfolio will lower the portfolio's beta. E. Stocks that move in tandem with the overall market have zero betas.

C. The systematic risk of a portfolio can be effectively lowered by adding T-bills to the portfolio.

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs. A. flotation B. issue C. direct bankruptcy D. indirect bankruptcy E. unlevered

C. direct bankruptcy

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

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

Kelley's Baskets makes handmade baskets for distribution to upscale retail outlets. The firm is currently considering making handmade wreaths as well. Which one of the following is the best example of an incremental operating cash flow related to the wreath project? A. storing supplies in the same space currently used for materials storage B. utilizing the basket manager to oversee wreath production C. hiring additional employees to handle the increased workload should the firm accept the wreath project D. researching the market to determine if wreath sales might be profitable before deciding to proceed E. planning on lower interest expense by assuming the proceeds of the wreath sales will be used to reduce the firm's currently outstanding debt

C. hiring additional employees to handle the increased workload should the firm accept the wreath project

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs. A. flotation B. direct bankruptcy C. indirect bankruptcy D. financial solvency E. capital structure

C. indirect bankruptcy

A business firm ceases to exist as a going concern as a result of which one of the following? A. divestiture B. share repurchase C. liquidation D. reorganization E. capital restructuring

C. liquidation

Which one of the following costs was incurred in the past and cannot be recouped? A. incremental B. side C. sunk D. opportunity E. erosion

C. sunk

Homemade leverage is: A. the incurrence of debt by a corporation in order to pay dividends to shareholders. B. the exclusive use of debt to fund a corporate expansion project. C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. D. best defined as an increase in a firm's debt-equity ratio. E. the term used to describe the capital structure of a levered firm.

C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.

42. The optimal capital structure: A. will be the same for all firms in the same industry. B. will remain constant over time unless the firm changes its primary operations. C. will vary over time as taxes and market conditions change. D. places more emphasis on operations than on financing. E. is unaffected by changes in the financial markets.

C. will vary over time as taxes and market conditions change.

Winter's Toyland has a debt-equity ratio of .65. The pretax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the cost of equity if you ignore taxes? A) 19.74 percent B) 19.31 percent C) 20.46 percent D) 20.91 percent E) 20.29 percent

D) 20.91 percent RE = 0.161 + (0.161 - 0.087) × 0.65 = 20.91 percent

Which of the following should be included in the analysis of a new product? I. money already spent for research and development of the new product II. reduction in sales for a current product once the new product is introduced III. increase in accounts receivable needed to finance sales of the new product IV. market value of a machine owned by the firm which will be used to produce the new product A. I and III only B. II and IV only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV

D. II, III, and IV only

Which one of the following is the best example of a diversifiable risk? A. interest rates increase B. energy costs increase C. core inflation increases D. a firm's sales decrease E. taxes decrease

D. a firm's sales decrease

Which one of the following is the equity risk that is most related to the daily operations of a firm? A. market risk B. systematic risk C. extrinsic risk D. business risk E. financial risk

D. business risk

Net working capital: A. can be ignored in project analysis because any expenditure is normally recouped at the end of the project. B. requirements, such as an increase in accounts receivable, create a cash inflow at the beginning of a project. C. is rarely affected when a new product is introduced. D. can create either a cash inflow or a cash outflow at time zero of a project. E. is the only expenditure where at least a partial recovery can be made at the end of a project.

D. can create either a cash inflow or a cash outflow at time zero of a project.

A large U.S. company has £500,000 in excess cash from its foreign operations. The company would like to exchange these funds for U.S. dollars. In which of the following markets can this exchange be arranged? A. ADR B. national registry C. national discount window D. foreign exchange market E. Eurobond market

D. foreign exchange market

The business risk of a firm: A. depends on the firm's level of unsystematic risk. B. is inversely related to the required return on the firm's assets. C. is dependent upon the relative weights of the debt and equity used to finance the firm. D. has a positive relationship with the firm's cost of equity. E. has no relationship with the required return on a firm's assets according to M & M Proposition II.

D. has a positive relationship with the firm's cost of equity.

The operating cash flow for a project should exclude which one of the following? A. taxes B. variable costs C. fixed costs D. interest expense E. depreciation tax shield

D. interest expense

The option that is foregone so that an asset can be utilized by a specific project is referred to as which one of the following? A. salvage value B. wasted value C. sunk cost D. opportunity cost E. erosion

D. opportunity cost

Assume that an item costs $100 in the U.S. and the exchange rate between the U.S. and Canada is: $1 = C$1.27. Which one of the following concepts supports the idea that the item that sells for $100 in the U.S. is currently selling in Canada for $127? A. unbiased forward rates condition B. uncovered interest rate parity C. international Fisher effect D. purchasing power parity E. interest rate parity

D. purchasing power parity

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a: A. merger. B. repurchase program. C. liquidation. D. reorganization. E. divestiture.

