Fundamentals of Corporate Finance, 4e (Berk/DeMarzo/Harford ...

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Copyright © 2018 Pearson Education, Inc.

Fundamentals of Corporate Finance, 4e (Berk/DeMarzo/Harford)

Chapter 2 Introduction to Financial Statement Analysis

2.1 Firms' Disclosure of Financial Information 1) In the United States, publicly traded companies can choose whether or not they wish to release

periodic financial statements.

Answer: FALSE Diff: 1 Var: 1

Skill: Conceptual

AACSB Objective: Analytic Skills

Author: DS

Question Status: Previous Edition

2) Financial statements are optional accounting reports issued periodically by a firm which present

information on the past performance of the firm, a summary of the firm's assets and the financing of those

assets, and a prediction of the firm's future performance.


Skill: Conceptual


Author: DS

Question Status: Revised

3) International Financial Reporting Standards are taking root throughout the world. However, it is

unlikely that the U.S. will report according to IFRS before the second half of the twenty-first century.


Skill: Conceptual


Author: JP

Question Status: New

4) What is the main reason that it is necessary for public companies to follow the rules and format set out

in the Generally Accepted Accounting Principles (GAAP) when creating financial statements?

A) It ensures that the market value of assets and debt are reported accurately.

B) It ensures that information on the performance of public companies is reported on cash-basis

accounting.

C) It ensures that important budgetary information is not omitted.

D) It makes it easier to compare the financial results of different firms.

Answer: D Diff: 1 Var: 1

Skill: Conceptual


Author: DS


2


5) Which of the following best describes why a firm produces financial statements?

A) to use as a tool when planning future investments within a firm

B) to increase the intrinsic value of a firm

C) to provide a means for interested outside parties such as creditors to obtain information about a firm,

with an overview of the short- and long-term financial condition of a business

D) to show the daily activities a firm has undertaken in the previous financial year, and what activities

are planned for the near future

Answer: C Diff: 1 Var: 1

Skill: Conceptual


Author: DS


6) The exchanges in which of the following countries or regions do NOT accept the International

Financial Reporting Standards set out by the International Accounting Standards Board?

A) Germany

B) France

C) United States

D) United Kingdom


Skill: Conceptual


Author: DS


7) Which of the following is NOT one of the financial statements that must be produced by a public

company?

A) the balance sheet

B) the income statement

C) the statement of cash flows

D) the statement of activities


Skill: Conceptual


Author: DS


3


8) U.S. public companies are required to file their annual financial statements with the U.S. Securities and

Exchange Commission on which form?

A) 10-A

B) 10-K

C) 10-Q

D) 10-SEC

Answer: B Diff: 1 Var: 1

Skill: Definition


Author: JN


9) Which of the following is NOT a financial statement that every public company is required to produce?

A) income statement

B) statement of sources and uses of cash

C) balance sheet

D) statement of stockholders' equity


Skill: Conceptual


Author: JN


10) The third party who checks annual financial statements to ensure that they are prepared according to

Generally Accepted Accounting Principles (GAAP) and verifies that the information reported is reliable is

the ________.

A) NYSE Enforcement Board

B) Accounting Standards Board

C) Securities and Exchange Commission (SEC)

D) auditor


Skill: Definition


Author: JN


11) What is the role of an auditor in financial statement analysis?

Answer: Key points:

1. to ensure that the annual financial statements are prepared accurately

2. to ensure that the annual financial statements are prepared according to Generally Accepted

Accounting Principles (GAAP)

3. to verify that the information used in preparing the annual financial statements is reliable Diff: 2 Var: 1

Skill: Conceptual


Author: JN


4


12) What are the four financial statements that all public companies must produce?

Answer:

1. balance sheet

2. income statement

3. statement of cash flows

4. statement of stockholders' equity Diff: 2 Var: 1

Skill: Conceptual


Author: JN


2.2 The Balance Sheet 1) The balance sheet shows the assets, liabilities, and stockholders' equity of a firm over a given length of

time.


Skill: Conceptual


Author: DS


2) Stockholders' equity is the difference between a firm's assets and liabilities, as shown on the balance

sheet.

Answer: TRUE Diff: 1 Var: 1

Skill: Conceptual


Author: DS


3) Which of the following amounts would be included on the right side of a balance sheet?

A) the value of government bonds held by the company

B) the cash held by the company

C) the amount of deferred tax liability held by the company

D) the amount of money owed to the company by customers who have not yet paid for goods and

services they have received


Skill: Conceptual


Author: DS


5


4) Which of the following best describes why the left and right sides of a balance sheet are equal?

A) In a properly run business, the value of liabilities will not exceed the assets held by the company.

B) By definition, the assets plus the liabilities will be the same as the stockholders' equity.

C) The assets must equal liabilities plus stockholders' equity because stockholders' equity is the difference

between the assets and the liabilities.

D) By accounting convention, the assets of a company must be equal to the liabilities of that company.


Skill: Conceptual


Author: DS


5) A company that produces drugs is preparing a balance sheet. Which of the following would be most

likely to be considered a long-term asset on this balance sheet?

A) commercial paper held by the company

B) the inventory of chemicals used to produce the drugs made by the company

C) a patent for a drug held by the company

D) the cash reserves of the company


Skill: Conceptual


Author: DS


6) A delivery company is creating a balance sheet. Which of the following would most likely be

considered a short-term liability on this balance sheet?

A) the depreciation over the last year in the value of the vehicles owned by the company

B) revenue received for the delivery of items that have not yet been delivered

C) a loan which must paid back in two years

D) prepaid rent on the offices occupied by the company


Skill: Conceptual


Author: DS


6


7) A small company has current assets of $112,000 and current liabilities of $117,000. Which of the

following statements about that company is most likely to be true?

A) Since net working capital is negative, the company will not have enough funds to meet its obligations.

B) Since net working capital is high, the company will likely have little difficulty meeting its obligations.

C) Since net working capital is very high, the company will have ample money to invest after it meets its

obligations.

D) Since net working capital is nearly zero, the company is well run and will have little difficulty

attracting investors.

Answer: A Diff: 1 Var: 1

Skill: Conceptual


Author: DS


8) What is the main problem in using a balance sheet to provide an accurate assessment of the value of a

company's equity?

A) Valuable assets such as the company's reputation, the quality of its work force, and the strength of its

management are not captured on the balance sheet.

B) The balance sheet does not accurately represent the book value of assets held by the company.

C) The equity shown on the balance sheet does not reflect the market capitalization of the company.

D) Knowing at a single point in time what assets a firm possesses and the liabilities a firm owes does not

give any indication of what those assets can produce in the future.


Skill: Conceptual


Author: DS


9) The major components of stockholders' equity are ________.

A) cash, common stock, and paid-in surplus

B) common stock, paid-in surplus, and net income

C) common stock, paid-in surplus, and retained earnings

D) common stock, liabilities, and retained earnings


Skill: Conceptual


Author: JP


7


10) Balance Sheet

Assets Liabilities

Current Assets Current Liabilities

Cash 46 Accounts payable 39

Accounts receivable 23 Notes payable/short-term debt 5

Inventories 20

Total current assets 89 Total current liabilities 44

Long-Term Assets Long-Term Liabilities

Net property, plant,

and equipment 121 Long-term debt 133

Total long-term assets 121 Total long-term liabilities 133

Total Liabilities 177

Stockholders' Equity 33

Total Assets 210 Total Liabilities and 210

Stockholders' Equity

The above diagram shows a balance sheet for a certain company. All quantities shown are in millions of

dollars. What is the company's net working capital?

A) $133 million

B) $2 million

C) $89 million

D) $45 million

Answer: D

Explanation: D) Net working capital = total current assets - total current liabilities,

, as all quantities are expressed in millions of dollars on the table.

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


8


11) Balance Sheet

Assets Liabilities




Inventories 18










The above diagram shows a balance sheet for a certain company. If the company pays back all of its

accounts payable today using cash, what will its net working capital be?

A) $131 million

B) $6 million

C) $88 million

D) $45 million

Answer: D

Explanation: D) Both cash and accounts payable would fall by the same amount, leaving net working

capital the same:

Diff: 1 Var: 50+

Skill: Analytical


Author: JP


9


12) Balance Sheet

Assets Liabilities




Inventories 16










The above diagram shows a balance sheet for a certain company. If the company buys new property,

plant and equipment today using its entire cash balance, what will its net working capital be?

A) -$12 million

B) $12 million

C) -$24 million

D) $24 million

Answer: A

Explanation: A) Current assets would fall by $54, with no change in current liabilities.

Diff: 1 Var: 50+

Skill: Analytical


Author: JP


10


13) Balance Sheet

Assets Liabilities




Inventories 16











dollars. How would the balance sheet change if the company's long-term assets were judged to

depreciate at an extra $5 million per year?

A) Net property, plant, and equipment would rise to $126 million, and total assets and stockholders'

equity would be adjusted accordingly.

B) Net property, plant, and equipment would fall to $116 million, and total assets and stockholders'

equity would be adjusted accordingly.

C) Long-term liabilities would rise to $131 million, and total liabilities and stockholders' equity would be

adjusted accordingly.

D) Long-term liabilities would fall to $111 million, and total liabilities and stockholders' equity would be

adjusted accordingly.

Answer: B Diff: 1 Var: 50+

Skill: Analytical


Author: DS


11


14) Balance Sheet

Assets Liabilities




Inventories 17











dollars. If the company has 5 million shares outstanding, and these shares are trading at a price of $6.39

per share, what does this tell you about how investors view this firm's book value?

A) Investors consider that the firm's market value is worth very much less than its book value.

B) Investors consider that the firm's market value is worth less than its book value.

C) Investors consider that the firm's market value and its book value are roughly equivalent.

D) Investors consider that the firm's market value is worth more than its book value.

Answer: C Diff: 1 Var: 50+

Skill: Analytical


Author: DS


15) Which of the following balance sheet equations is INCORRECT?

A) Assets - Liabilities = Shareholders' equity

B) Assets = Liabilities + Shareholders' equity

C) Assets - Current liabilities = Long-term liabilities

D) Assets - Current liabilities = Long-term liabilities + Shareholders' equity


Skill: Conceptual


Author: JN


12


16) Cash is a ________.

A) long-term asset

B) current asset

C) current liability

D) long-term liability


Skill: Definition


Author: JN


17) Accounts payable is a ________.

A) long-term liability

B) current asset

C) long-term asset

D) current liability


Skill: Definition


Author: JN


18) A 30-year mortgage loan is a ________.

A) long-term liability

B) current liability

C) current asset

D) long-term asset


Skill: Definition


Author: JN


19) Which of the following statements regarding the balance sheet is INCORRECT?

A) The balance sheet provides a snapshot of a firm's financial position at a given point in time.

B) The balance sheet lists a firm's assets and liabilities.

C) The balance sheet reports stockholders' equity on the right-hand side.

D) The balance sheet reports liabilities on the left-hand side.


Skill: Conceptual


Author: JN


13


20) Luther Corporation

Consolidated Balance Sheet

December 31, 2006 and 2005 (in $ millions)

Assets 2006 2005

Liabilities and

Stockholders' Equity 2006 2005


Cash 50.7 58.5 Accounts payable 84.4 73.5

Accounts receivable 54.9 39.6

Notes payable / short-term

debt 9.4 9.6

Inventories 44.7 42.9

Current maturities of long-

term debt 39.8 36.9

Other current assets 6.1 3.0 Other current liabilities 6.0 12.0

Total current assets 156.4 144.0 Total current liabilities 139.6 132.0


Land 66.8 62.1 Long-term debt 222.3 168.9

Buildings 106.2 91.5 Capital lease obligations

Equipment 115.7 99.6

Less accumulated

Depreciation (56.5) (52.5) Deferred taxes 22.8 22.2

Net property, plant, and

equipment 232.2 200.7 Other long-term liabilities --- ---

Goodwill 60.0 -- Total long-term liabilities 245.1 191.1

Other long-term assets 63.0 42.0 Total liabilities 384.7 323.1

Total long-term assets 355.2 242.7 Stockholders' Equity 126.9 63.6

Total Assets 511.6 386.7

Total liabilities and

Stockholders' Equity 511.6 386.7

Refer to the balance sheet above. What is Luther's net working capital in 2006?

A) $16.8 million

B) $296.0 million

C) $33.6 million

D) $8.4 million

Answer: A

Explanation: A)

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


14


2.3 The Income Statement 1) The income statement reports the firm's revenues and expenses, and it computes the firm's bottom line

of net income, or earnings.


Skill: Conceptual


Author: DS


2) What is a firm's net income?

A) the difference between the sales and other income generated by a firm, and all costs, taxes, and

expenses incurred by the firm in a given period

B) the last or "bottom" line of the income statement

C) a measure of the firm's profitability over a given period

D) all of the above


Skill: Conceptual


Author: DS


3) What is a firm's gross profit?

A) the difference between the sales and other income generated by the firm, and all costs, taxes, and

expenses incurred by a firm in a given period

B) the difference between sales revenues and the costs

C) the difference between sales revenues and cash expenditures associated with those sales

D) all of the above


Skill: Conceptual


Author: JP


4) Which of the following is NOT considered to be an operating expense on the income statement?

A) administrative expenses and overhead

B) corporate taxes

C) salaries

D) depreciation and amortization


Skill: Conceptual


Author: DS


15


5) Income Statement for Xenon Manufacturing:

2008 2009

Total sales 202 212

Cost of sales -148 -172

Gross Profit 54 40

Selling, general,

and administrative expenses -22 -20

Research and development -8 -7

Depreciation and amortization -4 -3

Other income 4 6

Earnings before interest

and taxes (EBIT) 24 16

Interest income (expense) -7 -4

Pretax income 14 12

Taxes -4 -3

Net Income 10 9

Consider the above Income Statement for Xenon Manufacturing. All values are in millions of dollars. If

Xenon Manufacturing has 20 million shares outstanding, what is its EPS in 2008?

A) $0.50

B) $0.25

C) $0.40

D) $0.60

Answer: A

Explanation: A) EPS = Net income / Shares outstanding = $10 million / 20 million shares = $0.50 per share Diff: 2 Var: 22

Skill: Analytical


Author: DS


16


6) Income Statement for CharmCorp:

2008 2009

Total sales 600 540


Gross Profit 68 52

Selling, general,




Operating Income 23 21

Other income 1 5




Pretax income 14 19

Taxes -4 5

Net Income 10 14

Consider the above Income Statement for CharmCorp. All values are in millions of dollars. If

CharmCorp. has 4 million shares outstanding, and its managers and employees have stock options for 2

million shares, what is its diluted EPS in 2008?

A) $0.83

B) $1.33

C) $1.67

D) $2.00


Skill: Analytical


Author: DS


7) Which of the following statements regarding the income statement is INCORRECT?

A) The income statement shows the cash flows and expenses at a given point in time.

B) The income statement shows the flow of revenues and expenses generated by a firm between two

dates.

C) The last or "bottom" line of the income statement shows a firm's net income.

D) The first line of an income statement lists the revenues from the sales of products or services.


Skill: Conceptual


Author: JN


17


8) Gross profit is calculated as ________.

A) total sales - cost of sales - selling, general, and administrative expenses - depreciation and amortization

B) total sales - cost of sales - selling, general, and administrative expenses

C) total sales - cost of sales

D) none of the above


Skill: Conceptual


Author: JN


9) Which of the following is NOT an operating expense?

A) interest expense

B) depreciation and amortization

C) selling, general, and administrative expenses

D) research and development


Skill: Conceptual


Author: JN


18



Consolidated Income Statement

Year ended December 31 (in $millions)

2006 2005

Total sales 610.1 578.3

Cost of sales -500.2 -481.9

Gross profit 109.9 96.4

Selling, general, and

administrative expenses -40.5 -39.0

Research and development -24.6 -22.8

Depreciation and amortization -3.6 -3.3

Operating income 41.2 31.3

Other income -- --

Earnings before interest and taxes (EBIT) 41.2 31.3

Interest income (expense) -25.1 -15.8

Pretax income 16.1 15.5

Taxes -5.5 -5.3

Net income 10.6 10.2

Price per share $16 $15

Sharing outstanding (millions) 10.3 8.0

Stock options outstanding (millions) 0.4 0.1


Total Liabilities and Stockholders' Equity 533.1 386.7

Refer to the income statement above. For the year ending December 31, 2006 Luther's earnings per share

is closest to ________.

A) $0.51

B) $1.03

C) $0.82

D) $1.23

Answer: B

Explanation: B)

Diff: 1 Var: 50+

Skill: Analytical


Author: JN


19





2006 2005









Other income -- --




Taxes -5.5 -5.3







Refer to the income statement above. Assuming that Luther has no convertible bonds outstanding, then

for the year ending December 31, 2006 Luther's diluted earnings per share are closest to ________.

A) $1.03

B) $0.51

C) $0.82

D) $1.23

Answer: A

Explanation: A) Diluted EPS = Net income / (Shares outstanding + Options contracts outstanding +

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


20


12) How does a firm select the dates for preparation of its income statement?

Answer: The income statement is prepared on the fiscal closing date for the accounts of a firm that may

or may not coincide with the calendar year-end of December 31st. Typically the income statement spans

the flow between two adjacent balance sheets. Diff: 3 Var: 1

Skill: Analytical


Author: SS


13) What will be the effect on the income statement if a firm buys a new processing plant through a new

loan?

Answer: The effect on the income statement will be in the form of a depreciation expense for the first

year on the new processing plant. Diff: 3 Var: 1

Skill: Conceptual


Author: SS


2.4 The Statement of Cash Flows 1) A firm's statement of cash flows uses the balance sheet and the income statement to determine the

amount of cash a firm has generated and how it has used that cash during a given period.


Skill: Conceptual


Author: DS


2) Which of the following is NOT a reason that the income statement does not accurately indicate how

much cash a firm has earned?

A) It includes entries for the depreciation of assets.

B) It does not include entries for expenditures on inventory.

C) It does not include entries for collection of money from account receivables.

D) It includes cash inflows from services rendered.


Skill: Conceptual


Author: DS


21


3) Which of the following is a way that the operating activity section of the statement of cash flows

adjusts Net Income from the balance sheet?

A) It subtracts all expenses and costs related to a firm's operating activities.

B) It adds all non-cash entries related to a firm's operating activities.

C) It adds the cash that flows from investors to a firm.

D) It removes the cash used for investment purposes.


Skill: Conceptual

AACSB Objective: Reflective Thinking Skills

Author: DS


4) Allen Company bought a new copy machine to be depreciated straight line for three years for use by

sales personnel. Where would this purchase be reflected on the Statement of Cash Flows?

A) It would be an expense on the income statement so it would be reflected in operating cash flows.

B) It would be an addition to property, plant and equipment so it would be an investing activity.

C) It would be an addition to cash so it would be reflected in the change in cash.

D) None of the above answers is correct.


Skill: Conceptual


Author: JP


5) A printing company prints a brochure for a client and then bills them for this service. At the time the

printing company's financial disclosure statements are prepared, the client has not yet paid the bill for

this service. How will this transaction be recorded?

A) The sale will be added to Net Income on the income statement and retained in Net Income on the

statement of cash flows.

B) The sale will be added to Net Income on the income statement but deducted from Net Income on the


C) The sale will not be added to Net Income on the income statement but added to Net Income on the


D) The sale will neither be added to Net Income on the income statement nor used to adjust Net Income

on the statement of cash flows.


Skill: Conceptual


Author: DS


22


6) A manufacturer of plastic bottles for the medical trade purchases a new compression blow molder for

its bottle production plant. How will the cost to the company of this piece of equipment be recorded?

A) It will be depreciated over time on the income statement and subtracted as a capital expenditure on

the statement of cash flows.

B) It will be depreciated over time on the income statement and subtracted as Inventory on the statement

of cash flows.

C) It will be depreciated over time on the income statement and therefore not be recorded separately on

the statement of cash flows.

D) It will be subtracted from Gross Profit on the income statement and therefore, not be recorded

separately on the statement of cash flows.


Skill: Conceptual


Author: DS


7) A software company acquires a smaller company in order to acquire the patents that it holds. Where

will the cost of this acquisition be recorded on the statement of cash flows?

A) as an outflow under operating activities

B) as an outflow under investment activities

C) as an outflow under financial activities

D) not recorded on the statement of cash flows


Skill: Conceptual


Author: DS


23


8) AOS Industries Statement of Cash Flows for 2008

Operating activities

Net Income 3.2

Depreciation and amortization 1.4

Cash effect of changes in

Accounts receivable -1.9

Accounts payable 1.0

Inventory -0.6

Cash from operating activities 3.1

Investment activities

Capital expenditures -2.2

Acquisitions and other investing activity -0.4

Cash from investing activities -2.6

Financing activities

Dividends paid -1.0

Sale or purchase of stock 2.1

Increase in short-term borrowing 1.4

Increase in long-term borrowing 3.2

Cash from financing activities 5.7

Change in Cash and Cash Equivalents 6.2

Consider the above statement of cash flows. If all amounts shown above are in millions of dollars, what

were AOS Industries' retained earnings for 2008?

A) $5.2 million

B) $2.2 million

C) $4.4 million

D) $3.1 million

Answer: B

Explanation: B) $3.2 - $1 = $2.2 million Diff: 2 Var: 50+

Skill: Analytical


Author: DS


24


Use the table for the question(s) below.

AOS Industries Statement of Cash Flows for 2008


Net Income 3.2





Inventory -0.8







Dividends paid -1.5






9) Consider the above statement of cash flows. What were AOS Industries' major means of raising money

in 2008?

A) from investment activities

B) by sale of stock

C) from its operations

D) by issuing debt


Skill: Analytical


Author: DS


25


10) Consider the above statement of cash flows. Which of the following is true of AOS Industries'

operating cash flows?

A) It collected more cash from its customers than it charged.

B) It sold more inventory than it bought.

C) It charged more on its accounts payable back than it paid back.

D) All of the above are true.


Skill: Analytical


Author: JP


26


11) AOS Industries Statement of Cash Flows for 2008


Net Income 3.2





Inventory -0.8







Dividends paid -1.5






Consider the above statement of cash flows. In 2008, AOS Industries had contemplated buying a new

warehouse for $3 million, the cost of which would be depreciated over 10 years. If AOS Industries has a

tax rate of 25%, what would be the impact for the amount of cash held by AOS at the end of the 2008?

A) It would have $3,000,000 less cash at the end of 2008.

B) It would have $2,925,000 less cash at the end of 2008.

C) It would have $1,500,000 less cash at the end of 2008.

D) It would have an additional $7,500,000 in cash at the end of 2008.

Answer: B

Explanation: B) -$3,000,000 + 300,000 × 25% = -$2,925,000 Diff: 3 Var: 8

Skill: Analytical


Author: DS


12) How can we cross check the statement of cash flows?

Answer: The last item in the statement of cash flows should equal the difference in cash balances

between two adjacent balance sheets. Diff: 3 Var: 1

Skill: Conceptual


Author: SS


27


13) What will be the effect on the statement of cash flows if a firm buys a new processing plant through a

new loan?

Answer: The new loan entry should show as a cash inflow for the firm, while the payment for the new

processing plant will be entered as a cash outflow. Diff: 3 Var: 1

Skill: Conceptual


Author: SS


2.5 Other Financial Statement Information 1) The management of public companies is not legally required to disclose any off-balance sheet

transactions.


Skill: Conceptual


Author: DS


2) A firm whose primary business is in a line of regional grocery stores would be most likely to have to

include which of the following facts, if true, in the firm's management discussion and analysis (MD&A)?

A) that a large number of funds were allocated to advertising to increase awareness of the firm's brand in

new areas it had expanded into this year

B) that some senior members of the management team have retired in this financial year

C) that the company has lost a class action suit brought against the firm by its employees and is expected

to have to pay a large amount of damages

D) that the firm has plans to expand into the organic food business in the next financial year by

purchasing several small organic food retailers


Skill: Conceptual

AACSB Objective: Ethical Understanding and Reasoning Abilities

Author: DS


3) The notes to the financial statements would LEAST likely be used for which of the following purposes?

A) to provide information regarding the context in which these financial numbers were generated

B) to disclose the financial implications of any off-balance sheet transactions

C) to show how the value of assets listed in the financial statements were arrived at

D) to explain the method of accounting that was used in the preparation of the financial statements


Skill: Conceptual


Author: DS


28


4) What is the need for the notes to the financial statements when a firm's operations are already

documented in the financial statements?

Answer: Not all actions of the firm can be directly converted to an entry on the financial statements. For

example, the firm may be involved in off balance sheet transactions, which have to be reported through

notes to the financial statements. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


2.6 Financial Statement Analysis 1) In general, a successful firm will have a market-to-book ratio that is substantially greater than 1.


Skill: Conceptual


Author: DS


29





Assets 2006 2005

Liabilities and






debt 10.4 9.6



term debt 37.3 36.9




Land 66.1 62.1 Long-term debt 236 168.9



Less accumulated

depreciation (54.9) (52.5) Deferred taxes 22.8 22.2









Refer to the balance sheet above. If in 2006 Luther has 10.2 million shares outstanding and these shares

are trading at $16 per share, then Luther's market-to-book ratio would be closest to ________.

A) 2.58

B) 0.64

C) 1.29

D) 1.80

Answer: C

Explanation: C) MTB = Market Value of Equity / Book Value of Equity

= (10.2 million × 16) / 126.7 = 163.2 / 126.7 = 1.288 Diff: 2 Var: 50+

Skill: Analytical


Author: JN


30





Assets 2006 2005

Liabilities and






debt 10.7 9.6



term debt 38.7 36.9







Less accumulated










Refer to the balance sheet above. When using the book value of equity, the debt-equity ratio for Luther in

2006 is closest to ________.

A) 4.51

B) 2.25

C) 1.13

D) 3.16

Answer: B

Explanation: B) D / E = Total debt / Total equity

Long-term debt (234.4) =

283.8 million

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


31





Assets 2006 2005

Liabilities and






debt 10.5 9.6



term debt 39.6 36.9







Less accumulated











are trading at $16 per share, then using the market value of equity, the debt-equity ratio for Luther in

2006 is closest to ________.

A) 3.45

B) 1.72

C) 0.86

D) 2.41

Answer: B

Explanation: B) D / E = Total debt / Total equity

Total Debt = Notes payable (10.5) +

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


32





Assets 2006 2005

Liabilities and






debt 10.9 9.6



term debt 40.7 36.9




Land 66.8 62.1 Long-term debt 227 168.9



Less accumulated



equipment 238 200.7 Other long-term liabilities --- ---



Total long-term assets 361 242.7 Stockholders' Equity 125.9 63.6





are trading at $16 per share, then what is Luther's enterprise value?

A) -$540.0 million

B) $771.4 million

C) $385.7 million

D) $521.4 million

Answer: C

Explanation: C) Enterprise value = Market Value of Equity + Debt - Cash = (10.2 × $16) + $278.6 - $56.1 =

$385.7 Diff: 2 Var: 50+

Skill: Analytical


Author: JN


33





Assets 2006 2005

Liabilities and






debt 10.3 9.6



term debt 38.6 36.9







Less accumulated










Refer to the balance sheet above. Luther's current ratio for 2006 is closest to ________.

A) 1.67

B) 2.22

C) 0.56

D) 1.11

Answer: D

Explanation: D)

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


34





Assets 2006 2005

Liabilities and






debt 9.6 9.6



term debt 39.9 36.9







Less accumulated










Refer to the balance sheet above. Luther's quick ratio for 2006 is closest to ________.

A) 0.87

B) 1.75

C) 0.88

D) 1.31

Answer: A

Explanation: A)

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


35





Assets 2006 2005

Liabilities and Stockholders'

Equity 2006 2005





debt 9.3 9.6



term debt 39.9 36.9







Less accumulated










Refer to the balance sheet above. The change in Luther's quick ratio from 2005 to 2006 is closest to

________.

A) a decrease of 0.01

B) an increase of 0.01

C) a decrease of 0.02

D) an increase of 0.02

Answer: B

Explanation: B) Quick ratio in 2006 = ($158.9 - $46.5) / $144.1 = 0.78

Quick ratio in 2005 = ($144.0 - $42.9) / 132 = 0.77

So, the quick ratio increased by 0.78 - 0.77 = 0.01. Diff: 3 Var: 50+

Skill: Analytical


Author: JN


36


9) A public company has a book value of $128 million. They have 20 million shares outstanding, with a

market price of $4 per share. Which of the following statements is true regarding this company?

A) Investors may consider this firm to be a growth company.

B) Investors believe the company's assets are not likely to be profitable since its market value is worth less

than its book value.

C) The firm's market value is more than its book value.

D) The value of the firm's assets is greater than their liquidation value.


Skill: Analytical


Author: DS


10) GenCorp. has a total debt of $140 million and stockholders' equity of $50 million. It also has 26 million

shares outstanding, with a market price of $4.00 per share. What is GenCorp's market debt-equity ratio?

A) 0.67

B) 1.08

C) 2.80

D) 1.35

Answer: D

Explanation: D) 140 / ($4.00 × 26) = 1.35 Diff: 2 Var: 50+

Skill: Analytical


Author: DS


11) A company has a share price of $22.15 and 118 million shares outstanding. Its market-to-book ratio is

4.2, its book debt-equity ratio is 3.2, and it has cash of $800 million. How much would it cost to take over

this business assuming you pay its enterprise value?

A) $1.9 billion

B) $3.044 billion

C) $4.566 billion

D) $3.8 billion

Answer: D

Explanation: D) Market cap = $22.15 × 118 = $2.614 billion;

Diff: 3 Var: 50+

Skill: Analytical


Author: DS


37


12) Convex Industries has inventories of $218 million, current assets of $1.4 billion, and current liabilities

of $504 million. What is its quick ratio?

A) 1.17

B) 0.94

C) 2.81

D) 2.35

Answer: D

Explanation: D) ($1400 - $218) / $504 = 2.35 Diff: 2 Var: 50+

Skill: Analytical


Author: DS


13) Which ratio would you use to measure the financial health of a firm by assessing that firm's leverage?

A) debt-equity or equity multiplier ratio

B) market-to-book ratio

C) market debt-equity ratio

D) current or quick ratio


Skill: Conceptual


Author: DS


14) Company A has current assets of $42 billion and current liabilities of $41 billion. Company B has

current assets of $2.7 billion and current liabilities of $1.8 billion. Which of the following statements is

correct, based on this information?

A) Company A is less likely than Company B to have sufficient working capital to meet its short-term

needs.

B) Company A has greater leverage than Company B.

C) Company A has less leverage than Company B.

D) Company A and Company B have roughly equivalent enterprise values.


Skill: Analytical


Author: DS


38



Balance Sheet

Assets 2007 2008 Liabilities 2007 2008


Cash 50 46 Accounts payable 42 48

Accounts receivable 22 12 Notes payable/short-term debt 7 5

Inventories 17 38

Total current assets 89 96 Total current liabilities 49 53



and equipment 121 116 Long-term debt 128 136

Total long-term assets 121 116 Total long-term liabilities 128 136

Total Liabilities 177 189


Total Assets 210 212 Total Liabilities and 210 212


15) If the above balance sheet is for a retail company, what indications about this company would best be

drawn from the changes in the balance sheet between 2007 and 2008?

A) The company is having difficulties selling its product.

B) The company has reduced its debt.

C) The company has added a major new asset in terms of plant and equipment.

D) The company has experienced a significant rise in its market value.


Skill: Analytical


Author: DS



drawn from the changes in stockholders' equity between 2007 and 2008?

A) The company is very profitable because it is obviously collecting receivables faster.

B) The company is selling its property, plant and equipment, which may result in a long-term deficiency

in production capacity.

C) The company's net income in 2008 was negative.

D) No conclusions can be drawn regarding stockholders' equity without additional information.


Skill: Analytical


Author: JP


39



drawn from the changes in quick ratio between 2007 and 2008?

A) The company has eliminated the risk that it will experience a cash shortfall in the near future.

B) The company has reduced the risk that it will experience a cash shortfall in the near future.

C) The risk that the company will experience a cash shortfall in the near future is unchanged.

D) The company has increased the risk that it will experience a cash shortfall in the near future.


Skill: Analytical


Author: DS


18) If the above balance sheet is for a retail company, how has the company's leverage changed between

2007 and 2008?

A) The company has experienced a very significant decrease in its leverage.

B) The company has experienced a significant decrease in its leverage.

C) The company has experienced no significant change in its leverage.

D) The company has experienced a significant increase in its leverage.


Skill: Analytical


Author: DS


40



Luther Corporation


Year ended December 31 (in $ millions)

2006 2005


Cost of sales (500.2) (481.9)



administrative expenses (40.5) (39.0)

Research and development (24.6) (22.8)

Depreciation and amortization (3.6) (3.3)


Other income --- ---


Interest income (expense) (25.1) (15.8)


Taxes (5.5) (5.3)



Shares outstanding (millions) 10.2 8.0




19) Refer to the partial balance sheet above. If on December 31, 2005 Luther has 8 million shares

outstanding trading at $15 per share, then what is Luther's market-to-book ratio?

Answer: Market-to-book = Market value of equity / Book value of equity

Market-to-book = 8 million × $15 / $63.6 = 1.89 Diff: 2 Var: 1

Skill: Analytical


Author: JN


41



Luther Corporation



Assets 2006 2005

Liabilities and





Notes payable /

short-term debt 10.5 9.6



term debt 39.9 36.9





Buildings 109.5 91.5 Capital lease obligations --- ---

Equipment 119.1 99.6 Total Debt 239.7 168.9

Less accumulated










20) Refer to the balance sheet above. If on December 31, 2005 Luther has 8 million shares outstanding

trading at $15 per share, then what is Luther's enterprise value?

Answer: Enterprise value = Market value of equity + Debt - Cash

Market value of equity = 8 million × $15 = $120 million

Debt = Notes payable + Current maturities of long-term debt + Long-term debt

Debt = $9.6 + $36.9 + $168.9 = $215.4

Cash = $58.5

So, enterprise value = $120 + 215.4 - 58.5 = $276.90. Diff: 2 Var: 1

Skill: Analytical


Author: JN


42


21) How does a firm select the date for preparation of its balance sheet?

Answer: The balance sheet is prepared on the fiscal closing date for the accounts of a firm that may or

may not coincide with the calendar year-end of December 31st. Diff: 3 Var: 1

Skill: Analytical


Author: SS


22) What will be the effect on the balance sheet if a firm buys a new processing plant through a new loan?

Answer: The Assets side will increase under Net property, plant, and equipment with the net effect of

the new processing plant, while the Liabilities side will correspondingly show the new debt that was

incurred in paying for the plant. Diff: 3 Var: 1

Skill: Conceptual


Author: SS


23) Price-earnings ratios tend to be high for fast-growing firms.


Skill: Conceptual


Author: DS


43





2006 2005



Gross profit 109.9 182






Other income -- --




Taxes -5.5 -35.175







Refer to the income statement above. Luther's operating margin for the year ending December 31, 2005 is

closest to ________.

A) 10.18%

B) 16.29%

C) 20.36%

D) 24.43%

Answer: C

Explanation: C) Operating margin = Operating income / Sales = $114.6 / $562.8 = 0.2036 or 20.36% Diff: 1 Var: 50+

Skill: Analytical


Author: JN


44





2006 2005









Other income -- --




Taxes -5.5 -35.595







Refer to the income statement above. Luther's net profit margin for the year ending December 31, 2005 is


A) 11.61%

B) 5.80%

C) 9.28%

D) 13.93%

Answer: A

Explanation: A)

Diff: 1 Var: 50+

Skill: Analytical


Author: JN


45





2006 2005









Other income -- --




Taxes -5.5 -40.81







Refer to the income statement above. Luther's earnings before interest, taxes, depreciation, and

amortization (EBITDA) for the year ending December 31, 2005 is closest to ________.

A) $271.8 million

B) $108.7 million

C) $163.1 million

D) $135.9 million

Answer: D

Explanation: D)

Diff: 1 Var: 50+

Skill: Analytical


Author: JN


46





2006 2005









Other income -- --




Taxes -5.5 -42.315







Refer to the income statement above. Luther's return on equity (ROE) for the year ending December 31,

2005 is closest to ________.

A) 247.12%

B) 98.85%

C) 123.56%

D) 148.27%

Answer: C

Explanation: C)

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


47





2006 2005








Operating income 41.2 137

Other income -- --

Earnings before interest and taxes (EBIT) 41.2 137



Taxes -5.5 -42.945







Refer to the income statement above. Luther's return on assets (ROA) for the year ending December 31,

2005 is closest to ________.

A) 24.32%

B) 48.64%

C) 19.46%

D) 1.99%

Answer: A

Explanation: A) ROA = (Net income + Interest Expense) / Total assets

This is a little tricky in that Total Assets are not given in the problem. The student must remember the

basic balance sheet equation Total Liabilities and Shareholders' Equity is given and this is the

same as Total Assets. So,

Diff: 3 Var: 50+

Skill: Analytical


Author: JN


48



Income Statement for Xenon Manufacturing:

2008 2009

Total sales 202 212


Gross Profit 54 40

Selling, general,




Other income 4 6




Pretax income 14 12

Taxes -4 -3

Net Income 10 9

29) Consider the above Income Statement for Xenon Manufacturing. All values are in millions of dollars.

Calculate the operating margin for 2008 and 2009. What does the change in the operating margin between

these two years imply about the company?

A) The efficiency of Xenon Manufacturing has significantly risen between 2008 and 2009.

B) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of producing

them rose between 2008 and 2009.

C) The efficiency of Xenon Manufacturing has significantly fallen between 2008 and 2009.

D) The leverage of Xenon Manufacturing fell slightly between 2008 and 2009.

Answer: C

Explanation: C) 24 / 202 = 0.12; 16 / 212 = 0.08 Diff: 3 Var: 1

Skill: Analytical


Author: DS


49


30) Consider the above Income Statement for Xenon Manufacturing. All values are in millions of dollars.

Calculate the gross margin for 2008 and 2009. What does the change in the gross margin between these

two years imply about the company?

A) The efficiency of Xenon Manufacturing has significantly risen between 2008 and 2009.

B) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of producing

them rose between 2008 and 2009.

C) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of producing

them fell between 2008 and 2009.

D) The leverage of Xenon Manufacturing fell slightly between 2008 and 2009.


Skill: Analytical


Author: JP


31) In 2009, an agricultural company introduced a new cropping process which reduced the cost of

growing some of its crops. If sales in 2008 and 2009 were steady at $30 million, but the gross margin

increased from 2.8% to 3.9% between those years, by what amount was the cost of sales reduced?

A) $330,000

B) $660,000

C) $264,000

D) $462,000

Answer: A

Explanation: A) [($30 × 3.9%) - ($20 × 2.8%)] × 1,000,000 = $330,000 Diff: 2 Var: 27

Skill: Analytical


Author: DS


50


32)

Firm A: Firm B:

Assets Assets

Current assets 4 Current assets 7

Fixed assets 10 Fixed assets 7

Total assets 14 Total assets 14

Firm A: Firm B:

Total sales 12 Total sales 12

Cost of sales -5 Cost of sales -7

Gross Profit 7 Gross Profit 5

Above are portions of the balance sheet and income statement for two companies in 2008. Based upon

this information, which of the following statements is most likely to be true?

A) Asset turnover ratios indicate that firm A is generating greater revenue per dollar of assets than firm

B.

B) Fixed asset turnover ratios indicate that firm A generating fewer sales for the assets it employs than

firm B.

C) Both asset turnover ratios and fixed asset turnover ratios indicate that firm A is generating greater

revenue per dollar of assets than firm B.

D) Fixed asset turnover ratios indicate that firm A generating more sales for the assets it employs than

firm B.


Skill: Analytical


Author: DS


51


33) Balance Sheet

Assets Liabilities




Inventories 17








Total Liabilities and

Total Assets 210 Stockholders' Equity 210

Income Statement

Total sales 312

Cost of sales -210

Gross Profit 102

Selling, general,

and administrative expenses -34

Research and development -10

Depreciation and amortization -5

Operating Income 53

Other income -


and taxes (EBIT) 53

Interest income (expense) -20

Pretax income 33

Taxes -8

Net Income 25

The balance sheet and income statement of a particular firm are shown above. What does the account

receivable days ratio tell you about this company?

A) It takes on average about 4 weeks to collect payment from its customers.

B) It takes on average about 6 weeks to collect payment from its customers.

C) It takes on average about 7 weeks to collect payment from its customers.

D) It takes on average about 11 weeks to collect payment from its customers.


Skill: Analytical


Author: DS


52


34) Which of the following is the LEAST likely explanation for a firm's high ROE?

A) The firm is growing.

B) The firm is able to find investment opportunities that are very profitable.

C) The firm has very efficient use of its assets.

D) The firm enjoys high sales margins.


Skill: Analytical


Author: DS


35) Which of the following firms would be expected to have a high ROE?

A) a medical supply company that provides very precise instruments at a high price to large medical

establishments such as hospitals

B) a high-end fashion retailer that has a very high mark-up on all items it sells

C) a brokerage firm that has high levels of leverage

D) a grocery store chain that has very high turnover, selling many multiples of its assets per year


Skill: Conceptual


Author: DS


36) Which of the following firms would be expected to have a high ROE based on that firm's high

profitability?

A) a medical supply company that provides very precise instruments at a high price to large medical

establishments such as hospitals

B) a low-end retailer that has a low mark-up on all items it sells

C) a brokerage firm that has high levels of leverage

D) a grocery store chain that has very high turnover, selling many multiples of its assets per year


Skill: Conceptual


Author: JP


53


37) Manufacturer A has a profit margin of 2.2%, an asset turnover of 1.7 and an equity multiplier of 5.0.

Manufacturer B has a profit margin of 2.5%, an asset turnover of 1.2 and an equity multiplier of 4.7.

How much asset turnover should manufacturer B have to match manufacturer A's ROE?

A) 1.59%

B) 3.18%

C) 2.23%

D) 1.27%

Answer: A

Explanation: A) ROEA = 2.2 × 1.7 × 5.0 = 18.7; 18.7 / (2.5 × 4.7) = 1.59

Diff: 3 Var: 50+

Skill: Analytical


Author: DS


38) Firm A Firm B Firm C Firm D

Net Income $34.1 million $5.7 million $31.1 million $13.2 million

Market Capitalization $310 million $53 million $280 million $112 million

Earnings per share $4.10 $4.05 $6.75 $12.70

The above data is for four regional trucking firms. Based on price-earnings ratios, which firm's stock is

the best value?

A) Firm A

B) Firm B

C) Firm C

D) Firm D


Skill: Analytical


Author: DS


39) Why must care be taken when comparing a firm's share price to its operating income?

A) Both share price and operating income are related to the whole firm.

B) Share price is a quantity related to the entire firm, while operating income is an amount that is related

solely to equity holders.

C) Both share price and operating income are related solely to equity holders.

D) Share price is a quantity related to equity holders, while operating income is an amount that is related

to the whole firm.


Skill: Conceptual


Author: DS


54


2.7 Financial Reporting in Practice 1) Use of Generally Accepted Accounting Principles (GAAP) and auditors have eliminated the danger of

inadvertent or deliberate fraud in financial statements.


Skill: Conceptual


Author: DS


2) One way Enron manipulated its financial statements was to sell assets at inflated prices to other firms,

while giving a promise to buy back those assets at a later date. The incoming cash was recorded as

revenue, but the promise to buy back the assets was not disclosed. Which of the following is one of the

ways that such a transaction is deceptive?

A) The assets should have been listed on the balance sheet as long-term assets.

B) Cash raised by selling assets should not be recorded as revenue.

C) The off-balance sheet promises to repurchase assets should have been disclosed in management

discussion and analysis (MD&A) or notes to the financial statement.

D) Both B and C are deceptive.


Skill: Conceptual


Author: DS


3) WorldCom classified $3.85 billion in operating expenses as long-term investments. How would this

make WorldCom's financial statements more attractive to investors?

A) by decreasing depreciation

B) by reducing capital expenditures

C) by raising its reported earnings

D) by boosting its cash flows


Skill: Conceptual


Author: DS


55


4) Which of the following is NOT one of the ways that the Sarbanes-Oxley Act sought to improve the

accuracy of information given to both boards and shareholders?

A) by increasing the penalties to firms for providing false information

B) by increasing the independence of auditors and clients

C) by decreasing the non-audit fees that an auditor can receive from a client

D) by forcing companies to audit financial statements they release


Skill: Conceptual


Author: DS


5) What are the requirements of section 404 of SOX?

A) It requires that senior management return any profits or bonuses resulting from stock sales during any

period covered by financial statements that must later be restated.

B) It requires that auditors do not perform any non-auditing tasks for the companies they audit.

C) It requires that audit partners rotate every five years.

D) It requires that senior management and the boards of public companies attest to the effectiveness and

validity of their financial control process.


Skill: Conceptual


Author: DS


6) Which of the following is the main lesson that analysts and investors should take from the cases of

Enron and WorldCom?

A) The usefulness of financial statements to investors is entirely dependent on the ethics of those

constructing them.

B) It is not possible to effectively evaluate a company unless all the financial statements are fully and

correctly prepared.

C) The information in financial statements should be viewed extremely critically.

D) Readers of even fraudulent financial statements can spot signs of a firm's financial health, if those

statements are read fully and with care.


Skill: Conceptual


Author: DS


7) What role do external auditors play in a firm's financial reporting process?

Answer: As the name implies, external auditors act as third party monitors to a firm's financial reporting

process. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


56


8) What role does Generally Accepted Accounting Principles (GAAP) play in the accounting process?

Answer: All firms quoted on a U.S. exchange are required to use GAAP in their financial reporting

process. This standardization process makes it easier to adjust and/or compare the financial figures across

different firms. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


9) State the names of some of the firms discussed in the chapter that had inaccurate reporting in their

financial statements.

Answer: Examples of some firms that had practiced inaccurate reporting are Enron and WorldCom. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


10) According to the text, did Enron and WorldCom follow Generally Accepted Accounting Principles

(GAAP) in their financial reporting process?

Answer: Many of the problems of Enron and WorldCom were kept hidden from boards and

shareholders, until it was too late. People felt that the accounting statements of these companies, while

often remaining true to the letter of GAAP, did not present an accurate picture of the financial health of

the company. Diff: 2 Var: 1

Skill: Conceptual


Author: SS


1



Chapter 9 Fundamentals of Capital Budgeting

9.1 The Capital Budgeting Process 1) A capital budget lists the potential projects a company may undertake in future years.


Skill: Conceptual


Author: DS


2) Capital budgeting decisions use the Net Present Value rule so that those decisions maximize net

present value (NPV).