D. reorganization.

The value of a firm is maximized when the: A. cost of equity is maximized. B. tax rate is zero. C. levered cost of capital is maximized. D. weighted average cost of capital is minimized. E. debt-equity ratio is minimized.

D. weighted average cost of capital is minimized.

The expected return on a stock given various states of the economy is equal to the: A. highest expected return given any economic state. B. arithmetic average of the returns for each economic state. C. summation of the individual expected rates of return. D. weighted average of the returns for each economic state. E. return for the economic state with the highest probability of occurrence.

D. weighted average of the returns for each economic state.

Consider an asset that costs $176,000 and is depreciated straight-line to zero over its 11-year tax life. The asset is to be used in a 7-year project; at the end of the project, the asset can be sold for $22,000. The relevant tax rate is 30 percent. What is the aftertax cash flow from the sale of this asset? A. $31,800 B. $32,600 C. $33,300 D. $34,100 E. $34,600

E. $34,600 Book value at end of year 7 = $176,000 × 4/11 = $64,000 Aftertax salvage value = $22,000 + [($64,000 - $22,000) × .30] = $34,600

By definition, which of the following costs are included in the term "financial distress costs"? I. direct bankruptcy costs II. indirect bankruptcy costs III. direct costs related to being financially distressed, but not bankrupt IV. indirect costs related to being financially distressed, but not bankrupt A. I only B. III only C. I and II only D. III and IV only E. I, II, III, and IV

E. I, II, III, and IV

Which of the following conditions are required for absolute purchasing power parity to exist? I. goods must be identical II. goods must have equal economic value III. transaction costs must be zero IV. there can be no barriers to trade A. I and III only B. II and IV only C. I, III, and IV only D. I, II, and III only E. I, II, III, and IV

E. I, II, III, and IV

The present value of the interest tax shield is expressed as: A. (Tc × D)/RA. B. VU + (Tc × D). C. [EBIT × (Tc × D)]/RU. D. [EBIT × (Tc × D)]/RA. E. Tc × D.

E. Tc × D.

A project has a net present value of zero. Which one of the following best describes this project? A. The project has a zero percent rate of return. B. The project requires no initial cash investment. C. The project has no cash flows. D. The summation of all of the project's cash flows is zero. E. The project's cash inflows equal its cash outflows in current dollar terms.

E. The project's cash inflows equal its cash outflows in current dollar terms.

You are considering two independent projects with the following cash flows. The required return for both projects is 16 percent. Given this information, which one of the following statements is correct? A. You should accept Project A and reject Project B based on their respective NPVs. B. You should accept Project B and reject Project A based on their respective NPVs. C. You should accept Project A and reject Project B based on their respective IRRs. D. You should accept Project B and reject Project A based on their respective IRRs. E. You should accept both projects based on both the NPV and IRR decision rules.

E. You should accept both projects based on both the NPV and IRR decision rules.

The operating cash flow of a cost cutting project: A. is equal to the depreciation tax shield. B. is equal to zero because there is no incremental sales. C. can only be analyzed by projecting the sales and costs for a firm's entire operations. D. includes any changes that occur in the current accounts. E. can be positive even though there are no sales.

E. can be positive even though there are no sales.

Which one of the following is the equity risk related to a firm's capital structure policy? A. market B. systematic C. extrinsic D. business E. financial

E. financial

Which one of the following makes the capital structure of a firm irrelevant? A. taxes B. interest tax shield C. 100 percent dividend payout ratio D. debt-equity ratio that is greater than 0 but less than 1 E. homemade leverage

E. homemade leverage

The condition stating that the interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate is called: A. the unbiased forward rates condition. B. uncovered interest rate parity. C. the international Fisher effect. D. purchasing power parity. E. interest rate parity.

E. interest rate parity.

Trader A has agreed to give 100,000 U.S. dollars to Trader B in exchange for British pounds based on today's exchange rate of $1 = £0.62. The traders agree to settle this trade within two business day. What is this exchange called? A. swap B. option trade C. futures trade D. forward trade E. spot trade

E. spot trade

G & L Plastic Molders spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost? A. opportunity B. fixed C. incremental D. erosion E. sunk

E. sunk

The absolute priority rule determines: A. when a firm must be declared officially bankrupt. B. how a distressed firm is reorganized. C. which judge is assigned to a particular bankruptcy case. D. how long a reorganized firm is allowed to remain under bankruptcy protection. E. which parties receive payment first in a bankruptcy proceeding.

E. which parties receive payment first in a bankruptcy proceeding.