Skill: Conceptual


Author: DS


3) The capital budgeting process begins by ________.

A) analyzing alternate projects

B) evaluating the net present value (NPV) of each project's cash flows

C) compiling a list of potential projects

D) forecasting the future consequences for the firm of each potential project


Skill: Conceptual


Author: DS


4) The ultimate goal of the capital budgeting process is to ________.

A) determine how the consequences of making a particular decision affects the firm's revenues and costs

B) list the projects and investments that a company plans to undertake in the future

C) forecast the consequences of a list of future projects for the firm

D) determine the effect of the decision to accept or reject a project on the firm's cash flows


Skill: Conceptual


Author: DS


2


5) Which of the following best defines incremental earnings?

A) cash flows arising from a particular investment decision

B) the amount by which a firm's earnings are expected to change as a result of an investment decision

C) the earnings arising from all projects that a company plans to undertake in a fixed time span

D) the net present value (NPV) of earnings that a firm is expected to receive as the result of an investment

decision


Skill: Conceptual


Author: DS


6) Which of the following best describes why the predicted incremental earnings arising from a given

decision are not sufficient in and of themselves to determine whether that decision is worthwhile?

A) They do not tell how the decision affects the firm's reported profits from an accounting perspective.

B) They are not easily predicted from historical financial statements of a firm and its competitors.

C) These earnings are not actual cash flows.

D) They do not show how the firm's earnings are expected to change as the result of a particular decision.


Skill: Conceptual


Author: DS


7) What is the correct tax rate that should be used for capital budgeting decisions?

Answer: The correct tax rate that should be used is the firm's marginal tax rate, which is the tax rate paid

on the last dollar earned by the firm. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


8) How do we handle interest expense when making a capital budgeting decision?

Answer: We do not generally include interest expense when making capital budgeting decisions. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


3


9.2 Forecasting Incremental Earnings

1) When evaluating the effectiveness of an improved manufacturing process we should evaluate the total

sales and costs generated by this process.


Skill: Conceptual


Author: DS


2) Interest and other financing-related expenses are excluded when determining a project's unlevered net

income.


Skill: Conceptual


Author: DS


3) Cameron Industries is purchasing a new chemical vapor depositor in order to make silicon chips. It

will cost $6 million to buy the machine and $10,000 to have it delivered and installed. Building a clean

room in the plant for the machine will cost an additional $3 million. The machine is expected to have a

working life of six years. Which of these activities will be reported as an operating expense?

A) the delivery and install cost only

B) the cost of the depositor only

C) the delivery and install cost and the cost of the depositor

D) None of these costs should be reported an an operating expense.


Skill: Conceptual


Author: DS


4



will cost to buy the machine and $12,000 to have it delivered and installed. Building a clean

room in the plant for the machine will cost an additional The machine is expected to have a

working life of six years. If straight-line depreciation is used, what are the yearly depreciation expenses in

this case?

A) $666,667

B) $668,667

C) $1,166,667

D) $1,168,667

Answer: B

Explanation: B) ($4 million + $12,000) / 6 = $668,667 Diff: 1 Var: 27

Skill: Analytical


Author: DS


5) An oil company is buying a semi-submersible oil rig for $15 million. Additionally, it will cost

to move the oil rig to the oil-field and to prepare it for operations. If it is depreciated over five

years using straight-line depreciation, what are the yearly depreciation expenses in this case?

A) $2.7 million

B) $3.0 million

C) $3.3 million

D) $3.8 million

Answer: C

Explanation: C) $(15 + 1.5) / 5 = $3.3 million Diff: 1 Var: 12

Skill: Analytical


Author: DS


6) Which of the following is usually NOT a factor that must be considered when estimating the revenues

and costs arising from a new product?

A) the fluctuations in the cost of capital over the period in question

B) the sales of a new product will typically accelerate, plateau, and ultimately decline over time

C) the prices of technology products generally fall over time

D) competition tends to reduce profit margins over time in most industries


Skill: Analytical


Author: DS


5


7) Vernon-Nelson Chemicals is planning to release a new brand of insecticide, Bee-Safe, that will kill

many insect pests but not harm useful pollinators. Buying new equipment to manufacture the product

will cost and there will be an additional cost to reconfigure existing plant. The

equipment is expected to have a lifetime of nine years and will be depreciated by the straight-line method

over its lifetime. The firm expects that they should be able to sell 1,500,000 gallons per year at a price of

$53 per gallon. It will take $36 per gallon to manufacture and support the product. If Vernon-Nelson's

marginal tax rate is 40%, what are the incremental earnings after tax in year 3 of this project?

A) $25.5 million

B) $14.3 million

C) $23.8 million

D) $9.5 million

Answer: B

Explanation: B) 1.5 million × ($53 - $36) = $25.5 million;

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


8) CathFoods will release a new range of candies which contain anti-oxidants. New equipment to

manufacture the candy will cost which will be depreciated by straight-line depreciation over

six years. In addition, there will be spent on promoting the new candy line. It is expected that

the range of candies will bring in revenues of per year for five years with production and

support costs of $1.5 million per year. If CathFoods' marginal tax rate is 35%, what are the incremental

earnings in the second year of this project?

A) $2.492 million

B) $2.100 million

C) $3.833 million

D) $1.342 million

Answer: A

Explanation: A) Depreciation = 4 / 6 = $0.66666667 million; earnings before

earnings after

Diff: 1 Var: 12

Skill: Analytical


Author: DS


6


9) A small manufacturer that makes clothespins and other household products buys new injection

molding equipment for a cost of $500,000. This will allow the manufacturer to make more clothespins in

the same amount of time with an estimated increase in sales of 25%. If the manufacturer currently makes

75 tons of clothespins per year, which sell at $18,000 per ton, what will be the increase in revenue next

year from the new equipment?

A) $125,000

B) $303,750

C) $337,500

D) $837,500

Answer: C

Explanation: C) Incremental revenue = 25% × 75 × $18,000 = $337,500 Diff: 1 Var: 27

Skill: Analytical


Author: DS


10) Which of the following is NOT a factor that a manager should bear in mind when estimating a

project's revenues and costs?

A) Sales of a product will typically accelerate, stabilize, and then decline as the product becomes outdated

or faces increased competition.

B) A new product typically has its highest sales immediately after release as customers are attracted by

the novelty of the product.

C) The prices of technology products tend to fall over time as newer, superior technologies emerge and

production costs decline.

D) Prices and costs tend to rise with the general level of inflation in the economy.


Skill: Conceptual


Author: DS


7


11) A brewer is launching a new product: brewed ginger ale with a low alcohol content. The brewer plans

to spend promoting this product this year, which is expected to expand the sales of this

product to this year and next year. They do expect there will be loss of sales of

this year and next year in their other products as customers switch to drinking the new ginger

ale. The gross profit margin for the new ginger ale is 40%, the gross profit margin of all of the brewer's

other products is 30%, and the brewer's marginal corporate tax rate is 35%. What are incremental

earnings arising from the promotional campaign this year?

A) $1.625 million

B) $1.26 million

C) $2.11 million

D) $4.40 million

Answer: A

Explanation: A) ($11 - $4) × 40% - ($1 × 30%) = $2.5; $2.5 × 0.65 = $1.625 million Diff: 1 Var: 27

Skill: Analytical


Author: DS


12) A stationery company plans to launch a new type of indelible ink pen. Advertising for the new

product will be heavy and will cost the company $8 million, although the company expects general

revenues of $280 million next year from sources other than sales of the new pen. If the company has a

corporate tax-rate of 35% on its pretax income, what effect will the advertising for the new pen have on

its taxes?

A) It will increase taxes by $8 million.

B) It will increase taxes by $2.8 million.

C) It will have no effect on taxes.

D) It will reduce taxes by $2.8 million.

Answer: D

Explanation: D) $8 × 0.35 = $2.8 million Diff: 1 Var: 15

Skill: Analytical


Author: DS


13) Which of the following statements is FALSE?

A) We begin the capital budgeting process by determining the incremental earnings of a project.

B) The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre-tax

income.

C) Investments in plant, property, and equipment are directly listed as expense when calculating

earnings.

D) The opportunity cost of using a resource is the value it could have provided in its best alternative use.


Skill: Conceptual


Author: JN


8



A) Many projects use a resource that the company already owns.

B) When evaluating a capital budgeting decision, we generally include interest expense.

C) Only include as incremental expenses in your capital budgeting analysis the additional overhead

expenses that arise because of the decision to take on the project.

D) As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin

by forecasting earnings.


Skill: Conceptual


Author: JN


15) Which of the following costs would you consider when making a capital budgeting decision?

A) sunk cost

B) opportunity cost

C) interest expense

D) fixed overhead cost


Skill: Conceptual


Author: JN


16) Ford Motor Company is considering launching a new line of hybrid diesel-electric SUVs. The heavy

advertising expenses associated with the new SUV launch would generate operating losses of million

next year. Without the new SUV, Ford expects to earn pre-tax income of $80 million from operations next

year. Ford pays a 35% tax rate on its pre-tax income. The amount that Ford Motor Company owes in taxes

next year without the launch of the new SUV is closest to ________.

A) $28.0 million

B) 12.3 million

C) $40.3 million

D) $15.8 million

Answer: A

Explanation: A) $80 × 0.35 = $28.0 million Diff: 1 Var: 12

Skill: Analytical


Author: JN


9


17) Ford Motor Company is considering launching a new line of hybrid diesel-electric SUVs. The heavy

advertising expenses associated with the new SUV launch would generate operating losses of $30 million

next year. Without the new SUV, Ford expects to earn pre-tax income of $80 million from operations next

year. Ford pays a 30% tax rate on its pre-tax income. The amount that Ford Motor Company owes in taxes

next year with the launch of the new SUV is closest to ________.

A) $15.0 million

B) $9.0 million

C) $33.0 million

D) $24.0 million

Answer: D

Explanation: D) $80 × 0.30 = $24.0 million Diff: 1 Var: 30

Skill: Analytical


Author: JN


18) Food For Less (FFL), a grocery store, is considering offering one-hour photo developing in their store.

The firm expects that sales from the new one-hour machine will be $175,000 per year. FFL currently offers

overnight film processing with annual sales of $90,000. While many of the one-hour photo sales will be to

new customers, FFL estimates that 40% of their current overnight photo customers will switch and use

the one-hour service. The level of incremental sales associated with introducing the new one hour photo

service is closest to ________.

A) $139,000

B) $175,000

C) $36,000

D) $70,000

Answer: A

Explanation: A)

Diff: 1 Var: 46

Skill: Analytical


Author: JN


19) Which of the following would you NOT consider when making a capital budgeting decision?

A) the additional taxes a firm would have to pay in the next year

B) the cost of a marketing study completed last year

C) the opportunity to lease out a warehouse instead of using it to house a new production line

D) the change in direct labor expense due to the purchase of a new machine

Answer: B

Explanation: B) This is a sunk cost. Diff: 1 Var: 1

Skill: Conceptual


Author: WC


10


20) Which of the following is an example of cannibalization?

A) A toothpaste manufacturer adds a new line of toothpaste (that contains baking soda) to its product

line.

B) A grocery store begins selling T-shirts featuring the local university's mascot.

C) A basketball manufacturer adds basketball hoops to its product line.

D) A convenience store begins selling pre-paid cell phones.


Skill: Conceptual


Author: WC


21) How are the taxes paid under MACRS different from that paid under straight-line depreciation?

Answer: We are not paying less in taxes when using MACRS, but it is the timing of the tax payment that

is different. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


22) If available, should MACRS be preferred to straight-line depreciation?

Answer: Yes, MACRS should be preferred to straight-line depreciation due to the time value of money.

While both methods pay the same amount in taxes, MACRS gives more money in the pocket in the initial

days. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


9.3 Determining Incremental Free Cash Flow

1) To evaluate a capital budgeting decision, it is sufficient to determine its consequences for the firm's

earnings.


Skill: Conceptual


Author: DS


2) The cash flow effect from a change in Net Working Capital is always equal in size and opposite in sign

to the changes in Net Working Capital.


Skill: Conceptual


Author: DS


11


3) Which of the following adjustments should NOT be made when computing free cash flow from

incremental earnings?

A) adding depreciation

B) adding all non-cash expenses

C) subtracting increases in Net Working Capital

D) subtracting depreciation expenses from taxable earnings


Skill: Conceptual


Author: DS



will cost $5,000,000 to buy the machine and $10,000 to have it delivered and installed. Building a clean

room in the plant for the machine will cost an additional $3 million. The machine is expected to raise

gross profits by $4,500,000 per year, starting at the end of the first year, with associated costs of $1 million

for each of those years. The machine is expected to have a working life of six years and will be

depreciated over those six years. The marginal tax rate is 40%. What are the incremental free cash flows

associated with the new machine in year 2?

A) $835,000

B) $2,665,000

C) $2,434,000

D) $831,667

Answer: C

Explanation: C) Depreciation = ($5,000,000 + $10,000) / 6 = $835,000;

$4,500,000 - 1,000,000 - $835,000 = $2,665,000;

$2,665,000 × (0.6) = $1,599,000; add back depreciation to get $2,434,000. Diff: 2 Var: 50+

Skill: Analytical


Author: DS


5) Which of the following formulas will correctly calculate Net Working Capital?

A) Cash + Inventory + Receivables + Payables

B) Cash + Inventory + Receivables - Payables

C) Cash + Inventory - Receivables + Payables

D) Cash - Inventory + Receivables + Payables


Skill: Conceptual


Author: DS


12



will cost $7,000,000 to buy the machine and $20,000 to have it delivered and installed. Building a clean

room in the plant for the machine will cost an additional $3 million. The machine is expected to raise

gross profits by $4,500,000 per year, starting at the end of the first year, with associated costs of $1 million

for each of those years. The machine is expected to have a working life of seven years and will be

depreciated over those seven years. The marginal tax rate is 40%. What are the incremental free cash

flows associated with the new machine in year 0?

A) -$10,020,000

B) -$7,000,000

C) -$9,018,000

D) $1,002,857

Answer: A

Explanation: A) -$7,000,000 - $20,000 - $3,000,000 = -$10,020,000 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


7) CathFoods will release a new range of candies which contain antioxidants. New equipment to

manufacture the candy will cost $2 million, which will be depreciated by straight-line depreciation over

four years. In addition, there will be $5 million spent on promoting the new candy line. It is expected that

the range of candies will bring in revenues of $4 million per year for four years with production and

support costs of $1.5 million per year. If CathFoods' marginal tax rate is 35%, what are the incremental

free cash flows in the second year of this project?

A) $1.800 million

B) $1.400 million

C) $2.000 million

D) $0.700 million

Answer: A

Explanation: A) Depreciation = $2 / 4 = $0.5;

Diff: 1 Var: 10

Skill: Analytical


Author: DS


13


8) Balance Sheet

Assets Liabilities


Cash $47 Accounts payable $40

Accounts receivable 23 Total current liabilities 40

Inventories 16

Total current assets 86





Total Assets 250 Total Liabilities 210


Total Liabilities and


250

The balance sheet for a small firm is shown above. All amounts are in thousands of dollars. What is this

firm's Net Working Capital?

A) $126 thousand

B) $7 thousand

C) $46 thousand

D) $86 thousand

Answer: C

Explanation: C)

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


9) A firm reports that in a certain year it had a net income of $5.0 million, depreciation expenses of $3.0

million, capital expenditures of $2.0 million, and Net Working Capital decreased by $1.1 million. What is

the firm's free cash flow for that year?

A) $11.1 million

B) $7.1 million

C) $5.1 million

D) $4.9 million

Answer: B

Explanation: B)

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


14


10) A company buys tracking software for its warehouse which, along with the computer system and

ancillaries to run it, will cost $1.6 million. This purchase will be deducted over five years. It is expected

that the software will reduce inventory by $10.7 million at the end of the first year after it is installed,

though there will be an annual cost of $120,000 per year to run the system. If the company's marginal tax

rate is 40%, how will the purchase of this item change the company's free cash flows in the first year?

A) $10.756 million

B) $10.380 million

C) $9.680 million

D) $11.832 million

Answer: A

Explanation: A) (

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


11)

Cromwell Industries is considering a new project which will have costs, revenues, etc. as shown by the

data above. If the cost of capital is 8.0%, what is the net present value (NPV) of this project?

A) -$56,662

B) -$59,810

C) $62,958

D) $69,254

Answer: C

Explanation: C)

Using a financial calculator, ,

Diff: 2 Var: 50+

Skill: Analytical


Author: DS


15


12)

A garage is installing a new "bubble-wash" car wash. It will promote the car wash as a fun activity for the

family, and it is expected that the novelty of this approach will boost sales in the medium term. If the cost

of capital is 10%, what is the net present value (NPV) of this project?

A) -$135,493

B) -$143,021

C) $165,603

D) $150,548

Answer: D

Explanation: D) CF1 = -7410 + 75,000 + 5,000 = 72,590;

CF2 and 3 = 90,090 + 75,000 + 5,000 = 170,090;

CF4 = 60,840 + 75,000 + 5,000 = 140,840;

Using a financial calculator, CF0 = -280,000, CF1 = 72,590, CF2 = 170,090,

CF3 = 170,090, CF4 = 140,840; calculating NPV at 10% = $150,548. Diff: 2 Var: 50+

Skill: Analytical


Author: DS


13) Your firm is considering building a new office complex. Your firm already owns land suitable for the

new complex. The current book value of the land is $130,000; however, a commercial real estate agent has

informed you that an outside buyer is interested in purchasing this land would be willing to pay $700,000

for it. When calculating the net present value (NPV) of your new office complex, ignoring taxes, the

appropriate incremental cash flow for the use of this land is ________.

A) $700,000

B) $0

C) $130,000

D) $830,000

Answer: A

Explanation: A) It is appropriate to use the market value. If taxes are included, the value would be the

after-tax value of the land. Diff: 2 Var: 50+

Skill: Definition


Author: JN


16


14) You are considering adding a microbrewery onto one of your firm's existing restaurants. This will

entail an increase in inventory of $8700, an increase in accounts payables of $2300, and an increase in

property, plant, and equipment of $48,000. All other accounts will remain unchanged. The change in net

working capital resulting from the addition of the microbrewery is ________.

A) $54,400

B) $11,000

C) $7680

D) $6400

Answer: D

Explanation: D)

Diff: 1 Var: 50+

Skill: Analytical


Author: JN


15) You are considering adding a microbrewery onto one of your firm's existing restaurants. This will

entail an investment of $47,000 in new equipment. This equipment will be depreciated straight-line over

five years. If your firm's marginal corporate tax rate is 35%, then what is the value of the microbrewery's

depreciation tax shield in the first year of operation?

A) $3290

B) $16,450

C) $6110

D) $30,550

Answer: A

Explanation: A) First figure out the straight-line depreciation.

$47,000 / 5 years = $9400 depreciation per year.

Then 0.35 × $9400 = $3290 depreciation tax shield per year. Diff: 1 Var: 42

Skill: Analytical


Author: JN


16) The Sisyphean Company is considering a new project that will have an annual depreciation expense

of $3.6 million. If Sisyphean's marginal corporate tax rate is 35% and its average corporate tax rate is 30%,

then what is the value of the depreciation tax shield on the company's new project?

A) $1,080,000

B) $1,260,000

C) $1,890,000

D) $1,134,000

Answer: B

Explanation: B) Here we need to use the marginal tax rate.

Diff: 1 Var: 32

Skill: Analytical


Author: JN


17


17) The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an

estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated

straight line over its three-year life to a residual value of $0.

The cane manufacturing machine will result in sales of 2500 canes in year 1. Sales are estimated to grow

by 9% each year through year 3. The price per cane that Sisyphean will charge its customers is $16 each

and is to remain constant. The canes have a cost per unit to manufacture of $10 each.

Installation of the machine and the resulting increase in manufacturing capacity will require an increase

in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 3%

of its annual sales in cash, 5% of its annual sales in accounts receivable, 10% of its annual sales in

inventory, and 5% of its annual sales in accounts payable. The firm is in the 35% tax bracket and has a

cost of capital of 9%.

The required net working capital in the first year for the Sisyphean Corporation's project is closest to

________.

A) $5200

B) $5668

C) -$2800

D) $9200

Answer: A

Explanation: A) Net Working Capital Forecast

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


18













The required net working capital in the second year for the Sisyphean Corporation's project is closest to

________.

A) $4114

B) $3740

C) -$3366

D) $8602

Answer: A

Explanation: A) Net Working Capital Forecast

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


19













The change in net working capital from year 1 to year 2 is closest to ________.

A) a decrease of $356

B) an increase of $356

C) an increase of $389

D) a decrease of $389

Answer: B

Explanation: B) Net Working Capital Forecast

Change = $4316 - $3960 = $356 Diff: 2 Var: 50+

Skill: Analytical


Author: JN


20


20) Bubba Ho-Tep Company reported net income of $290 million for the most recent fiscal year. The firm

had depreciation expenses of $100 million and capital expenditures of $150 million. Although it had no

interest expense, the firm did have an increase in net working capital of $30 million. What is Bubba Ho-

Tep's free cash flow?

A) $10 million

B) $210 million

C) $270 million

D) $570 million

Answer: B

Explanation: B) FCF = NI + Dep - Capital Ex - inc. in NWC

= $290 million + $100 million - $150 million - $30 million = $210 million Diff: 2 Var: 50+

Skill: Analytical


Author: JN


21) Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a

temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this

facility to various agencies and groups providing relief services to the area. THSI estimates that this

project will initially cost $6 million to set up and will generate $22 million in revenues during its first and

only year in operation (paid in one year). Operating expenses are expected to total $11 million during this

year and depreciation expense will be another $2 million. THSI will require no working capital for this

investment. THSI's marginal tax rate is 35%.

Ignoring the original investment of $5 million, what is THSI's free cash flow for the first and only year of

operation?

A) $6.00 million

B) $3.85 million

C) $9.81 million

D) $7.85 million

Answer: D

Explanation: D) FCF = (revenues - expenses - depreciation) × (1 - tax rate) + depreciation

FCF = ($22 - $11 - $2) × (1 - 0.35) + $2 = $7.85 million Diff: 2 Var: 50+

Skill: Analytical


Author: JN


21


22) Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a

temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this

facility to various agencies and groups providing relief services to the area. THSI estimates that this

project will initially cost $5 million to set up and will generate $21 million in revenues during its first and

only year in operation (paid in one year). Operating expenses are expected to total $8 million during this

year and depreciation expense will be another $2 million. THSI will require no working capital for this

investment. THSI's marginal tax rate is 35%

Assume that THSI's cost of capital for this project is 15%. The net present value (NPV) of this temporary

housing project is closest to ________.

A) $2,956,522

B) -$9.15

C) $5,913,044

D) -$2,956,522

Answer: A

Explanation: A) million

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


23) Shepard Industries is evaluating a proposal to expand its current distribution facilities. Management

has projected the project will produce the following cash flows for the first two years (in millions).

Year 1 2

Revenues 1050 1425

Operating expense 375 550

Depreciation 230 280

Increase in working capital 50 80

Capital expenditures 270 320

Marginal corporate tax rate 30% 30%

The depreciation tax shield for Shepard Industries project in year 1 is closest to ________.

A) $84 million

B) $104 million

C) $83 million

D) $69 million

Answer: D

Explanation: D) $230 × 0.30 = $69 million Diff: 1 Var: 50+

Skill: Analytical


Author: JN


22


24) Shepard Industries is evaluating a proposal to expand its current distribution facilities. Management

has projected that the project will produce the following cash flows for the first two years (in millions of

dollars).

Year 1 2

Revenues 1000 1325

Operating expense 400 550

Depreciation 230 300

Increase in working capital 40 80

Capital expenditures 250 300

Marginal corporate tax rate 30% 30%

The depreciation tax shield for Shepard Industries project in year 2 is closest to ________.

A) $90 million

B) $69 million

C) $135 million

D) $108 million

Answer: A

Explanation: A) $300 × 0.30 = $90 million Diff: 1 Var: 50+

Skill: Analytical


Author: JN


23


25) Epiphany Industries is considering a new capital budgeting project that will last for three years.

Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it

has prepared the following incremental cash flow projects:

Year 0 1 2 3

Sales (Revenues) 100,000 100,000 100,000

- Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000

- Depreciation 30,000 30,000 30,000

= EBIT 20,000 20,000 20,000

- Taxes (35%) 7000 7000 7000

= unlevered net income 13,000 13,000 13,000

+ Depreciation 30,000 30,000 30,000

+/(-) increase/(decrease) in working

capital 5,000 5,000 5,000

- capital expenditures -90,000

The free cash flow for the first year of Epiphany's project is closest to ________.

A) $45,600

B) $28,500

C) $38,000

D) $53,200

Answer: C

Explanation: C) Year 0 1 2 3

Sales (Revenues) 100,000 100,000 100,000


- Depreciation 30,000 30,000 30,000

= EBIT 20,000 20,000 20,000

- Taxes (35%) 7000 7000 7000


+ Depreciation 30,000 30,000 30,000


capital 5,000 5,000 5,000


Free Cash = -90,000 38,000

Increase in working capital requirements represent decrease in free cash flow. Diff: 2 Var: 15

Skill: Analytical


Author: JN


24





Year 0 1 2 3

Sales (Revenues) $150,000 $150,000 $150,000


- Depreciation 20,000 20,000 20,000

= EBIT 55,000 55,000 55,000

- Taxes (35%) 19,250 19,250 19,250


+ Depreciation 20,000 20,000 20,000


capital 5,000 5,000 -10,000

- capital expenditures -$90,000

The free cash flow for the last year of Epiphany's project is closest to ________.

A) $65,750

B) $59,175

C) $49,313

D) $52,600

Answer: A

Explanation: A) Year 0 1 2 3

Sales (Revenues) $150,000 $150,000 $150,000


- Depreciation 20,000 20,000 20,000

= EBIT 55,000 55,000 55,000

- Taxes (35%) 19,250 19,250 19,250


+ Depreciation 20,000 20,000 20,000


capital 5,000 5,000 -10,000

- capital expenditures -$90,000

= Free Cash Flow -$90,000 65,750

Decrease in working capital requirements represents increase in free cash flow. Diff: 2 Var: 15

Skill: Analytical


Author: JN


25





Year 0 1 2 3

Sales (Revenues) 150,000 150,000 150,000


- Depreciation 25,000 25,000 25,000

= EBIT 50,000 50,000 50,000

- Taxes (35%) 17,500 17,500 17,500


+ Depreciation 25,000 25,000 25,000

+(-) increase/(decrease) in working

capital 5,000 5,000 -10,000


The net present value (NPV) for Epiphany's Project is closest to ________.

A) $23,387

B) $140,319

C) $46,773

D) $93,546

Answer: C

Explanation: C) Year 0 1 2 3

Sales (Revenues) 150,000 150,000 150,000


- Depreciation 25,000 25,000 25,000

= EBIT 50,000 50,000 50,000

- Taxes (35%) 17,500 17,500 17,500


+ Depreciation 25,000 25,000 25,000

+(-) increase/(decrease) in working

capital 5000 5000 -10,000


= Free Cash Flow -90,000 52,500 52,500 67,500

PV of FCF (FCF/ -90,000 46,875.00 41,852.68 48,045.17

discount rate 0.12

NPV = 46,773

Diff: 2 Var: 15

Skill: Analytical


Author: JN


26


28) Luther Industries has outstanding tax loss carryforwards of $72 million from losses over the past four

years. If Luther earns $15 million per year in pre-tax income from now on, in how many years will Luther

first pay taxes?

A) 7 years

B) 2 years

C) 4 years

D) 5 years

Answer: D

Explanation: D) The number of years the tax loss carryforwards will last can be calculated as the tax loss

carryforward dividend by the annual pre-tax income or:

years with no so Luther won't have to pay taxes for the next four years, but

will have to start paying some taxes five years from now. Diff: 1 Var: 14

Skill: Analytical


Author: JN


29) A firm is considering changing their credit terms. It is estimated that this change would result in sales

increasing by $1,600,000. This in turn would cause inventory to increase by $125,000, accounts receivable

to increase by $100,000, and accounts payable to increase by $90,000. What is the firm's expected change

in net working capital?

A) $1,735,000

B) $315,000

C) $225,000

D) $135,000

Answer: D

Explanation: D)

Diff: 1 Var: 50+

Skill: Analytical


Author: WC


30) A firm is considering investing in a new machine that will cost $400,000 and will be depreciated

straight-line over five years. If the firm's marginal tax rate is 39%, what is the annual depreciation tax

shield of purchasing the machine?

A) $80,000

B) $31,200

C) $28,080

D) $156,000

Answer: B

Explanation: B) $400,000 / 5 = $80,000; $80,000 × 0.39 = $31,200 Diff: 1 Var: 27

Skill: Analytical


Author: WC


27


31) A firm is considering a new project that will generate cash revenue of $1,300,000 and cash expenses of

$700,000 per year for five years. The equipment necessary for the project will cost $300,000 and will be

depreciated straight line over four years. What is the expected free cash flow in the second year of the

project if the firm's marginal tax rate is 35%?

A) $374,625

B) $341,250

C) $416,250

D) $499,500

Answer: C

Explanation: C) Annual

Diff: 1 Var: 50+

Skill: Analytical


Author: WC




straight line over its three-year life to a residual value of


by 10% per year each year through year 3. The price per cane that Sisyphean will charge its customers is

each and is to remain constant. The canes have a cost per unit to manufacture of each.






The depreciation tax shield for the Sisyphean Corporation's project in the first year is closest to ________.

A) $10,500

B) $3500

C) $3150

D) $2800

Answer: B

Explanation: B) Depreciation tax

Diff: 1 Var: 15

Skill: Analytical


Author: JN


33) If a business owner is using the extra space at home for his business, does it imply a zero opportunity

cost for the space?

Answer: As long as there is an alternative use of the place, it has an opportunity cost. Opportunity cost of

idle assets is often mistaken as zero, but that is inaccurate. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


28


9.4 Other Effects on Incremental Free Cash Flows

1) Firms should use the most accelerated depreciation scheme allowable.


Skill: Conceptual


Author: DS


2) An announcement by the government that they will decrease corporate marginal tax rates in the future

would increase the attractiveness of MACRS depreciation.


Skill: Conceptual


Author: DS


3) The term "cannibalization" refers to ________.

A) decrease in the sales of current project caused by the launching of new project

B) decrease in the sunk cost caused by launching of new project

C) decrease in overhead expenses incurred due to launch of new project

D) cost of using a resource for the best value it could provide in its best alternative


Skill: Definition


Author: JN


4) A company spends $20 million researching whether it is possible to create a durable plastic from the

process waste from feedstock preparation. The $20 million should best be considered ________.

A) as a sunk cost

B) as an opportunity cost

C) as a fixed overhead expense

D) as a capital cost


Skill: Conceptual


Author: DS


29


5) Joe pre-orders a non-refundable movie ticket. He then reads a number of reviews of the movie in

question that make him realize that he will not enjoy it. He goes to see it anyway, rationalizing that

otherwise his money will have been wasted. Is Joe succumbing to the Sunk Cost Fallacy, and why?

A) Yes, since he invested a valuable asset, his time, in a project based on its previous costs.

B) No, because the cost of the movie was not recoverable and would have been lost whatever action he

took.

C) No, because going to see the movie means that the product of his initial investment was realized as

originally planned.

D) Yes, because he incurred no further costs by going to see the movie.


Skill: Conceptual


Author: DS


6) An insurance office owns a large building downtown. The sixth floor of this building currently houses

its entire Human Resources Department. After carrying out a survey to see whether the sixth floor could

be rented and for what price, the company must decide whether to split the Human Resources

Department between currently unoccupied spaces on several floors and rent out the entire sixth floor or

to leave things as they currently are. Which of the following should NOT be considered when deciding

whether to rent out the sixth floor?

A) the amount obtained by renting the sixth floor

B) the cost of refurbishing the new space to be occupied by the Human Resources Department

C) cost involved with a loss of efficiency resulting from the Human Resources Department being split

between several spaces

D) the cost of the research into the feasibility of renting the sixth floor


Skill: Conceptual


Author: DS


7) Which of the following is an example of cannibalization?

A) A toothpaste manufacturer adds a new line of toothpaste (that contains baking soda) to its product

line.

B) A grocery store begins selling T-shirts featuring the local university's mascot.

C) A basketball manufacturer adds basketball hoops to its product line.

D) A convenience store begins selling pre-paid cell phones.


Skill: Conceptual


Author: WC


30


8)

A fast-food company invests $2.2 million to buy machines for making slurpees. These can be depreciated

using the MACRS schedule shown above. If the cost of capital is 10%, what is the increase in the net

present value (NPV) of the product gained by using MACRS depreciation over straight-line depreciation

for three years?

A) $28,559

B) $47,599

C) $76,158

D) $190,321

Answer: D

Explanation: D) Incremental cash flows:

using a financial calculator, NPV at 10% equals $190,321.

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


9)

A textile company invests $10 million in an open-end spinning machine. This was depreciated using the

seven-year MACRS schedule shown above. If the company sold it immediately after the end of year 3 for

$7 million, what would be the after-tax cash flow from the sale of this asset, given a tax rate of 40%?

A) $1,550,400

B) $3,124,000

C) $3,876,000

D) $5,449,600

Answer: D

Explanation: D)

Diff: 1 Var: 12

Skill: Analytical


Author: DS


31


10)

A bakery invests $40,000 in a light delivery truck. This was depreciated using the five-year MACRS

schedule shown above. If the company sold it immediately after the end of year 2 for $21,000, what

would be the after-tax cash flow from the sale of this asset, given a tax rate of 40%?

A) $11,520

B) $9480

C) $3792

D) $17,208

Answer: D

Explanation: D)

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


11)

Massive Amusements, an owner of theme parks, invests $65 million to build a roller coaster. This can be

depreciated using the MACRS schedule shown above. How much less is the depreciation tax shield for

year 4 under MACRS depreciation than under 7-year, straight-line depreciation, if the tax rate is 35%?

A) $974,680

B) $1,218,350

C) $2,193,030

D) $6,091,750

Answer: B

Explanation: B)

Diff: 1 Var: 22

Skill: Analytical


Author: DS


32


12)

Year 0 Year 1 Year 2 Year 3

Revenues 500,000 500,000 500,000

- Cost of Goods Sold -150,000 -150,000 -150,000

- Depreciation -100,000 -100,000 -100,000

= EBIT 250,000 250,000 250,000

- Taxes (35%) -87,500 -87,500 -87,500

= Unlevered net income 162,500 162,500 162,500

+ Depreciation 100,000 100,000 100,000

- Additions to Net Working Capital -20,000 -20,000 -20,000

- Capital Expenditures -300,000

= Free Cash Flow 242,500 242,500 242,500

Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive research,

they come up with the above estimates of free cash flow from this project. The depreciation schedule

shown is for three-year, straight-line depreciation. By how much would the net present value (NPV) of

this project be increased, if the cars were depreciated by the MACRS schedule shown below given that

the cost of capital is 10%?

A) $7266

B) $9082

C) $10,898

D) $22,705

Answer: B

Explanation: B) NPV straight-line depreciation = $303,062

NPV MACRS depreciation = $312,144

Difference = $9082

- 1 2 3

Re $500,000 $500,000 $500,000

COGS $(150,000) $ (150,000) $(150,000)

DEP $(100,000) $ (100,000) $(100,000)

EBIT $ 250,000 $ 250,000 $ 250,000

Taxes $(87,500) $ (87,500) $(87,500)

Unlev NI $ 162,500 $ 162,500 $ 162,500

DEP $100,000 $ 100,000 $100,000

WC $(20,000) $ (20,000) $(20,000)

CAPEX $(300,000)

FCF $ 242,500 $ 242,500 $ 242,500

NPV $303,062

33


- 1 2 3

Re $500,000 $500,000 $500,000

COGS $(150,000) $(150,000) $(150,000)

DEP $(99,990) $(133,350) $(44,430) $(22,230)

EBIT $(99,990) $ 216,650 $ 305,570 $327,770

Taxes $34,997 $(75,828) $(106,950) $(114,720)

Unlev NI $(64,994) $ 140,822 $ 198,620 $ 213,050

DEP $99,990 $ 133.350 $ 44,430 $22,230

WC $ (20,000) $(20,000) $(20,000)

CAPEX $(300,000)

FCF $(265,004) $ 254,172 $ 223,050 $ 215,280

NPV $312,144

$312,144 - $303,062 = $9082 Diff: 1 Var: 35

Skill: Analytical


Author: DS


13) Which of the following best explains why is it sensible for a firm to use an accelerated depreciation

schedule such as MACRS rather than straight-line depreciation?

A) The firm will substantially decrease its depreciation tax shield across all of the depreciation timeline.

B) The firm can decide over how many years an item may be depreciated, thus allowing it full control of

its depreciation expenses.

C) The firm will have substantially fewer depreciation expenses later in the depreciation timeline.

D) The firm will receive greater benefits to its cash flow earlier in the depreciation timeline and thus

increase net present value (NPV).


Skill: Conceptual


Author: DS


34


14)


MACRS

Depreciation Rate 33.33% 44.45% 14.81% 7.41%

A machine is purchased for $575,000 and is used through the end of Year 2. The machine will be

depreciated using the 3-Year MACRS schedule. At the end of Year 2, the machine is sold for $75,000.

What is the after-tax cash flow from the sale of the machine at the end of Year 2 if the firm's marginal tax

rate is 35%?

A) $42,608

B) $15,916

C) $32,392

D) $63,663

Answer: D

Explanation: D)

Diff: 1 Var: 50+

Skill: Analytical


Author: WC


15)


MACRS

Depreciation Rate 33.33% 44.45% 14.81% 7.41%

A firm is considering the purchase of a new machine for $325,000. The firm is unsure if it should use the

3-Year MACRS schedule or straight-line depreciation over three years. What is the difference in the book

value after three years if the firm uses MACRS instead of straight-line depreciation?

A) $0

B) $24,083

C) $48,166

D) $300,918

Answer: A

Explanation: A) At the end of three years, both will be completely depreciated, thus

Diff: 1 Var: 9

Skill: Analytical


Author: WC


35


16) What are the most difficult parts of capital budgeting?

Answer: The most difficult part of capital budgeting is deciding how to estimate the cash flows and the

cost of capital. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


17) What is the most important function of sensitivity analysis?

Answer: Sensitivity analysis shows how the net present value (NPV) varies as the underlying

assumptions change. Thus we understand the critical assumptions underlying the project. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


18) What do you understand by break-even analysis?

Answer: Break-even analysis is an extension of sensitivity analysis basically telling us the minimum level

of different parameters that would give a zero net present value (NPV). Diff: 1 Var: 1

Skill: Conceptual


Author: SS


19) How are the taxes paid under MACRS different from that paid under straight-line depreciation?

Answer: We are not paying less in taxes when using MACRS, but it is the timing of the tax payment that

is different. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


20) If available, should MACRS be preferred to straight-line depreciation?

Answer: Yes, MACRS should be preferred to straight-line depreciation due to the time value of money.

While both methods pay the same amount in taxes, MACRS gives more money in the pocket in the initial

days. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


36


21) What are project externalities?

Answer: Project externalities are indirect effects of the project that may increase or decrease the profits of

other business activities of the firm. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


22) What are sunk costs?

Answer: Sunk costs are payments already made or that will be made that are independent of the project

under discussion. These are costs for which the firm is already liable. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


9.5 Analyzing the Project 1) The most difficult part of the capital budgeting process is accurately estimating cash flows and cost of

capital.


Skill: Conceptual


Author: DS


37


Use the figure for the question(s) below.

2) A consumer good company is developing a new brand of organic toothpaste. Above is the sensitivity

analysis for this product. The assumptions regarding which parameter should be scrutinized most

carefully in the estimation process?

A) units sold

B) sales price

C) cost of goods

D) cost of capital


Skill: Conceptual


Author: DS


3) A consumer good company is developing a new brand of organic toothpaste. Above is the sensitivity

analysis for this product. If the best-case assumptions for Net Working Capital are met, what will the net

present value (NPV) of this project be?

A) $0.65 million

B) $1.7 million

C) $2 million

D) $3 million

Answer: B

Explanation: B) As observed from the given graph Diff: 1 Var: 1

Skill: Conceptual


Author: DS


38


4) A company planning to market a new model of motor scooter analyzes the effect of changes in the

selling price of the motor scooter, the number of units that will be sold, the cost of making the motor

scooter, the effect on Net Working Capital, and the cost of capital for the project. They predict that the

break-even point for sales price for the motor scooter is $2,480. What does this mean?

A) If the motor scooter is sold for $2,480, then the project will make a profit.

B) If the motor scooter is sold for $2,480, then the net present value (NPV) for the product will be zero.

C) The predicted selling price of the motor scooter is $2,480.

D) The maximum that the motor scooter can sell for and still make the project have a positive net present

value (NPV) is $2,480.


Skill: Conceptual


Author: DS


Use the figure for the question(s) below.

5) The graph above shows the break-even analysis for the cost of making a certain good. Based on this

chart, which of the following is true?

A) The net present value (NPV) of the project increases with increased cost of goods sold.

B) The project should not be undertaken if the predicted cost of goods sold is less than $110.

C) The net present value (NPV) of the project will be positive if the cost of goods sold is greater than $110.

D) If the good costs $110 to make, the net present value (NPV) of the project will be zero.


Skill: Conceptual


Author: DS


39


6) The EBIT break-even point can be calculated using which of the following formulas?

A) (Units Sold × Sale Price) - (Units Sold × Cost per unit) - SG&A - Depreciation = 0

B) (Units Sold × Sale Price) + (Units Sold × Cost per unit) - SG&A - Depreciation = 0

C) (Units Sold × Sale Price) - (Units Sold × Cost per unit) + SG&A + Depreciation = 0

D) (Units Sold × Sale Price) + (Units Sold × Cost per unit) + SG&A - Depreciation = 0


Skill: Conceptual


Author: DS


7) A maker of computer games expects to sell 475,000 games at a price of $48 per game. These units cost

$10 to produce. Selling, general, and administrative expenses are $1.0 million and depreciation is

$280,000. What is the EBIT break-even point for the number of games sold in this case?

A) $26,667

B) $26,316

C) $100,000

D) $33,684

Answer: D

Explanation: D) Units sold = $1,280,000 / $38 = $33,684 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


8) A maker of kitchenware is planning on selling a new chef-quality kitchen knife. The manufacturer

expects to sell 1.6 million knives at a price of $120 each. These knives cost $80 each to produce. Selling,

general, and administrative expenses are $500,000. The machinery required to produce the knives cost

$1.4 million, depreciated by straight-line depreciation over five years. The maker determines that the

EBIT break-even point for units sold and sale price is less than these estimates and that the EBIT break-

even point for costs per unit, SG&A, and depreciation are greater than these estimates, so decides to go

ahead with manufacturing the knife. Was this the correct decision?

A) No, since the cost per unit should be greater than the EBIT break-even point for cost of goods if the

project is to have a positive EBIT.

B) Yes, since if the estimates for each parameter are correct, the EBIT will be positive.

C) Yes, since a positive EBIT ensures that the project will have a positive net present value (NPV).

D) It cannot be determined whether the decision was correct, since other factors contributing to the

project's net present value (NPV), such as the upfront investment, have not been included in the analysis.


Skill: Conceptual


Author: DS


40


9) The manufacturer of a brand of kitchen knives is investigating the likely effects that an increase in the

cost of the raw materials required to make these knives will have on the cost of manufacturing the knives,

the selling price of the knives, the number of knives that will then be sold, and the project's net present

value (NPV). Which of the following best describes what type of analysis the manager is performing?

A) scenario analysis

B) sensitivity analysis

C) break-even analysis

D) EBIT-break even analysis


Skill: Conceptual


Author: DS


10)

Year 0 Years 1 to 10

Revenues 2.90

- Manufacturing Expenses -0.5

- Marketing Expenses -0.15

- Depreciation - 0.5

= EBIT 1.75

- Taxes (40%) -0.70

= Unlevered net income 1.05

+ Depreciation +0.5

- Additions to Net Working Capital -0.4

- Capital Expenditures -6.00

= Free Cash Flow 1.15

Panjandrum Industries, a manufacturer of industrial piping, is evaluating whether it should expand into

the sale of plastic fittings for home garden sprinkler systems. It has made the above estimates of free cash

flows resulting from such a decision. There are concerns of the sensitivity of this project to changes in the

cost of capital. For what cost of capital does this project break-even?

A) 8%

B) 10%

C) 12%

D) 14%

Answer: D

Explanation: D) Using a financial calculator,

calculate

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


41


11)


Revenues 4.3



- Depreciation -0.5

= EBIT 3.05

- Taxes (40%) -1.22


+ Depreciation +0.5


- Capital Expenditures - 6




flows resulting from such a decision (all quantities in millions of dollars). There are some concerns that

estimates of manufacturing expenses may be low, due to the rising cost of raw materials. What is the

break-even point for manufacturing expenses, if all other estimates are correct and the cost of capital is

9%?

A) $1.66 million

B) $1.83 million

C) $1.99 million

D) $2.32 million

Answer: A

Explanation: A) Using a financial calculator,

using TVM keys,

Pre-tax manufacturing

Diff: 2 Var: 50+

Skill: Analytical


Author: DS


42


12)


Revenues 4.4



- Depreciation -0.7

= EBIT 3.15

- Taxes (40%) -1.26


+ Depreciation +0.7


- Capital Expenditures -7




flows resulting from such a decision (all quantities in millions of dollars). It is thought that if marketing

expenses are increased by 40%, then revenues will rise. By how much will revenues have to rise for the

net present value (NPV) of the project to increase?

A) at least 0.8%

B) at least 1.4%

C) at least 1.5%

D) at least 2.0%

Answer: B

Explanation: B)

Diff: 3 Var: 50+

Skill: Analytical


Author: DS


43


13)


Revenues 363,688.342 363,688.342 363,688.342


- Depreciation -80,000 -80,000 -80,000

= EBIT 133,688.342 133,688.342 133,688.342

- Taxes (35%) -46,790.9196 -46,790.9196 -46,790.9196

= Unlevered net income 86,897.4221 86,897.4221 86,897.4221

+ Depreciation 80,000 80,000 80,000



= Free Cash Flow 146,897.422 146,897.422 146,897.422


they come up with the above estimates of free cash flow from this project. By how much could the

discount rate rise before the net present value (NPV) of this project is zero, given that it is currently 10%?

A) 12%

B) 17%

C) 27%

D) 22%

Answer: A

Explanation: A) Using a financial calculator,

calculate IRR = 22%;

thus, rise in discount

Diff: 3 Var: 50+

Skill: Analytical


Author: DS


44


14)


Revenues 475,000 475,000 475,000


- Depreciation -85,000 -85,000 -85,000

= EBIT 240,000 240,000 240,000

- Taxes (35%) -84,000 -84,000 -84,000

= Unlevered net income 156,000 156,000 156,000

+ Depreciation 85,000 85,000 85,000



= Free Cash Flow 221,000 221,000 221,000


they come up with the above estimates of free cash flow from this project. Visby learns that a competitor

is thinking of offering similar services, thus reducing Visby's sales. By how much could sales fall before

the net present value (NPV) was zero, given that the cost of capital is 8%, and that cost of goods sold is

45% of revenues?

A) 28%

B) 34%

C) 45%

D) 56%

Answer: D

Explanation: D) Using a financial calculator, CF0 = -325,000, CF1 = 221,000, F1 = 3;

calculate NPV at 8% = $244,538.43;

using TVM keys, PV = 244,538.43, N = 3, I = 8, compute PMT = $94,889.1063;

pre-tax EBIT = $94,889.1063 / 0.65 = $145,983.24;

change in revenue incorporating cost of goods sold = $145,983.24 / 0.55 = $265,424.074;

percentage change = 265,424.074 / $475,000 = 56% Diff: 3 Var: 50+

Skill: Analytical


Author: DS


45



A) The break-even level of an input is the level for which the investment has an internal rate of return

(IRR) of zero.

B) The most difficult part of capital budgeting is deciding how to estimate the cash flows and the cost of

capital.

C) When evaluating a capital budgeting project, financial managers should make the decision that

maximizes net present value (NPV).

D) Sensitivity analysis reveals those aspects of the project which are most critical when we are actually

managing the project.


Skill: Conceptual


Author: JN



A) Sensitivity analysis allows us to explore the effects of errors in our estimated inputs in our net present

value (NPV) analysis for the project.

B) To compute the net present value (NPV) for a project, you need to estimate the incremental cash flows

and choose a discount rate.

C) Estimates of the cash flows and cost of capital are often subject to significant uncertainty.

D) When we are certain regarding the input to a capital budgeting decision, it is often useful to determine

the break-even level of that input.


Skill: Conceptual


Author: JN



A) We can use scenario analysis to evaluate alternative pricing strategies for our project.

B) Scenario analysis considers the effect on net present value (NPV) of changing multiple project

parameters.

C) The difference between the internal rate of return (IRR) of a project and the cost of capital tells you

how much error in the cost of capital it would take to change the investment decision.

D) Scenario analysis breaks the net present value (NPV) calculation into its component assumptions and

shows how the net present value (NPV) varies as each one of the underlying assumptions changes.


Skill: Conceptual


Author: JN


46


18) The difference between scenario analysis and sensitivity analysis is ________.

A) scenario analysis is based upon the internal rate of return (IRR) and sensitivity analysis is based upon

net present value (NPV)

B) only sensitivity analysis allows us to change estimated inputs of net present value (NPV) analysis

C) scenario analysis considers the effect on net present value (NPV) of changing multiple project

parameters

D) only scenario analysis breaks the net present value (NPV) calculation into its component assumptions


Skill: Definition


Author: JN


19) An exploration of the effect of changing multiple project parameters on net present value (NPV) is

called ________.


B) internal rate of return (IRR) analysis

C) accounting break-even analysis

D) sensitivity analysis


Skill: Definition


Author: JN


20) An analysis that breaks the net present value (NPV) calculation into its component assumptions and

shows how the net present value (NPV) varies as one of the underlying assumptions changes is called

________.


B) internal rate of return (IRR) analysis

C) accounting break-even analysis

D) sensitivity analysis


Skill: Definition


Author: JN


47


21) Which of the following will cause the EBIT Break-Even for sales to increase?

A) a decrease in the sales price

B) a decrease in depreciation expense

C) a decrease in selling, general, and administrative expenses

D) a decrease in the number of units sold


Skill: Conceptual


Author: WC


22) What is the major difference between scenario analysis and sensitivity analysis?

Answer: Sensitivity analysis focuses on the impact of changing one variable, holding all other variables

constant. Scenario analysis allows for multiple variables to change at once, typically such that the change

will impact NPV in the same direction (all change such that NPV increases or all change such that NPV

decreases.) Diff: 1 Var: 1

Skill: Conceptual


Author: WC


9.6 Real Options in Capital Budgeting

1) A real option is the obligation to take a particular business action.


Skill: Conceptual


Author: DS


2) Jim owns a farm that he wants to sell. He learns that a highway will be built near the farm in the future,

giving access to the farmland from a nearby city and thus making the land attractive to housing

developers. Expecting the net present value (NPV) of the sale to be greater after the highway is built, he

decides not to sell at this time. What real option is Jim taking?

A) option to delay

B) option to expand

C) option to abandon

D) option to switch


Skill: Conceptual


Author: DS


48


3) After research into where to place a new restaurant, Burger Billies, a small fast-food chain, plans to

open a new store near a small college. The anticipated customer base is students attending the college.

They learn that a major fast food chain will be opening a franchise within the college, which leads the

owners of Burger Billies to revise their estimate of sales to one below the break-even point. Which of the

following is most likely the best real option for Burger Billies to take with regard to the proposed

restaurant site?

A) option to delay

B) option to expand


D) option to switch


Skill: Conceptual


Author: DS


4) A manufacturer of peripheral devices for PCs decides to try and capture some of the PC gaming

market by creating gaming versions of its traditional peripheral devices. It decides to start with a gaming

version of its standard keyboard, increasing the number of macro keys, adding a small LCD screen to

display game data, and giving the user the ability to backlight keys in different colors. If this device is a

success, the manufacturer plans to release gaming versions of its trackballs and other peripherals. What

option is the manufacturer gaining by the release of the new keyboard?

A) option to delay

B) option to expand


D) option to switch


Skill: Conceptual


Author: DS


5) Which of the following statements regarding real options is NOT correct?

A) Real options should only be exercised when they increase the NPV of a project.

B) Real options enhance the forecast of a project's expected future cash flows by incorporating, at the start

of the project, the effect of decisions that will be made at a later date.

C) Real options give owners the right, but not the obligation, to exercise these opportunities at a later

date.

D) Real options build greater flexibility into a project and thus increase its net present value (NPV).


Skill: Conceptual


Author: DS


49


6) Why does the option to abandon a project have value?

Answer: The option to abandon a project can add value because it allows a firm to drop a project if the

project turns out to be unsuccessful. This allows the firm to cut its losses. Diff: 1 Var: 1

Skill: Conceptual


Author: WC


1



Chapter 10 Stock Valuation: A Second Look

10.1 The Discounted Free Cash Flow Model

1) The discounted free cash flow model ignores interest income and expense but adjusts for cash and debt

directly, if free cash flow is calculated based on EBIT.


Skill: Conceptual


Author: DS


2) Year 1 2 3 4

Free Cash Flow $12 million $18 million $22 million $26 million

Conundrum Mining is expected to generate the above free cash flows over the next four years, after

which they are expected to grow at a rate of 6% per year. If the weighted average cost of capital is 12%

and Conundrum has cash of $80 million, debt of $60 million, and 30 million shares outstanding, what is

Conundrum's expected terminal enterprise value at year 4?

A) $413.4 million

B) $459.3 million

C) $505.3 million

D) $528.2 million

Answer: B

Explanation: B) million

Diff: 2 Var: 15

Skill: Analytical


Author: JP


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3) Year 1 2 3 4

Free Cash Flow $12 million $18 million $22 million $26 million

Conundrum Mining is expected to generate the above free cash flows over the next four years, after

which they are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 11%

and Conundrum has cash of $85 million, debt of $65 million, and 30 million shares outstanding, what is

Conundrum's expected current share price?

A) $12.61

B) $16.40

C) $20.18

D) $20.81

Answer: A

Explanation: A) FCF5 = $26 million × (1 + 0.05) = $27.3 million; V4 = $27.3 million / (0.11 - 0.05

using a financial calculator, V0 = $358.36 million;

P0 = (358.36 + 85 - 65) / 30 = $12.61

Diff: 2 Var: 50+

Skill: Analytical


Author: DS


4) Year 1 2 3 4 5

Free Cash Flow $22 million $26 million $29 million $30 million $32 million

General Industries is expected to generate the above free cash flows over the next five years, after which

free cash flows are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 9%

and General Industries has cash of $15 million, debt of $45 million, and 80 million shares outstanding,

what is General Industries' expected current share price?

A) $7.78

B) $8.17

C) $9.34

D) $11.67

Answer: A

Explanation: A)

million; using a financial calculator, V0 = 652.45;

P0 = $(652.45 + 15 - 45) million / 80 million = $7.78

Diff: 2 Var: 50+

Skill: Analytical


Author: DS


3


5) Gonzales Corporation generated free cash flow of $88 million this year. For the next two years, the

company's free cash flow is expected to grow at a rate of 10%. After that time, the company's free cash

flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average

cost of capital is 12% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100

million shares outstanding, what is Gonzales Corporation's expected terminal enterprise value in year 2?

A) $1384.24

B) $1245.82

C) $1107.39

D) $968.97

Answer: A

Explanation: A) FCF1 = $88 million × (1 + 0.1) = $96.8 million;

FCF2 = $88 million × = $106.48 million;

V2 = ($106.48 million × 1.04) / (0.12 - 0.04) = $1384.24 million

Diff: 2 Var: 50+

Skill: Analytical


Author: JP



company's free cash flow is expected to grow at a rate of 9%. After that time, the company's free cash flow

is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost

of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100 million

shares outstanding, what is Gonzales Corporation's expected free cash flow in year 2?

A) $1429.79 million

B) $86.61 million

C) $1572.77 million

D) $96.24 million

Answer: D

Explanation: D) FCF1 = 81 × (1 + 0.09) = 88.29;

FCF2 = $81 million × = $96.2361 million

Diff: 1 Var: 50+

Skill: Analytical


Author: JP


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company's free cash flow is expected to grow at a rate of 10%. After that time, the company's free cash

flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average

cost of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $275 million, and 100

million shares outstanding, what is Gonzales Corporation's expected current share price?

A) $14.37

B) $11.87

C) $12.49

D) $16.24

Answer: C

Explanation: C) FCF1 = $86 million × (1 + 0.1) = $94.6 million;

FCF2 = $86 million × = $104.06 million;

FCF3 = 104.06 million × (1 + 0.04) = $108.2224 million

V2 = $108.2224 million / (0.11 - 0.04) = $1546.03 million

using a financial calculator, V0 = $1424.48 million

P0 = (1424.48 million - 275 million + 100 million) / 100 million = $12.49

Diff: 2 Var: 50+

Skill: Analytical


Author: JP


5


8) Use the table for the question(s) below.

FCF Forecast ($ million)

Year 0 1 2 3 4

Sales 240 270 290 310 325.5

Growth versus Prior Year 12.5% 7.4% 6.9% 5.0%

EBIT (10% of Sales) 27.00 29.00 31.00 32.55

Less: Income Tax (37%) (9.99) 10.73 11.47 12.44

Less Increase in NWC (12% of Change in Sales) 3.6 2.4 2.4 1.86

Free Cash Flow 13.41 15.87 17.13 18.65

Banco Industries expect sales to grow at a rapid rate over the next three years, but settle to an industry

growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries. If

Banco industries has a weighted average cost of capital of 11%, $50 million in cash, $80 million in debt,

and 18 million shares outstanding, which of the following is the best estimate of Banco's stock price at the

start of year 1?

A) $6.52

B) $11.74

C) $13.04

D) $23.48

Answer: C

Explanation: C) FCF5 = $18.65 million × (1 + 0.05) = $19.5825 million;

V4 = $19.5825 million / (0.11 - 0.05) = $326.38 million;

using a financial calculator, V0 = $264.7655 million;

P0 = ($264.7655 million + 50 - 80) / 18 million = $13.04

Diff: 2 Var: 50+

Skill: Analytical


Author: DS


6


9) Use the table for the question(s) below.

FCF Forecast ($ million)

Year 0 1 2 3 4

Sales 240 270 290 310 325.5

Growth versus Prior Year 12.5% 7.4% 6.9% 5.0%

EBIT (10% of Sales) 27.00 29.00 31.00 32.55

Less: Income Tax (37%) (9.99) (10.73) (11.47) (12.44)

Less Increase in NWC (12% of Change in Sales) 3.6 2.4 2.4 1.86

Free Cash Flow 13.41 15.87 17.13 18.65

Banco Industries expect sales to grow at a rapid rate over the next 3 years, but settle to an industry

growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries.

Banco industries has a weighted average cost of capital of 11%, $40 million in cash, $70 million in debt,

and 18 million shares outstanding. If Banco Industries can reduce its operating expenses so that EBIT

becomes 12% of sales, by how much will its stock price increase?

A) $3.27

B) $3.92

C) $5.72

D) $9.80

Answer: A

Explanation: A) Calculate FCF1 = $16.812 million, FCF2 = $19.524 million,

using a financial calculator, million

Diff: 2 Var: 50+

Skill: Analytical


Author: DS


10) Which of the following is the appropriate way to calculate the price of a share of a given company

using the free cash flow valuation model?

A) P0 = Div1/(rE - g)

B) P0 = PV(Future Free Cash Flow of Firm) / (Shares Outstanding0)

C) P0 = [Div1 / (rE - g)] / (Shares Outstanding0)

D) P0 = (V0 + Cash0 - Debt0) / (Shares Outstanding0)


Skill: Analytical


Author: DS


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11) If you want to value a firm that consistently pays out its earnings as dividends, the simplest model for

you to use is the ________.

A) enterprise value model

B) method of comparables

C) dividend-discount model

D) discounted free cash flow model


Skill: Conceptual


Author: JN


12) If you want to value a firm but do not want to explicitly forecast its dividends, the simplest model for

you to use is ________.

A) the discounted free cash flow model

B) the dividend-discount model

C) the enterprise value model

D) None of the above models can be used if you do not want to forecast dividends or use of debt.


Skill: Conceptual


Author: JN



A) The more cash a firm uses to repurchase shares, the less it has available to pay dividends.

B) Free cash flow measures the cash generated by a firm after payments to debt or equity holders are

considered.

C) We estimate a firm's current enterprise value by computing the present value (PV) of the firm's free

cash flow.

D) We can interpret the enterprise value of a firm as the net cost of acquiring the firm's equity, taking its

cash, and paying off all debts.

Answer: B

Explanation: B) FCF is cash generated by a firm before payments to debt and equity holders. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


8



A) A firm's weighted average cost of capital, denoted rwacc, is the cost of capital that reflects the risk of

the overall business, which is the combined risk of the firm's equity and debt.

B) Intuitively, the difference between the discounted free cash flow model and the dividend-discount

model is that in the divided-discount model, a firm's cash and debt are included indirectly through the

effect of interest income and expenses on earnings in the dividend-discount model.

C) We interpret rwacc as the expected return a firm must pay to investors to compensate them for the risk

of holding the firm's debt and equity together.

D) When using the discounted free cash flow model, we should use a firm's equity cost of capital.

Answer: D

Explanation: D) You should use the firm's weighted average cost of capital. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) The long-run growth rate gFCF is typically based on the expected long-run growth rate of a firm's

revenues.

B) Since a firm's free cash flow is equal to the sum of the free cash flows from the firm's current and

future investments, we can interpret the firm's enterprise value as the total net present value (NPV) that

the firm will earn from continuing its existing projects and initiating new ones.

C) If a firm has no debt, then rwacc equals the risk-free rate of return.

D) When using the discounted free cash flow model, we forecast a firm's free cash flow up to some

horizon, together with some terminal (continuation) value of the enterprise.

Answer: C

Explanation: C) If the firm has no debt, then rwacc = the cost of equity.

Diff: 1 Var: 1

Skill: Conceptual


Author: JN


16) What additional adjustments are required to find the share price, in case we are using the discounted

cash flow model?

Answer: Discounted cash flow model gives us the enterprise value, which needs to be adjusted for debt

and cash, and divided by shares outstanding to arrive at the stock price. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


9


10.2 Valuation Based on Comparable Firms

1) In the method of comparables, the known values of a firm's cash flows are used to estimate the

unknown cash flows of a similar firm.


Skill: Conceptual


Author: DS


2) Several methods should be used to provide an estimate of a stock's value since no single method

provides a definitive value.


Skill: Conceptual


Author: DS


3) On a particular date, FedEx has a stock price of $89.27 and an EPS of $7.11. Its competitor, UPS, had an

EPS of $0.38. What would be the expected price of UPS stock on this date, if estimated using the method

of comparables?

A) $4.77

B) $7.16

C) $9.54

D) $10.50

Answer: A

Explanation: A) FedEx P/E = $89.27 / 7.11 = $12.5556;

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


4) Which of the following statements concerning the valuation of firms using the method of comparables

is FALSE?

A) If two different firms generate identical cash flows, the Law of One Price will imply that both firms

have the same value.

B) Comparables adjust for scale differences when valuing similar firms.

C) Valuation multiples take into account differences in the risk and future growth between the firms

being compared.

D) Two firms that sell very similar products or offer very similar services will have different values if

they are of different sizes.


Skill: Conceptual


Author: DS


10


Use the figure for the question(s) below:

5) On a particular date, the above information concerning Office Depot, Incorporated, was given on

Google Finance. Its competitor, Staples Incorporated, had a stock price of $24.33. Which of the following

is closest to the EPS of Staples Incorporated if it is estimated using valuation multiples based on price-

earnings ratios?

A) $1.58

B) $1.84

C) $2.63

D) $14.15

Answer: C

Explanation: C) EPS Staples = $24.33 / $9.26 = $2.63 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


6) An investor estimates the value of a firm which manufactures cookware by examining the cash flows

of similar firms. Which of the following is assumed to be the same for these firms?

A) P/E

B) annual growth rates

C) payout rates

D) all of the above


Skill: Conceptual


Author: DS


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Name Market

Capitalization

($ million)

Enterprise

Value ($

million) P/E

Price/

Book

Enterprise

Value/

Sales

Enterprise

Value/

EBITDA

Gannet 6350 10,163 7.36 0.73 1.4 5.04

New York Times 2423 3472 18.09 2.64 1.10 7.21

McClatchy 675 3061 9.76 1.68 1.40 5.64

Media General 326 1192 14.89 0.39 1.31 7.65

Lee Enterprises 267 1724 6.55 0.82 1.57 6.65

Average 11.33 1.25 1.35 6.44

Maximum +60% 112% +16% +22%

Minimum -40% -69% -18% -19%

7) The table above shows the stock prices and multiples for a number of firms in the newspaper

publishing industry. Another newspaper publishing firm (not shown) had sales of $600 million, EBITDA

of $84 million, excess cash of $68 million, $18 million of debt, and 120 million shares outstanding. If the

average enterprise value to sales for comparable businesses is used, which of the following is the best

estimate of the firm's share price?

A) $6.45

B) $7.20

C) $7.17

D) $7.53

Answer: C

Explanation: C) Enterprise Value = 1.35 × $600 million = $810 million;

P0 = ($810 + $68 - $18) / 120 = $7.17

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


12





average enterprise value to sales for comparable businesses is used, which of the following is the range of

reasonable share price estimates?

A) $6.27 to $8.86

B) $4.59 to $12.23

C) $1.15 to $1.53

D) $6.19 to $9.32

Answer: A

Explanation: A) Enterprise Value = 1.35 × $640 = $864 million;

P0 = ($864 million + $67 million - $14 million) / 120 = $7.64

Range is from 82% to 116% of estimate.

$7.64 × 0.82 = $6.27; $7.64 × 1.16 = $8.86 Diff: 1 Var: 50+

Skill: Analytical


Author: JP





firm had an EPS of $0.41, what is the difference between the estimated share price of this firm if the

average price-earnings ratio is used and the estimated share price if the average enterprise value/EBITDA

ratio is used?

A) -$0.08

B) -$0.13

C) -$1.27

D) -$1.39

Answer: B

Explanation: B) Price using price-earnings ratio = 11.33 × $0.41 = $4.6453;

using enterprise value / EBITDA ratio = 6.44 × $81 million = $521.64 million;

P0 = ($521.64 million + $62 million - $11 million) / 120 million = $4.77;

difference = $-0.13

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


13



publishing industry. Which of the following ratios would most likely be the most reliable in determining

the stock price of a comparable firm?

A) P/E

B) Price/Book

C) Enterprise Value/Sales

D) Enterprise Value/EBITDA

Answer: C

Explanation: C) The Enterprise Value/Sales method has the tightest range between minimum and

maximum. Diff: 1 Var: 1

Skill: Conceptual


Author: DS


11) Which of the following is NOT an advantage of the valuation multiple method as compared to the

discounted cash flow method?

A) calculations based upon widely available information

B) based upon actual stock prices of real firms

C) does not rely on estimates of future cash flows

D) takes into account important differences between different firms


Skill: Conceptual


Author: DS



A) Even two firms in the same industry selling the same types of products, while similar in many

respects, are likely to be of different size or scale.

B) In the method of comparables, we estimate the value of a firm based on the value of other, comparable

firms or investments that we expect will generate very similar cash flows in the future.

C) Consider the case of a new firm that is identical to an existing publicly traded company. If these firms

will generate identical cash flows, the Law of One Price implies that we can use the value of the existing

company to determine the value of the new firm.

D) A valuation multiple is a ratio of some measure of a firm's scale to the value of the firm.

Answer: D

Explanation: D) A valuation multiple is a ratio of the value of the firm to some measure of the firm's

scale. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


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A) The most common valuation multiple is the price-earnings ratio.

B) You should be willing to pay proportionally more for a stock with lower current earnings.

C) A firm's price-earnings ratio is equal to the share price divided by its earnings per share.

D) The intuition behind the use of the price-earnings ratio is that when you buy a stock, you are in a sense

buying the rights to the firm's future earnings, and differences in the scale of firms' earnings are likely to

persist.

Answer: B

Explanation: B) You should be willing to pay proportionally more for a stock with higher current

earnings. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) We can estimate the value of a firm's shares by multiplying its current earnings per share by the

average price-earnings ratio of comparable firms.

B) For valuation purposes, the trailing price-earnings ratio is generally preferred, since it is based on

actual not expected earnings.

C) Forward earnings are the expected earnings over the coming 12 months.

D) Trailing earnings are the earnings over the previous 12 months.

Answer: B

Explanation: B) For valuation purposes, the forward price-earnings ratio is generally preferred, since it is

based on the expected earnings. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) As the enterprise value represents the entire value of a firm before the firm pays its debt, to form an

appropriate multiple, we divide it by a measure of earnings or cash flows after interest payments are

made.

B) We can compute a firm's price-earnings ratio by using either trailing earnings or forward earnings

with the resulting ratio called the trailing price-earnings or forward price-earnings.

C) It is common practice to use valuation multiples based on a firm's enterprise value.

D) Using a valuation multiple based on comparables is best viewed as a "shortcut" to the discounted cash

flow method of valuation.

Answer: A

Explanation: A) As the enterprise value represents the entire value of a firm before the firm pays its debt,

to form an appropriate multiple, we divide it by a measure of earnings or cash flows before interest

payments are made. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


15


16) Which is the best valuation technique when using comparables?

Answer: No single technique provides a final answer regarding a stock's true value. All approaches have

their individual assumptions and the firm value is subject to those assumptions. So, the best technique is

to use several methods to identify a reasonable range for the value. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


10.3 Stock Valuation Techniques: A Final Word

1) There are no questions for this section. Diff: 1 Var: 1

10.4 Information, Competition, and Stock Prices

1) If you value a stock using a range of stock valuation methods and these valuations indicate a stock

price that is greater than its actual market price, it is most likely that the stock is under-valued.


Skill: Conceptual


Author: DS


2) In an efficient market, investors will only find positive-NPV trading opportunities if they have some

form of competitive advantage over other investors.


Skill: Conceptual


Author: DS


16


3) Valuation models use the relationship between share value, future cash flows, and the cost of capital to

estimate these quantities for a given firm. Realistically, for a publicly traded firm, what can we reliably

use such models to determine?

I. the firm's future cash flows

II. the firm's cost of capital

III. the firm's market price

A) I only

B) II only

C) III only

D) I and II


Skill: Conceptual


Author: DS


4) Praetorian Industries will pay a dividend of $2.50 per share this year and has an equity cost of capital

of 8%. Praetorian's stock is currently trading at $84 per share. By comparing Praetorian with similar firms,

an investor expects that its dividends will grow by up to 5% per year. What is the best next step that the

investor should take regarding Praetorian's stock?

A) Sell any Praetorian stock that she owns.

B) Short Praetorian's stock.

C) Revise Praetorian's equity cost of capital.

D) Revise her estimate of Praetorian's dividend growth.


Skill: Conceptual


Author: DS


5) On a certain date, Kastbro has a stock price of $42.50, pays a dividend of $0.64, and has an equity cost

of capital of 8%. An investor expects the dividend rate to increase by 6% per year in perpetuity. He then

sells all stocks that he owns in Kastbro. Given Kastbro's share price, was this a reasonable action?

A) No, since the constant dividend growth rate gives a stock estimate of $42.50.

B) No, since the constant dividend growth rate gives a stock estimate greater than $42.50.

C) Yes, since the constant dividend growth rate gives a stock estimate greater than $42.50.

D) No, since the difference between his calculated stock price and the actual stock price most likely

indicates that his estimate of dividend growth rate was incorrect.

Answer: D

Explanation: D) Calculated stock price = $0.64 / (0.08 - 0.06) = $32; actual stock price = $42.50. Difference =

$10.50. Diff: 1 Var: 1

Skill: Conceptual


Author: DS


17


6) Which of the following is the best statement of the efficient markets hypothesis?

A) Investors with information that a stock had a positive net present value (NPV) will buy it, while

investors with information that a stock had a negative net present value (NPV) will sell it.

B) Investor's decisions are dependent on complete current information of a firm's cash flows and accurate

predictions of future cash flows.

C) Competition between investors works to make the net present value (NPV) of all trading opportunities

zero.

D) A share's price is the aggregate of the information of many investors.


Skill: Conceptual


Author: DS


7) Carbondale Oil announces that a well that it has sunk in a new oil province has shown the existence of

substantial oil reserves. The exploitation of these reserves is expected to increase Carbondale's free cash

flow by $100 million per year for eight years. If investors had not been expecting this news, what is the

most likely effect on Carbondale's stock price upon the announcement, given that Carbondale has 80

million shares outstanding, no debt, and an equity cost of capital of 11%?

A) no effect

B) rise by $5.15

C) rise by $6.43

D) rise by $7.72

Answer: C

Explanation: C) PV of 100 million for 8 years at 11% = $514.6123 million per share

= $6.43

Diff: 1 Var: 45

Skill: Analytical


Author: DS


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8) Advanced Chemical Industries is awaiting the verdict from a court case over whether it is liable for the

clean-up of wastes on a disused factory site. If it is liable, this will result in a reduction of its free cash

flow by $11 million per year for ten years. If it is not liable, there will be no effect. On the close of trading

the day before the announcement of the verdict, Advanced Chemicals was trading at $20 per share. Most

investors calculate that there is a 100% chance that Advanced Chemicals will have a verdict returned

against them. One investor, Jo, has performed extensive research into the outcome of the trial and

estimates that there is no chance Advanced Chemicals will have a verdict returned against them. Given

that Advanced Chemicals has 40 million shares outstanding and an equity cost of capital of 6% with no

debt, Jo's estimate of the value of a share of Advanced Chemicals would be how much more than the

market price?

A) $2.02

B) $20.81

C) $21.01

D) $21.62

Answer: A

Explanation: A) Using a financial calculator, PV of 11 million for 10 years at 6% = $80.961 million;

per share effect = $80.961 million / 40 million = $2.02 Diff: 1 Var: 44

Skill: Analytical


Author: DS


9) Aerelon Airways, a commercial airline, suffers a major crash. As a result, passengers are considered to

be less likely to choose Aerelon as their carrier, and it is expected free cash flows will fall by $15million

per year for five years. If Aerelon has 55 million shares outstanding, an equity cost of capital of 10%, and

no debt, by how much would Aerelon's shares be expected to fall in price as a result of this accident?

A) $0.93

B) $1.03

C) $1.14

D) $1.34

Answer: B

Explanation: B) Using a financial calculator, PV of 15 million for 5 years at 10% = $56.86 million;

per share fall = $56.86 million / 55 million = $1.03 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


19


10) Which of the following should be done by a manager wishing to raise his stock's price?

I. Focus on maximizing the present value (PV) of the free cash flow.

II. Focus on accounting earnings.

III. Focus on financial policy.

A) I only

B) II only

C) I and II

D) II and II


Skill: Conceptual


Author: DS


11) On a particular day, a mining company reveals that, due to new extraction technology, the extractable

yield from several of its nickel/lead mines has risen by 15%. Which of the following is the LEAST likely

consequence of such an announcement?

A) The price of the stock would rise.

B) Investors would determine that the estimates of the firm's value on the date prior to the announcement

were too high.

C) Investors would increase their forecast of future cash flows in that firm.

D) Investors would revise their estimates of the net present value (NPV) of the firm.


Skill: Conceptual


Author: DS


12) What are the implications of the efficient markets hypothesis for corporate managers regarding

accounting earnings?

Answer: Instead of focusing on accounting earnings, managers should focus on maximizing cash flows. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


10.5 Individual Biases and Trading

1) Individual investors trade conservatively, given the difficulty of finding over-valued and under-valued

stocks.


Skill: Conceptual


Author: JP


20


2) Individual investors who grow up and live during a time of high stock returns are more likely to invest

in stocks.


Skill: Conceptual


Author: JP


3) Individual investors' tendency to trade too much based on the mistaken belief that they can pick

winners and losers better than investment professionals is known as ________.

A) the disposition effect

B) the investor attention hypothesis

C) the investor overconfidence hypothesis

D) the excessive trading costs hypothesis


Skill: Conceptual


Author: JP


4) A study of trading behavior of individual investors at a discount brokerage found that individual

investors ________.

A) trade very actively, despite the fact that their performance is actually worse because of trading costs

B) trade very conservatively, despite the fact that their performance is actually worse because of trading

costs

C) trade very actively, partly because their performance is better than the professionals' due to low

trading costs

D) trade very conservatively, partly because their performance is better than the professionals' due to low

trading costs


Skill: Conceptual


Author: JP


5) Disposition effect is the tendency of individual investors to ________.

A) trade too much based on the mistaken belief that they can pick winners and losers better than

investment professionals

B) buy stocks that have been in the news, advertised more, have very high trading volume, or recently

had extreme (high or low) returns

C) put too much weight on their own experience rather than considering historical evidence

D) hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase


Skill: Conceptual


Author: JP


1



Chapter 13 The Cost of Capital

13.1 A First Look at the Weighted Average Cost of Capital

1) Financial managers must determine their firm's overall cost of capital based on all sources of financing.


Skill: Conceptual


Author: KB


2) To attract capital from outside investors, a firm must offer potential investors an expected return that is

commensurate with the level of risk that they can bear.


Skill: Conceptual


Author: KB


3) One should use accounting-based book values rather than market values of debt and equity to

determine the weights for the different sources of capital.


Skill: Conceptual


Author: KB


4) A firm's sources of financing, which usually consists of debt and equity, represent its ________.

A) total assets

B) capital

C) total liabilities

D) current liabilities


Skill: Definition


Author: KB


2


5) The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its

________.

A) asset ratio

B) current ratio

C) capital structure

D) retained earnings


Skill: Conceptual


Author: KB


6) A firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as

the firm's ________.

A) weighted average cost of capital

B) cost of equity infusion

C) cost of debt

D) cost of preferred stock


Skill: Definition


Author: KB


7) The book value of a firm's equity is $100 million and its market value of equity is $200 million. The face

value of its debt is $50 million and its market value of debt is $60 million. What is the market value of

assets of the firm?

A) $150 million

B) $160 million

C) $260 million

D) $250 million

Answer: C

Explanation: C) Market value of debt plus market value of equity gives market value of assets.

$200 + $60 = $260 million Diff: 1 Var: 1

Skill: Analytical


Author: KB


3


8) A firm raised all its capital via equity rather than debt. Such a firm is also referred to as a(n) ________

firm.

A) levered

B) margined

C) risk less

D) unlevered


Skill: Definition


Author: KB


9) A levered firm is one that has ________ outstanding.

A) debt

B) equity

C) preferred stock

D) equity options


Skill: Definition


Author: KB


10) Leverage is the amount of ________ on a firm's balance sheet.

A) equity

B) debt

C) preferred stock

D) retained earnings


Skill: Definition


Author: KB


11) For an unlevered firm, the cost of capital can be determined by using the ________.

A) yield on the traded debt

B) Capital Asset Pricing Model

C) dividend yield

D) preferred stock yield


Skill: Conceptual


Author: KB


4


12) Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8

billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

A) 0.10, 0.90

B) 0.832, 0.168

C) 0.168, 0.832

D) 0.90, 0.10

Answer: C

Explanation: C) Weight in debt equals market value of debt divided by market value of debt plus equity.

Similarly, weight in equity is market value of equity divided by market value of debt plus equity.

Weight in equity = $4 billion / ($4 + $19.8) billion = 0.168;

Weight in debt = $19.8 billion / ($4 + $19.8) billion = 0.832 Diff: 1 Var: 9

Skill: Analytical


Author: KB


13) Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of

debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial

analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values

should be used for calculating the firm's WACC?

A) $6 billion of equity and $19.7 billion of debt

B) $2.5 billion of equity and $20 billion of debt

C) $3 billion of equity and $19.9 billion of debt

D) $2.5 billion of equity and $18.5 billion of debt


Skill: Conceptual


Author: KB


14) Assume the total market value of General Motors (GM) is $10 billion. GM has a market value of $6

billion of equity and a face value of $12 billion of debt. What are the weights in equity and debt that are

used for calculating the WACC?

A) 0.30, 0.70

B) 0.60, 0.40

C) 0.40, 0.60

D) cannot be determined

Answer: B

Explanation: B) Weight in debt equals market value of debt divided by market value of debt plus equity.

Similarly, weight in equity is market value of equity divided by market value of debt plus equity.

Equity = $6 million / $10 million = 0.60; Debt = ($10 million - $6 million) / $10 million = 0.40 Diff: 1 Var: 47

Skill: Analytical


Author: KB


5


15) The after-tax cost of equity is ________ the pretax cost of equity.

A) higher than

B) lower than

C) the same as

D) less than or equal to


Skill: Conceptual


Author: KB


16) Epiphany is an all-equity firm with an estimated market value of $400,000. The firm sells $225,000 of

debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight

in debt after the proposed financing and repurchase of equity.

A) 0.28, 0.72

B) 0.44, 0.56

C) 0.39, 0.61

D) 0.56, 0.44

Answer: B

Explanation: B) Weight in debt = Debt raised / Market value of the firm

Weight in debt = $225,000 / $400,000 = 0.56

Weight in equity = 1- Weight in debt

Weight in equity = 1 - 0.56 = 0.44 Diff: 2 Var: 10

Skill: Analytical


Author: KB





A) 0.42, 0.58

B) 0.50, 0.50

C) 0.17, 0.83

D) 0.58, 0.42

Answer: C

Explanation: C) Weight in debt = Debt raised / Market value of firm

Weight in equity = 1 - Weight in debt

Weight in debt = $250,000 / $300,000 = 0.83


Skill: Analytical


Author: KB


6





A) 0.15, 0.85

B) 0.18, 0.82

C) 0.30, 0.70

D) 0.70, 0.30

Answer: D

Explanation: D) Weight in debt = Debt raised / Market value of firm

Weight in equity = 1 - Weight in debt

Weight in debt = $150,000 / $500,000 = 0.30


Skill: Analytical


Author: KB


19) Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has

book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in

calculating its WACC?

A) 41.86% for debt, 58.14% for equity

B) 37.67% for debt, 62.33% for equity

C) 33.49% for debt, 66.51% for equity

D) 29.30% for debt, 70.70% for equity

Answer: A

Explanation: A) Market Value Debt = $24 million × 120% = $28.8 million

Market Value Equity = 2 million × $20 = $40 million

Total Market Value = $68.8 million

Weight of debt = $28.8 million / $68.8 million = 41.86%

Weight of equity = $40 million / $68.8 million = 58.14% Diff: 1 Var: 50+

Skill: Analytical


Author: WC


20) As a firm increases its level of debt relative to its level of equity, the firm is ________.

A) increasing the fraction of its equity

B) decreasing the fraction of its debt

C) decreasing its leverage

D) increasing its leverage


Skill: Conceptual


Author: WC


7


21) Why do we use market values rather than book values in calculation of WACC?

Answer: We use market values rather than book values because the cost of capital is based on investors'

current assessment of the value of a firm and not on accounting-based book values. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


22) Why do we use leverage if it increases the risk of a firm?

Answer: Usually, the cost of debt is cheaper than the cost of equity due to lower risk of the debt holders

as well as tax deductibility of interest payment. Thus, including debt, everything else remaining same,

reduces the cost of capital for a firm. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


13.2 The Firm's Costs of Debt and Equity Capital

1) A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.


Skill: Conceptual


Author: KB


2) The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.


Skill: Conceptual


Author: KB


3) The ________ of a firm's debt can be used as the firm's current cost of debt.

A) current yield

B) coupon rate

C) yield to maturity

D) discount yield


Skill: Conceptual


Author: KB


8


4) Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of Home Depot is

30%. What is the effective cost of debt of Home Depot?

A) 5.88%

B) 8%

C) 6.44%

D) 5.60%

Answer: D

Explanation: D) Multiply the yield to maturity by 1 minus the tax rate.

0.08 × (1 - 0.3) = 0.056 = 5.60% Diff: 1 Var: 18

Skill: Analytical


Author: KB




A) 4.50%

B) 4.65%

C) 3.60%

D) 3.00%

Answer: D

Explanation: D) Multiply the yield to maturity by 1 minus the tax rate.

0.05 × (1 - 0.4) = 0.030 = 3.00% Diff: 1 Var: 18

Skill: Analytical


Author: KB




A) 4.55%

B) 5.01%

C) 5.46%

D) 5.69%

Answer: A

Explanation: A) Multiply the yield to maturity by 1 minus the tax rate.

0.07 × (1 - 0.35) = 0.046 = 4.55% Diff: 1 Var: 18

Skill: Analytical


Author: KB


9


7) Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35.

What is the cost of preferred stock capital for Ford?

A) 11.4%

B) 12.6%

C) 13.7%

D) 14.9%

Answer: A

Explanation: A) Divide the dividend by the preferred stock price.

$4 / $35 = 0.114 or 11.4% Diff: 1 Var: 50

Skill: Analytical


Author: KB


8) Assume preferred stock of Ford Motors pays a dividend of $3.50 each year and trades at a price of $30.


A) 10.5%

B) 11.7%

C) 11.1%

D) 10.7%

Answer: B

Explanation: B) Divide the dividend by the preferred stock price.

$3.50 / $30 = 0.117 or 11.7% Diff: 1 Var: 25

Skill: Analytical


Author: KB


9) Assume preferred stock of Ford Motors pays a dividend of $3.00 each year and trades at a price of $20.


A) 12.0%

B) 13.5%

C) 15.0%

D) 16.5%

Answer: C

Explanation: C) Divide the dividend by the preferred stock price.

$3.00 / $20 = 0.150 or 15.0% Diff: 1 Var: 25

Skill: Analytical


Author: KB


10


10) IBM expects to pay a dividend of $2 next year and expects these dividends to grow at 9% a year. The

price of IBM is $80 per share. What is IBM's cost of equity capital?

A) 9.20%

B) 10.35%

C) 10.93%

D) 11.50%

Answer: D

Explanation: D) Cost of equity is the next period dividend divided by the price plus the growth rate in

dividends.

Cost of equity = (Div1 / PE) + g = ($2 / $80) + 0.09 = 0.1150 = 11.50%

Diff: 1 Var: 50+

Skill: Analytical


Author: KB


11) IBM expects to pay a dividend of $5 next year and expects these dividends to grow at 7% a year. The

price of IBM is $90 per share. What is IBM's cost of equity capital?

A) 3.77%

B) 5.02%

C) 7%

D) 12.56%

Answer: D


dividends.

Cost of equity = (Div1 / PE) + g = ($5 / $90) + 0.07 = 0.1256 = 12.56%

Diff: 1 Var: 50+

Skill: Analytical


Author: KB


12) Assume IBM just paid a dividend of $4.50 and expects these dividends to grow at 8% a year. The price

of IBM is $100 per share. What is IBM's cost of equity capital?

A) 3.86%

B) 8%

C) 12.22%

D) 12.86%

Answer: D


dividends.

Diff: 1 Var: 50+

Skill: Analytical


Author: KB


11


13) Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General Motors

has a beta of 1.6. What is General Motors' cost of equity capital?

A) 15.2%

B) 14.4%

C) 16.0%

D) 13.7%

Answer: A

Explanation: A) Apply the CAPM equation.

Cost of equity = 0.04 + (1.6 × 0.07) = 0.152 = 15.2% Diff: 1 Var: 50+

Skill: Analytical


Author: KB


14) Your estimate of the market risk premium is 6%. The risk-free rate of return is 4% and General Motors

has a beta of 1.4. What is General Motors' cost of equity capital?

A) 11.2%

B) 12.4%

C) 11.8%

D) 13.0%

Answer: B

Explanation: B) Apply the CAPM equation.


Skill: Analytical


Author: KB


15) Your estimate of the market risk premium is 9%. The risk-free rate of return is 4.1% and General

Motors has a beta of 1.8. What is General Motors' cost of equity capital?

A) 20.3%

B) 18.3%

C) 19.3%

D) 21.3%

Answer: A

Explanation: A) Apply the CAPM equation.


Skill: Analytical


Author: KB


12


16) A firm has outstanding debt with a coupon rate of 8%, seven years maturity, and a price of $1,000.

What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

A) 5.2%

B) 5.5%

C) 5.7%

D) 6.0%

Answer: A

Explanation: A) YTM = coupon rate in this case since the bond is selling at par. Therefore,

Therefore, after-tax cost = 0.08 × (1 - 0.35) = 0.052 or 5.2%. Diff: 1 Var: 15

Skill: Analytical


Author: KB


17) A firm has outstanding debt with a coupon rate of 8%, nine years maturity, and a price of $1,000.

What is the after-tax cost of debt if the marginal tax rate of the firm is 40%?

A) 3.8%

B) 4.8%

C) 4.3%

D) 4.4%

Answer: B

Explanation: B) YTM = coupon rate in this case since the bond is selling at par. Therefore,

Therefore, after-tax cost = 0.08 × (1 - 0.4) = 4.8%. Diff: 1 Var: 14

Skill: Analytical


Author: KB


18) A firm has outstanding debt with a coupon rate of 5%, ten years maturity, and a price of $1,000. What

is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

A) 2.6%

B) 2.9%

C) 3.3%

D) 3.4%

Answer: C

Explanation: C) YTM = coupon rate in this case since the bond is selling at par. Therefore,

Therefore, after-tax cost = 0.05 × (1 - 0.35) = 3.3%. Diff: 1 Var: 15

Skill: Analytical


Author: KB


13


19) A firm has $1 million market value and it sells preferred stock with a par value of $100. If the coupon

rate on the preferred stock is 5% and the preferred stock trades at $91, what is the cost of preferred stock

capital?

A) 4.67%

B) 4.95%

C) 5.22%

D) 5.49%

Answer: D

Explanation: D)

Cost of preferred stock capital = (5% × $100) / $91 = 5.49% Diff: 1 Var: 50+

Skill: Analytical


Author: KB




capital?

A) 5.82%

B) 6.12%

C) 6.43%

D) 6.73%

Answer: B

Explanation: B)


Skill: Analytical


Author: KB




capital?

A) 8.26%

B) 8.70%

C) 9.13%

D) 9.57%

Answer: B

Explanation: B)


Skill: Analytical


Author: KB


14


22) An all-equity firm had a dividend expense of $30,000 last year. The market value of the firm is

$900,000 and the dividend is expected to increase at 6% each year. What is the cost of equity for this firm?

A) 9.53%

B) 10.01%

C) 10.96%

D) 11.44%

Answer: A

Explanation: A) Cost of equity =

Diff: 1 Var: 50+

Skill: Analytical


Author: KB




A) 6.80%

B) 7.65%

C) 8.50%

D) 9.35%

Answer: C

Explanation: C) Cost of equity = Dividend (in one year) / Current Price + Dividend Growth Rate

Cost of equity = ($20,000 × (1 + 0.05) / $600,000 )+ 0.05 = 8.50% Diff: 1 Var: 50+

Skill: Analytical


Author: KB




A) 11.72%

B) 12.37%

C) 13.02%

D) 14.32%

Answer: C

Explanation: C)

Cost of equity = ($45,000 × (1 + 0.07) / $800,000) + 0.07 = 13.02% Diff: 1 Var: 50+

Skill: Analytical


Author: KB


15


25) The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of

$95. What is the pretax cost of debt if the tax rate is 30%.

A) 4.9%

B) 6.5%

C) 7.0%

D) 7.37%

Answer: D

Explanation: D) Current yield = coupon / price;

0.07 = coupon / 95; hence, coupon = 0.07 × 95 = 6.65;

yield to maturity = pretax cost of debt;

using a financial calculator, -95 PV, 100 FV, 6.65 PMT, 10 N, CPT I = 7.37% Diff: 2 Var: 1

Skill: Analytical


Author: KB


26) The outstanding debt of Berstin Corp. has five years to maturity, a current yield of 6%, and a price of

$95. What is the pretax cost of debt if the tax rate is 30%.

A) 4.2%

B) 4.8%

C) 6.9%

D) more information needed

Answer: C

Explanation: C) Current yield = coupon / price;

0.06 = coupon / 95; hence, coupon = 0.06 × 95 = 5.7.

yield to maturity = pretax cost of debt;

using financial calculator, -95 PV, 100 FV, 5.7 PMT, 5 N, CPT I = 6.9% Diff: 2 Var: 1

Skill: Analytical


Author: KB


27) The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 7%, and a price of

$85. What is the pretax cost of debt if the tax rate is 40%?

A) 5.1%

B) 5.9%

C) 8.5%


Answer: C

Explanation: C) Current yield = Coupon / Price;

0.07 = Coupon / $85; hence, Coupon = 0.07 × $85 = $5.95.

Yield to maturity = Pretax cost of debt;

Diff: 2 Var: 48

Skill: Analytical


Author: KB


16


28) A firm has a pre-tax cost of debt of 9.0%. If the firm has a marginal tax rate of 35%, what is its effective

cost of debt?

A) 5.9%

B) 4.1%

C) 9.4%

D) 9.1%

Answer: A

Explanation: A) 9.0% × (1 - 0.35) = 5.9% Diff: 1 Var: 50+

Skill: Analytical


Author: WC


29) The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal

tax rate.

A) is always greater than

B) is always equal to

C) is always less than

D) may be greater than or less than


Skill: Conceptual


Author: WC


30) A firm incurs $40,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the

effective after-tax interest rate expense for the firm?

A) $21,000.00

B) $22,400.00

C) $23,800.00

D) $28,000.00

Answer: D

Explanation: D)

Diff: 1 Var: 14

Skill: Analytical


Author: KB


17




A) $22,050.00

B) $24,500.00

C) $28,175.00

D) $29,400.00

Answer: B

Explanation: B)

Diff: 1 Var: 21

Skill: Analytical


Author: KB




A) $34,300.00

B) $39,200.00

C) $49,000.00

D) $56,350.00

Answer: C

Explanation: C)

Diff: 1 Var: 28

Skill: Analytical


Author: KB


33) The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that

interest expense can be ________.

A) expensed

B) margined

C) refinanced

D) capitalized


Skill: Conceptual


Author: KB


18


34) Is it incorrect to use the coupon rate of debt toward cost of debt?

Answer: Yes, it is inaccurate to use the coupon rate of debt as a company's cost of capital is forward

looking while the coupon rate is a historic rate prevalent at the time of issuance of the debt. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


35) What is the difference between the effective cost of debt and the cost of debt?

Answer: The cost of debt is the before tax cost of debt while the effective cost of debt is the after-tax cost

of debt, which is lower for a profitable tax paying firm. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


36) Should a firm with high retained earnings have a lower cost of equity?

Answer: Cost of equity is the return that equity holders expect from a firm and is not directly related to

the firm's retained earnings. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


37) Among the two models Constant Dividend Growth Model (CDGM) and Capital Asset Pricing Model

(CAPM), which is a better method for computation of the cost of equity?

Answer: The Capital Asset Pricing Model (CAPM) is more popular for estimating the cost of equity

because of the difficulties in estimating the dividend growth rate required for the Constant Dividend

Growth Model (CDGM). Diff: 1 Var: 1

Skill: Conceptual


Author: SS


38) Which of the three costs—debt, preferred stock and common equity—is most difficult to estimate?

Answer: The cost of common equity is most difficult to estimate as it has the highest uncertainty about

its cash flows. The cash flows for debt and preferred stock are quite predictable, and hence their costs are

easier to calculate. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


19


13.3 A Second Look at the Weighted Average Cost of Capital

1) The WACC does not depend on the risk of a company's line of business.


Skill: Conceptual


Author: KB


2) Assume Time Warner shares have a market capitalization of $40 billion. The company is expected to

pay a dividend of $0.25 per share and each share trades for $40. The growth rate in dividends is expected

to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 9%. If

the firm's tax rate is 40%, what is the WACC?

A) 5.85%

B) 6.54%

C) 6.88%

D) 7.57%

Answer: C

Explanation: C) Cost of equity is the next period dividend divided by the price plus the growth rate in

dividends. Cost of debt is the yield to maturity times one minus the tax rate. WACC is the weight of

debt times cost of debt plus weight of equity times cost of equity.

Cost of equity = ($0.25 / $40) + 0.07 = 0.07625 or 7.63%;

Cost of debt = 0.09 × (1 - 0.4) = 0.054 or 5.4%;

WACC = ($40 billion × 0.07625) / $60 billion + ($20 billion × 0.054) / $60 billion = 0.0688 or 6.88% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


20


3) Assume Time Warner shares have a market capitalization of $60 billion. The company is expected to

pay a dividend of $0.30 per share and each share trades for $40. The growth rate in dividends is expected

to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 8%. If

the firm's tax rate is 35%, compute the WACC?

A) 6.05%

B) 6.40%

C) 6.76%

D) 7.11%

Answer: D




Cost of equity = ($0.30 / $40) + 0.07 = 0.0775 or 7.75%;

Cost of debt = 0.08 × (1 - 0.35) = 0.052 or 5.2%;

WACC = ($60 billion × 0.0775) / $80 billion + ($20 billion × 0.052) / $80 billion = 0.0711 or 7.11% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


4) Assume Time Warner shares have a market capitalization of $65 billion. The company just paid a

dividend of $0.40 per share and each share trades for $25. The growth rate in dividends is expected to be

7.00% per year. Also, Time Warner has $10 billion of debt that trades with a yield to maturity of 7%. If the

firm's tax rate is 40%, compute the WACC?

A) 7.70%

B) 8.11%

C) 8.92%

D) 9.33%

Answer: B

Explanation: B) Cost of equity is the next period dividend divided by the price plus the growth rate in



Cost of equity = ($0.40 × 1.07) / $25 + 0.07 = 0.08712 or 8.712%;

Cost of debt = 0.07 × (1 - 0.4) = 0.042 or 4.2%;

WACC = ($65 billion × 0.08712) / $75 billion + $10 billion × 0.042 / $75 billion = 0.0811 or 8.11% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


21


5) Assume the market value of Fords' equity, preferred stock, and debt are$6 billion, $2 billion, and $13

billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of

interest is 3%. Ford's preferred stock pays a dividend of $4 each year and trades at a price of $30 per

share. Ford's debt trades with a yield to maturity of 8.0%. What is Ford's weighted average cost of capital

if its tax rate is 30%?

A) 9.95%

B) 9.48%

C) 10.43%

D) 11.38%

Answer: B

Explanation: B) Cost of equity is the next period dividend divided by the price plus the growth rate in



Cost of equity = 0.03 + 1.7 × 0.08 = 0.166;

Cost of debt = 0.08 × (1 - 0.3) = 0.056;

Cost of preferred stock = 4 / 30 = 0.13333333;

WACC = $6 billion × 0.166 / $21 billion + $2 billion × 0.13333333 / $21 billion + $13 billion × 0.056 / $21

billion = 0.09479 or 9.48% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


6) Assume the market value of Fords' equity, preferred stock and debt are $6 billion, $3 billion, and $13

billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of

interest is 3%. Ford's preferred stock pays a dividend of $2.50 each year and trades at a price of $30 per

share. Ford's debt trades with a yield to maturity of 9.5%. What is Ford's weighted average cost of capital

if its tax rate is 35%?

A) 9.78%

B) 10.24%

C) 9.31%

D) 11.18%

Answer: C

Explanation: C) Cost of equity is the next period dividend divided by the price plus the growth rate in



Cost of equity = 0.03 + 1.7 × 0.08 = 0.166;

Cost of debt = 0.095 × (1 - 0.35) = 0.06175;

Cost of preferred stock = $2.50 / $30 = 0.08333333;

WACC = $6 billion × 0.166 / $22 billion + $3 billion × 0.08333333 / $22 billion + $13 billion × 0.06175 / 22 =

0.09313 or 9.31% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


22


7) Assume the market value of Fords' equity, preferred stock and debt are $7 billion, $4 billion and $10

billion respectively. Ford has a beta of 1.4, the market risk premium is 6% and the risk-free rate of interest

is 4%. Ford's preferred stock pays a dividend of $3 each year and trades at a price of $25 per share. Ford's

debt trades with a yield to maturity of 8.5%. What is Ford's weighted average cost of capital if its tax rate

is 35%?

A) 7.69%

B) 8.15%

C) 8.60%

D) 9.05%

Answer: D




Cost of equity = 0.04 + 1.4 × 0.06 = 0.124;

Cost of debt = 0.085 × (1 - 0.35) = 0.05525;

Cost of preferred stock = $3 / $25 = 0.12;

WACC = $7 billion × 0.124 / $21 billion + $4 billion × 0.12 / $21 billion + $10 billion × 0.05525 / $21 billion =

0.09050 or 9.05% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


8) When calculating the WACC, it is a standard practice to subtract ________ to compute the net debt

outstanding.

A) equity

B) dividends

C) cash and risk-free securities

D) coupons


Skill: Conceptual


Author: KB


9) Many financial managers use market risk premiums that are closer to 5%, which is lower than

historical averages, because ________.

A) the return investors require as compensation for taking on the risk of investing in equity markets has

diminished over a period of time

B) investors require a higher risk premium for holding risky securities than in the past

C) investors require a supernormal risk premium for holding risky securities as compared with the past

D) investors require the same premium for holding risky securities as in the past


Skill: Conceptual


Author: KB


23


10) When corporate tax rates decline, the net cost of debt financing ________.

A) decreases

B) is unchanged

C) increases

D) doubles


Skill: Conceptual


Author: KB


11) Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional

capital. Its current capital structure has a 25% weight in equity, 10% in preferred stock, and 65% in debt.

The cost of equity capital is 13%, the cost of preferred stock is 9%, and the pretax cost of debt is 8%. What

is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

A) 6.91%

B) 7.27%

C) 8.00%

D) 8.36%

Answer: B

Explanation: B) rwacc = rEE% + rD (1 - Tc) D% + rpfdP%

rwacc = 0.25 × 0.13 + 0.65 × 0.08 × (1 - 0.4) + 0.1 × 0.09 = 0.0727 = 7.27%

Diff: 2 Var: 50+

Skill: Analytical


Author: KB




The cost of equity capital is 16%, the cost of preferred stock is 11%, and the pretax cost of debt is 8%.

What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

A) 9.09%

B) 9.54%

C) 10.00%

D) 10.45%

Answer: A

Explanation: A) rwacc = rEE% + rD (1 - Tc) D% + rpfdP%

rwacc = 0.3 × 0.16 + 0.55 × 0.08 × (1 - 0.4) + 0.15 × 0.11 = 0.0909 = 9.09%

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


24




The cost of equity capital is 16%, the cost of preferred stock is 10%, and the pretax cost of debt is 8%.

What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

A) 6.61%

B) 6.96%

C) 7.31%

D) 7.66%

Answer: B

Explanation: B) rwacc = rEE% + rD (1 - Tc) D% + rpfdP%

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


14) Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The bonds have

a yield to maturity of 7%. The firm's book value of equity is $16 million, and it has 2 million shares

trading at $19 per share. The firm's cost of equity is 12%. What is JUP's WACC if the firm's marginal tax

rate is 35%?

A) 10.03%

B) 9.12%

C) 9.57%

D) 7.29%

Answer: B

Explanation: B) Market value debt = $20 million × 120% = $24 million

Market value equity = 2 million × $19 = $38 million

Total market value = $62 million

D% = $24 / $62 = 38.7096774%

E% = $38 / $62 = 61.2903226%

Diff: 2 Var: 50+

Skill: Analytical


Author: WC


15) Holding everything else constant, an increase in cash ________ a firm's net debt.

A) will decrease

B) will have no impact on

C) will increase

D) may increase or decrease


Skill: Conceptual


Author: WC


25


16) SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt. The

bank debt costs 5% per year. The estimated equity beta is 2. If the market risk premium is 9% and the

risk-free rate is 3%, compute the weighted average cost of capital if the firm's tax rate is 30%.

A) 15.17%

B) 15.93%

C) 16.68%

D) 17.44%

Answer: A

Explanation: A) Cost of debt = rate on bank debt = 5%

Cost of equity = Risk-free rate + Beta × Market risk premium

Weight of debt = 1- Weight of equity.

Cost of equity = 0.03 + 2 × 0.09 = 0.21 or 21%

Weight of equity = 10/(10 + 5) = 0.66666667 or 66.67%

Weight of debt = 1 - 0.66666667 = 0.33333333 or 33.33%

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


17) SIROM Scientific Solutions has $5 million of outstanding equity and $5 million of bank debt. The bank

debt costs 4% per year. The estimated equity beta is 2. If the market risk premium is 8% and the risk-free

rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 35%.

A) 11.87%

B) 12.43%

C) 11.30%

D) 13.00%

Answer: C

Explanation: C) Cost of debt = rate on bank debt



Cost of equity = 0.04 + 2 × 0.08 = 0.2 or 20%

Weight of equity = 5/(5 + 5) = 0.5 or 50%

Weight of debt = 1 - 0.5 = 0.5 or 50%

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


26


18) SIROM Scientific Solutions has $12 million of outstanding equity and $4 million of bank debt. The

bank debt costs 4% per year. The estimated equity beta is 1. If the market risk premium is 8% and the

risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 30%.

A) 8.73%

B) 9.22%

C) 9.70%

D) 10.67%

Answer: C

Explanation: C) Cost of debt = rate on bank debt



Cost of equity = 0.04 + 1 × 0.08 = 0.12 or 12%

Weight of equity= 12/(12 + 4) = 0.75 or 75%

Weight of debt = 1 - 0.75 = 0.25 or 25%

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


19) A firm has a capital structure with $50 million in equity and $100 million of debt. The cost of equity

capital is 11% and the pretax cost of debt is 5%. If the marginal tax rate of the firm is 40%, compute the

weighted average cost of capital of the firm.

A) 4.5%

B) 5.1%

C) 5.67%

D) 6.5%

Answer: C

Explanation: C)

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


27





A) 6.7%

B) 7.0%

C) 7.8%

D) 8.6%

Answer: C

Explanation: C)

Diff: 2 Var: 50+

Skill: Analytical


Author: KB





A) 7.3%

B) 7.6%

C) 8.0%

D) 8.4%

Answer: A

Explanation: A)

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


22) What type of adjustment to debt is in practice?

Answer: Most practitioners use net debt, which is total debt outstanding minus cash and other risk-free

securities. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


28


13.4 Using the WACC to Value a Project

1) When a firm is evaluating the purchase of a business that is unrelated to its current business, it is

appropriate to use the current WACC of the firm that is purchasing the business.


Skill: Conceptual


Author: KB


2) Assume General Motors has a weighted average cost of capital of 9%. GM is considering investing in a

new plant that will save the company $20 million over each of the first two years, and then $10 million

each year thereafter. If the investment is $100 million, what is the net present value (NPV) of the project?

A) $25.8 million

B) $31.6 million

C) $28.7 million

D) $27.3 million

Answer: C

Explanation: C) Compute the present value of future cash flows using the WACC, and subtract the

investment cost.

million

NPV = -$100 million + $20 million / (1.09) + ($20 million + 111.111111 million) / (1.09)2 = $28.7 million Diff: 2 Var: 24

Skill: Analytical


Author: KB


3) Assume General Motors has a weighted average cost of capital of 10%. GM is considering investing in

a new plant that will save the company $30 million over each of the first two years, and then $15 million


A) $18.2 million

B) $20.8 million

C) $23.4 million

D) $26.0 million

Answer: D

Explanation: D) Compute the present value of future cash flows using the WACC, and subtract the

investment cost.

NPV = -$150 million + $30 million / (1.1) + ($30 million + 150 million) / (1.1)2

Diff: 2 Var: 24

Skill: Analytical


Author: KB


29


4) Assume General Motors has a weighted average cost of capital of 10%. GM is considering investing in

a new plant that will save the company $30 million over each of the first two years, and then $25 million


A) $65.2 million

B) -$76.1 million

C) -$86.9 million

D) $108.7 million

Answer: D

Explanation: D) Compute the present value of future cash flows using the WACC, and subtract the

investment cost.

NPV = -$150 million + $30 million / 1.1 + ($30 million + $250 million) / (1.1)2

Diff: 2 Var: 15

Skill: Analytical


Author: KB


5) When we use the WACC to assess a project, we assume that the ________ ratio does not change.

A) reward to systematic risk

B) risk to reward

C) debt to equity

D) volatility to systematic risk


Skill: Conceptual


Author: KB


6) When we compute the cost of equity capital for a project we assume that the ________ of the project is

equivalent to the average market risk of the firm's investments.

A) diversifiable risk

B) market risk

C) unsystematic risk

D) volatility


Skill: Conceptual


Author: KB


30


7) Assume SAP Inc. received a $1 million grant under its Small Business Innovation program. SAP

invested the grant money and developed a system to remove metal contaminants from storm water in

shipyards. The firm estimates that each shipyard spends $500,000 a year on storm water clean-up efforts.

If SAP is able to sign up and retain four shipyards from the first year onwards, what is the present value

(PV) of the project (net of investment) if the cost of capital for SAP is 20% per year? Assume a cost of

operations and other costs for SAP equal 60% of revenue.

A) $3.00 million

B) $3.30 million

C) 3.60 million

D) $3.90 million

Answer: A

Explanation: A) Net present value = -Investment + Present Value of (Revenues × (1 - proportion of costs))

Diff: 1 Var: 30

Skill: Analytical


Author: KB


8) Assume SAP Inc. received a $2 million grant under its Small Business Innovation program. SAP

invested the grant money and developed a system to remove metal contaminants from storm water in

shipyards. The firm estimates that each shipyard spends $600,000 a year on storm water clean-up efforts.

If SAP is able to sign up and retain four shipyards from the first year onwards, what is the present value

(PV) of the project (net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of

operations and other costs for SAP equal 60% of revenue.

A) $3.89 million

B) $4.13 million

C) $4.86 million

D) $5.10 million

Answer: C

Explanation: C) Net present value = -Investment + Present Value of

Diff: 1 Var: 24

Skill: Analytical


Author: KB


31


9) SAP Inc. received a $1.5 million grant under its Small Business Innovation program. SAP invested the

grant money and developed a system to remove metal contaminants from storm water in shipyards. The

firm estimates that each shipyard spends $500,000 a year on storm water clean-up efforts. If SAP is able to

sign up and retain four shipyards in the first year onwards, what is the present value (PV) of the project

(net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of operations and other

costs for SAP equal 50% of revenue.

A) $4.51 million

B) $4.80 million

C) $5.93 million

D) $5.64 million

Answer: D

Explanation: D) Net present value = -Investment + Present Value of

Diff: 1 Var: 30

Skill: Analytical


Author: KB


10) A firm is considering investing in a new project with an upfront cost of $400 million. The project will

generate an incremental free cash flow of $50 million in the first year and this cash flow is expected to

grow at an annual rate of 3% forever. If the firm's WACC is 12%, what is the value of this project?

A) $155.6 million

B) $555.6 million

C) $583.3 million

D) $183.3 million

Answer: A

Explanation: A) Value of the project = FCF0 + FCF1/(rwacc - g) = -$400 million + $50 million /(0.12 - 0.03)

= $155.6 million Diff: 2 Var: 36

Skill: Analytical


Author: WC


11) Which of the following is NOT a step in the WACC valuation method?

A) Compute the weighted average cost of capital.

B) Discount the incremental free cash flows of the investment using the weighted average cost of capital.

C) Determine the incremental free cash flows of the investment.

D) Determine the mean weighted average cost of capital for the firm's industry.


Skill: Conceptual


Author: WC


32


12) What is the assumption about risk when using WACC to evaluate a project?

Answer: Using WACC in evaluating a firm's project implies that the risk of the project is comparable to

the average risk of the firm's other investments. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


13) What is the assumption about leverage when using WACC to evaluate a project?

Answer: The implied assumption in using WACC to evaluate a firm's project is that the firm is

continuously maintaining a constant ratio of market value of debt to market value of equity—a

relationship referred to as the debt-equity ratio. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


13.5 Project-Based Costs of Capital

1) Firms that have many divisions with different lines of business do not use a companywide WACC to

evaluate projects.


Skill: Conceptual


Author: KB


2) Divisional costs of capital are more appropriate when evaluating a project for a line of business when

the types of business in a firm are ________.

A) mature businesses

B) similar

C) new businesses

D) different


Skill: Conceptual


Author: KB


33


3) Anheuser Busch, a manufacturer of beverages, is planning to purchase Six Flags theme parks.

Anheuser Busch should use the ________ to evaluate the business of Six Flags.

A) WACC of Anheuser Busch

B) WACC of Six Flags

C) average market return

D) divisional cost of capital


Skill: Conceptual


Author: KB


4) Different divisions with differing lines of business use different costs of capital because their cost of

________ could be different.

A) debt

B) equity

C) capital

D) assets


Skill: Conceptual


Author: KB


5) Different divisions with differing lines of business use different costs of capital because their cost of

equity is different and also because the ________ could be different.

A) optimal volatility

B) optimal current ratio

C) optimal asset mix

D) optimal debt-equity ratio


Skill: Conceptual


Author: KB


34


6) Verano Inc. has two business divisions—a software product line and a waste water clean-up product

line. The software business has a cost of equity capital of 10% and the waste water clean-up business has

a cost of equity capital of 7%. Verano has 50% of its revenue from software and the rest from the waste

water business. Verano is considering a purchase of another company in the waste water business using

equity financing. What is the appropriate cost of capital to evaluate the business?

A) 10.0%

B) 7.0%

C) 8.5%

D) 9.0%

Answer: B

Explanation: B) Cost of capital = Cost of capital for the related division

Cost of capital = 7% Diff: 1 Var: 14

Skill: Analytical


Author: KB







A) 11.0%

B) 7.5%

C) 4.0%

D) 6.0%

Answer: C

Explanation: C) Cost of capital = Cost of capital for the related division


Skill: Analytical


Author: KB


35







A) 10.0%

B) 8.0%

C) 9.0%

D) 11.0%

Answer: B

Explanation: B) Cost of capital = Cost of capital for the related division


Skill: Analytical


Author: KB


13.6 When Raising External Capital Is Costly

1) The costs of external financing must be deducted from the net present value (NPV) of a project to

evaluate if it is worth undertaking.


Skill: Conceptual


Author: KB


2) Internal financing is more costly than external financing because of issuance costs.


Skill: Conceptual


Author: KB


36


3) Assume Ford Motors expects a new hybrid-engine project to produce incremental cash flows of $90

million each year and expects these to grow at 3% each year. The upfront project costs are $900 million

and Ford's weighted average cost of capital is 9%. If the issuance costs for external finances are $20

million, what is the net present value (NPV) of the project?

A) $986 million

B) $696 million

C) $609 million

D) $580 million

Answer: D

Explanation: D) Compute present value of the cash flows at WACC and subtract investment costs as well

as issuance costs.

Cash outflows = $900 million + $20 million = $920 million;

NPV = $1500 million - $920 million = $580 million Diff: 2 Var: 50+

Skill: Analytical


Author: KB



million each year, and expects these to grow at 4% each year. The upfront project costs are $420 million



A) $504 million

B) $560 million

C) $588 million

D) $616 million

Answer: B

Explanation: B) Compute present value of the cash flows at WACC and subtract investment costs as well

as issuance costs.

Cash outflows = $420 million + $20 million = $440 million;


Skill: Analytical


Author: KB


37



million each year, and expects these to grow at 3% each year. The upfront project costs are $380 million



A) $324 million

B) $378 million

C) $360 million

D) $396 million

Answer: C

Explanation: C) Compute present value of the cash flows at WACC and subtract investment costs as well

as issuance costs.

cash outflows = $380 million + $10 million = $390 million;


Skill: Analytical


Author: KB


6) A firm is considering acquiring a competitor. The firm plans on offering $160 million for the

competitor. The firm will need to issue new debt and equity to finance the acquisition. You estimate the

issuance costs to be $10 million. The acquisition will generate an incremental free cash flow of $20 million

in the first year and this cash flow is expected to grow at an annual rate of 3% forever. If the firm's WACC

is 13%, what is the value of this project?

A) $30 million

B) $38 million

C) $45 million

D) $53 million

Answer: A

Explanation: A) NPV = FCF0 + FCF1/(rwacc - g)

FCF0= -$160 - $10 = -$170

NPV = -$170 + $20 / (0.13 - 0.03) = $30.00 million Diff: 2 Var: 50+

Skill: Analytical


Author: WC


38



A) Issuance costs increase the WACC.

B) External equity is less expensive than retained earnings.

C) A project that can be financed with internal funds will be less costly than the same project if it were

financed with external funds.

D) Issuance costs should be treated as cash outflows in NPV analysis.


Skill: Conceptual


Author: WC


1



Chapter 14 Raising Equity Capital

14.1 Equity Financing for Private Companies 1) When a company founder sells stock to outside investors in order to raise capital, the share of the

company owned by the founder and the founder's control over the company will be reduced.


Skill: Conceptual


Author: DS


2) Equity investors in a private company usually plan to realize a return on their investment by selling

their stock when that company is acquired by another firm or sold to the public in a public offering.


Skill: Conceptual


Author: DS


3) Which of the following is LEAST likely to be a possible source of funds to finance a growing business?

A) angel investors

B) venture capital firms

C) institutional investors

D) family investors


Skill: Conceptual


Author: DS


4) Nature's Bounty, an organic seed company, is seeking to grow from a small company selling seeds in

local markets into a company that sells seeds across several states. The funding for this expansion comes

from a wealthy individual who uses his considerable inherited wealth to fund a variety of eco-friendly

businesses. Which of the following best describes the individual's relationship with Nature's Bounty?

A) an angel investor

B) a venture capitalist

C) an institutional investor

D) a corporate investor


Skill: Conceptual


Author: DS


2


5) Why do most people launching a start-up company acquire their funds through the venture capital

industry rather than through angel investors?

A) Most entrepreneurs are not willing to relinquish the control of their business demanded by angel

investors.

B) Most entrepreneurs do not want the fees associated with investment by an angel investor.

C) Most entrepreneurs do not need the expertise brought to a young firm by an angel investor.

D) Most entrepreneurs do not have any relationships with individuals with substantial capital to invest.


Skill: Conceptual


Author: DS


6) Which of the following is NOT a reason why an investor would choose to invest in new and growing

firms as a limited partner in a venture capital firm rather than making those investments directly by

themselves?

A) Venture capital firms use their control of the companies they invest in to protect those investments.

B) The investments of venture capital firm are more diversified than the investments of a single

individual.

C) A venture capital firm generally has a wide range of expertise among its general partners.

D) The investor will have a direct say in how the companies that the venture capital firm funds will be

run.


Skill: Conceptual


Author: DS


7) Which of the following best describes a limited partnership that specializes in raising money to invest

in the private equity of young firms?

A) venture capital firms

B) institutional investors

C) corporate investors

D) family investors


Skill: Conceptual


Author: DS


3


8) A large publishing firm specializing in college textbooks wishes to expand into online delivery of its

materials. In order to facilitate this, it invests in a number of small start-up companies that deliver college

courses online and uses these companies to start diversifying the delivery of its content. Which of the

following best describes the role of the publishing firm as described above?

A) a venture capitalist

B) an institutional investor

C) a corporate investor

D) a family investor


Skill: Conceptual


Author: DS


9) The Ontario Teachers' Pension Plan is a pension fund for public school teachers in the province of

Ontario. It has a large and diverse portfolio of investments, both in Canada and internationally, and had

net assets in December 2007 of C$108.5 billion. Which of the following best describes the Ontario

Teachers' Pension Plan?

A) an angel investor

B) a venture capitalist

C) an institutional investor

D) a family investor


Skill: Conceptual


Author: DS


10) A firm's founder sells equity to outside investors for the first time in the form of preferred stock. In

what way is this preferred stock most likely to differ from the preferred stock issued by an established

public firm?

A) It will have a larger dividend.

B) It will most likely not pay cash dividends.

C) It will give the holder seniority in any liquidation of the company.

D) It cannot be converted into common stock.


Skill: Conceptual


Author: DS


4


11) Simone founded her company using $200,000 of her own money, issuing herself 200,000 shares of

stock. An angel investor bought an additional 100,000 shares for $150,000. She now sells another 500,000

shares of stock to a venture capitalist for $1.5 million. What is the post-money valuation of the company?

A) $1,200,000

B) $1,320,000

C) $2,400,000

D) $3,600,000

Answer: C

Explanation: C) 500,000 shares at $1.5 million leads to a valuation of $3 per share;

Total shares = 500,000 + 200,000 + 100,000 = 0.8 million;

Company valuation = 0.8 million × $3 = $2.4 million Diff: 1 Var: 50+

Skill: Analytical


Author: DS


12) Simone founded her company using $200,000 of her own money, issuing herself 300,000 shares of

stock. An angel investor bought an additional 100,000 shares for $150,000. She now sells another 400,000

shares of stock to a venture capitalist for $2 million. What percentage of the firm does Simone now own?

A) 11%

B) 23%

C) 38%

D) 41%

Answer: C

Explanation: C)

Simone's ownership = 300,000 shares / 800,000 shares = 38% Diff: 1 Var: 50+

Skill: Analytical


Author: DS


13) An entrepreneur founded his company using $200,000 of his own money, issuing himself 200,000

shares of stock. An angel investor bought an additional 100,000 shares for $150,000. The entrepreneur

now sells another 400,000 shares of stock to a venture capitalist for$2 million. What is the post-money

valuation of the company?

A) $1,750,000

B) $1,925,000

C) $3,500,000

D) $4,025,000

Answer: C

Explanation: C) Total shares = 200,000 + 100,000 + 400,000 = 700,000;

400,000 shares for $2 million leads to a share price of $5.00 per share;

Company valuation = 5.00 × 700,000 = $3,500,000 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


5


14) Jeremy founded a company. He issues 100,000 shares of series A stock for his own $100,000

investment. He then goes through three further rounds of investment, as shown below:

Round Price Number of Shares

Series B $1.00 500,000

Series C $1.50 300,000

Series D $1.75 500,000

What is the post-money valuation for the series D funding round?

A) $1.23 million

B) $1.72 million

C) $2.21 million

D) $2.45 million

Answer: D

Explanation: D)

Post-money valuation = $1.75 × 1.4 million = $2.45 million Diff: 1 Var: 30

Skill: Analytical


Author: DS


15) Jeremy founded a company. He issues 100,000 shares of series A stock for his own $100,000



Series B $1.00 500,000

Series C $1.50 300,000

Series D $1.75 500,000

Which of the following is closest to the percentage of the company owned by the series D investors?

A) 29%

B) 36%

C) 39%

D) 54%

Answer: B

Explanation: B)

Series D ownership = 0.5 million / 1.4 million = 36% Diff: 1 Var: 30

Skill: Analytical


Author: DS


6


16) The founder of a company issues 100,000 shares of series A stock for his own $250,000 investment. He

then goes through three further rounds of investment, as shown below:


Series B $2.50 200,000

Series C $2.75 300,000

Series D $2.80 300,000

What is the post-money valuation for the series D funding round?

A) $2.27 million

B) $2.39 million

C) $2.52 million

D) $2.77 million

Answer: C

Explanation: C)

$2.80 × 0.9 million = $2.52 million Diff: 1 Var: 23

Skill: Analytical


Author: DS


17) The founder of a company issues 200,000 shares of stock of series A stock for his own $250,000



Series B $2.50 200,000

Series C $2.75 300,000

Series D $2.90 100,000

Which of the following is closest to the percentage of the company owned by the founder of the

company?

A) 25.0%

B) 50.0%

C) 62.5%

D) 68.8%

Answer: A

Explanation: A)

percentage owned by founder = 0.2 / 0.8 = 0.250 or 25.0% Diff: 1 Var: 24

Skill: Analytical


Author: DS


7


18) Which of the following statements is NOT true regarding angel investors?

A) They are typically arranged as limited partnerships.

B) For many start-ups, the first round of outside private equity financing is often obtained from them.

C) Because their capital investment is often large relative to the amount of capital already in place at the

firm, they typically receive a sizable equity share in the business in return for their funds.

D) These investors are frequently friends or acquaintances of the entrepreneur.


Skill: Conceptual


Author: JN


19) Which of the following statements is NOT true regarding venture capitalists?

A) They can provide substantial capital for young companies.

B) Firms offer limited partners a number of advantages over investing directly in start-ups themselves as

angel investors.

C) They use their control to protect their investments, so they may therefore perform a key nurturing and

monitoring role for the firm.

D) They might invest for strategic objectives in addition to the desire for investment returns.


Skill: Conceptual


Author: JN


20) Which of the following is NOT a common name for a corporation that invests in private companies?

A) strategic investor

B) corporate partner

C) venture partner

D) strategic partner


Skill: Conceptual


Author: JN


8



A) A venture capital firm is a limited partnership that specializes in raising money to invest in the private

equity of young firms.

B) Venture capitalists typically control about three-quarters of the seats on a startup's board of directors,

and often represent the single largest voting block on the board.

C) The initial capital that is required to start a business is usually provided by the entrepreneur and her

immediate family.

D) Individual investors who buy equity in small private firms are called angel investors.

Answer: B

Explanation: B) Venture capitalists typically control about one-third of the seats on a startup's board of

directors, and often represent the single largest voting block on the board. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) The general partners work for and run the venture capital firm; they are called venture capitalists.

B) An important consideration for investors in private companies is their exit strategy—how they will

eventually realize the return from their investment.

C) When a company founder decides to sell equity to outside investors for the first time, it is common

practice for private companies to issue common stock rather than preferred stock to raise capital.

D) Institutional investors such as pension funds, insurance companies, endowments, and foundations

manage large quantities of money.

Answer: C

Explanation: C) When a company founder decides to sell equity to outside investors for the first time, it

is common practice for private companies to issue preferred stock rather than common stock to raise

capital. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


9



A) The preferred stock issued by young companies typically does not pay regular cash dividends.

B) The preferred stock issued by young companies usually gives the owner an option to convert it to

common stock on some future date, so it is often called callable preferred stock.

C) If a company runs into financial difficulties, the preferred stockholders have a senior claim on the

assets of the firm relative to any common stockholders.

D) Preferred stock issued by mature companies such as banks usually has a preferential dividend and

seniority in any liquidation and sometimes special voting rights.

Answer: B

Explanation: B) The preferred stock issued by young companies usually gives the owner an option to

convert it to common stock on some future date, so it is often called convertible preferred stock. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


24) Which of the following statements regarding exit strategies is FALSE?

A) An alternative way to provide liquidity to its investors is for the company to become a publicly traded

company.

B) An important consideration for investors in private companies is their exit strategy, or how they will

eventually realize the return from their investment.

C) Often large corporations purchase successful start-up companies. In such a case, the acquiring

company purchases the outstanding stock of the private company, allowing all investors to cash out.

D) Roughly 25% of venture capital exits from 2001-2005 occurred through mergers or acquisitions.

Answer: D

Explanation: D) Roughly 85% of venture capital exits from 2001-2005 occurred through mergers or

acquisitions. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


10


25) You founded your own firm three years ago. You initially contributed $200,000 of your own money

and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million

shares of stock to angel investors. You are now considering raising capital from a venture capital firm.

This venture capital firm would invest $4 million and would receive 2 million newly issued shares in

return. The post-money valuation of your firm is closest to ________.

A) $10.0 million

B) $4.0 million

C) $9.0 million

D) $3.5 million

Answer: A

Explanation: A) Total shares outstanding = 2 million + 1 million + 2 million = 5 million shares

The venture capitalist would be paying = $2 per share

Diff: 2 Var: 50+

Skill: Analytical


Author: JN






return. Assuming that this is the venture capitalist's first investment in your firm, what percentage of the

firm will the venture capitalist own?

A) 36%

B) 29%

C) 17%

D) 21%

Answer: B

Explanation: B)

Diff: 1 Var: 50+

Skill: Analytical


Author: JN


11





This venture capital firm would invest $6 million and would receive 3million newly issued shares in

return. After the venture capitalist's investment, what percentage of the firm will you own?

A) 42%

B) 33%

C) 25%

D) 20%

Answer: B

Explanation: B)

Diff: 1 Var: 50+

Skill: Analytical


Author: JN






return. After the venture capitalist's investment, the post-money valuation of your shares is closest to

________.

A) $2.5 million

B) $6.3 million

C) $2.0 million

D) $1.3 million

Answer: A

Explanation: A)

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


12






return. After the venture capitalist's investment, the post-money valuation of the angel investor's shares is


A) $12.5 million

B) $4.0 million

C) $5.0 million

D) $2.5 million

Answer: D

Explanation: D)

Therefore, the angel investor's post-money

Diff: 2 Var: 50+

Skill: Analytical


Author: JN






return. Suppose you sold the 2 million shares to the angel investor for $500,000. What was the post-

money valuation of your shares immediately following the angel investor's investment?

A) $500,000

B) $0.75 million

C) $1.5 million

D) $1.9 million

Answer: B

Explanation: B) The angel investor paid = $0.25 per share

Diff: 2 Var: 50+

Skill: Analytical


Author: JP


13






return. Suppose you sold the 2 million shares to the angel investor for $500,000. What was your

percentage ownership in the company immediately following the angel investor's investment?

A) 50%

B) 40.0%

C) 60.0%

D) 100%

Answer: C

Explanation: C) Total shares outstanding = 3 million + 2 million = 5 million. Your share is

Diff: 2 Var: 50+

Skill: Analytical


Author: JP


32) What are angel investors?

Answer: Individual investors who buy equity in small private firms are called angel investors. These are

often friends or acquaintances of the entrepreneur and receive a sizable equity share in the business in

return for their funds. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


33) What are venture capital firms?

Answer: Venture capital firms are limited partnerships that specialize in raising money to invest in

private equity of young firms. Typically, institutional investors, such as pension funds are partners in the

venture capital firm. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


34) What is the difference between preferred stocks issued by a private company and a mature company?

Answer: Preferred stock issued by a private company generally does not carry a dividend but is often

convertible to common equity if the firm is successful. Alternately, if the firm does not do well, the

preferred stock has a higher claim on the assets of the firm. Preferred stock issued by a mature company

generally carries a preferred dividend, seniority in liquidation, and special voting rights. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


14


14.2 Taking Your Firm Public: The Initial Public Offering

1) The main advantages for a firm in going public are greater liquidity and better access to capital.


Skill: Conceptual


Author: DS


2) In a best-efforts IPO, the underwriter guarantees that all stock will be sold.


Skill: Conceptual


Author: DS


3) The firm commitment process is the most common practice for IPOs in the United States.


Skill: Conceptual


Author: DS


4) Which of the following is NOT a reason why an IPO is attractive to the managers of a private

company?

A) It gives its private equity investors the opportunity to diversify.

B) It gives access to large amounts of capital in the IPO.

C) It reduces the complexity of requirements regulating the company's management.

D) It gives access to much larger amounts of capital through the public markets in subsequent offerings.


Skill: Conceptual


Author: DS


5) Which of the following best describes those shares sold when a company goes public which raise new

capital?

A) primary offering

B) secondary offering

C) tertiary offering

D) preliminary offering


Skill: Conceptual


Author: DS


15


6) At what stage of the IPO process do senior management and the lead underwriters travel to promote

the company and explain their rationale for the offer price to the underwriters' largest customers?

A) when filing with the secs

B) after initial price range is established

C) when managing risk

D) when matching buyers to sellers of the stock


Skill: Conceptual


Author: DS


7) Which of the following is an activity typically taken by an underwriter during an IPO of a company?

A) helping the company with all necessary filings

B) determining the offer price

C) marketing the IPO

D) all of the above


Skill: Conceptual


Author: DS


8) Which of the following best describes a firm commitment IPO?

A) The underwriter purchases the entire issue at a small discount and then resells it at the offer price.

B) The underwriter sells new issues directly to the public in an online auction.

C) The underwriter tries to sell the stock for the best possible price but does not guarantee that the stock

will be sold.

D) The underwriter solicits bids from investors and chooses the highest price at which there is sufficient

demand to sell the entire issue.


Skill: Conceptual


Author: DS


16


9) Price ($) Number of Shares Bid

5.00 600,000

5.25 700,000

5.50 850,000

5.75 775,000

6.00 700,000

6.25 300,000

6.50 225,000

Felicity Industries is selling 2 million shares of stock in an auction IPO. At the end of the bidding period it

has received the bids shown above. Which of the following is closest to the price at which the shares will

be offered?

A) $5.00

B) $5.25

C) $5.75

D) $6.00

Answer: C

Explanation: C)

hence, $5.75 is the price at which there is sufficient demand to sell the entire issue. Diff: 1 Var: 50+

Skill: Analytical


Author: DS


10) Price ($)Number of Shares Bid

6.00 100,000

6.25 200,000

6.50 450,000

6.75 150,000

7.00 450,000

7.25 100,000

7.50 300,000

Harrison Products is selling 1 million shares of stock in an auction IPO. At the end of the bidding period

it has received the bids shown above. Which of the following is closest to the price at which the shares

will be offered?

A) $6.25

B) $6.60

C) $6.75

D) $7.00

Answer: C

Explanation: C)


Skill: Analytical


Author: DS


17


11) Price ($)Number of Shares Bid

3.00 100,000

3.25 100,000

3.50 170,000

3.75 100,000

4.00 40,000

4.25 80,000

4.50 135,000

4.75 65,000

Bejeweled, a chain of crafting shops, is selling 500,000 shares of stock in an auction IPO. At the end of the

bidding period they have received the bids shown above. Which of the following is closest to the price at

which the shares will be offered?

A) $3.50

B) $3.75

C) $4.25

D) $4.75

Answer: A

Explanation: A)


Skill: Analytical


Author: DS


18


12) David found a company and goes through the investment rounds shown below:

Round Source Price Number of Shares

Series A Self $0.50 375,000

Series B Angel $1.00 400,000

Series C Venture Capital $1.50 250,000

Series D Venture Capital $2.25 400,000

He decides to take the company public through an IPO, issuing 2 million new shares. Assuming that he

successfully completes the IPO, the net income for the next year is estimated to be $9 million. His banker

informs him that the price of shares should be set using average price-earnings ratios for similar

businesses, which is 14. What will be the IPO price per share?

A) $3.68

B) $22.07

C) $36.79

D) $68.06

Answer: C

Explanation: C)

EPS = $9 million / 3.425 million; IPO price = $14 × $9 million / 3.425 million = $36.79 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


13) David found a company and goes through the investment rounds shown below:





Series D Venture Capital $2.25 350,000

He decides to take the company public through an IPO, issuing 2 million new shares. Assuming that he

successfully completes the IPO, the net income for the next year is estimated to be $8 million. His banker

informs him that the price of shares should be set using average price-earnings ratios for similar

businesses, which is 14. What share of the company will David own after the IPO?

A) 10%

B) 13%

C) 15%

D) 19%

Answer: A

Explanation: A)

David's share = 0.325 million / 3.35 million = 10% Diff: 1 Var: 50+

Skill: Analytical


Author: DS


19


14) In its IPO, Jillian's Imprints, a small publishing house, offered stock at a price of $10.00 per share. The

underwriters of this IPO had a spread of 6.5% per share. If 2 million shares were sold, what funds did

Jillian's receive from the IPO?

A) $5.61 million

B) $18.70 million

C) $20.57 million

D) $22.44 million

Answer: B

Explanation: B) $10.00 × 2 million = $20 million; 93.5% of 20 million = $18.70 million Diff: 1 Var: 25

Skill: Analytical


Author: DS


15) The founders and owners of a private company have funded it through the following rounds of

investment:





The owners decide to take the company public through an IPO, issuing 1 million new shares. Assuming

that they successfully complete the IPO, the net income for the next year is estimated to be $5 million. The

price of shares is set using average price-earnings ratios for similar businesses of 16. What will be the IPO

price per share?

A) $12

B) $24

C) $9

D) $47

Answer: D

Explanation: D)

EPS = $5 million / 1.7 million; price = 16 × $5 million / 1.7 million = $47 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


20


16) The founders and owners of a private company have funded it through the following rounds of

investment:





The owners decide to take the company public through an IPO, issuing 1 million new shares. Assuming

that they successfully complete the IPO, the net income for the next year is estimated to be $6 million. The

price of shares is set using average price-earnings ratios for similar businesses of 15. What portion of the

company will be owned by the angel investor after the IPO?

A) 10%

B) 13%

C) 19%

D) 24%

Answer: B

Explanation: B)

angel investor = 0.225 million / 1.675 million = 13% Diff: 1 Var: 50+

Skill: Analytical


Author: DS


17) What is the major reason that underwriters tend to offer stocks in an IPO at a price that is below that

which the market will pay?

A) to gain from the rise in value of any stocks they hold after the IPO

B) to reduce their exposure to losses from unsold stock

C) to benefit from greenshoe provisions

D) to increase their spread


Skill: Conceptual


Author: DS


21


18) The founder of a company currently holds 12 million of the 15 million shares in that company. She

considers an IPO where she sells a mix of primary shares and 2 million of her own secondary shares for

$16 per share. If she wants to retain a 70% ownership of the company, how much money can she raise in

this IPO?

A) $9 million

B) $12 million

C) $15 million

D) $24 million

Answer: D

Explanation: D) 70% of 15 million shares = 0.7 × 15 million shares = 10.5 million shares;

Thus, the founder can sell 12 million - 10.5 million = 1.5 million shares;

The amount of money the owner can raise = 1.5 million × $16 = $24 million Diff: 1 Var: 18

Skill: Analytical


Author: DS



A) The process of selling stock to the public for the first time is called a seasoned equity offering (SEO).

B) Public companies typically have access to much larger amounts of capital through the public markets.

C) By going public, companies give their private equity investors the ability to diversify.

D) The two advantages of going public are greater liquidity and better access to capital.

Answer: A

Explanation: A) The process of selling stock to the public for the first time is called an initial public

offering (IPO). Diff: 1 Var: 1

Skill: Conceptual


Author: JN


22



A) Once a company goes public, it must satisfy all of the requirements of public companies.

B) Organizations such as the Securities and Exchange Commission (SEC), the securities exchanges

(including the NYSE and the NASDAQ), and Congress (through the Sarbanes-Oxley Act of 2002) adopted

new standards that focused on more thorough financial disclosure, greater accountability, and more

stringent requirements for the board of directors.

C) The major advantage of undertaking an IPO is also one of the major disadvantages of an IPO: When

investors diversify their holdings, the equity holders of the corporation become more concentrated.

D) Several high profile corporate scandals during the early part of the twenty-first century prompted

tougher regulations designed to address corporate abuses.

Answer: C

Explanation: C) The major advantage of undertaking an IPO is also one of the major disadvantages of an

IPO: When investors diversify their holdings, the equity holders of the corporation become more

dispersed. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) After deciding to go public, managers of the company work with an underwriter, an investment

banking firm that manages the offering and designs its structure.

B) The shares that are sold in the IPO may either be new shares that raise new capital, known as a

secondary offering, or existing shares that are sold by current shareholders (as part of their exit strategy),

known as a primary offering.

C) Many IPOs, especially the larger offerings, are managed by a group of underwriters.

D) In an IPO, a firm offers a large block of shares for sale to the public for the first time.

Answer: B

Explanation: B) The shares that are sold in the IPO may either be new shares that raise new capital,

known as a primary offering, or existing shares that are sold by current shareholders (as part of their exit

strategy), known as a secondary offering. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


23


22) Which of the following statements regarding best efforts IPOs is FALSE?

A) For smaller IPOs, the underwriter commonly accepts the deal on this basis.

B) The underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the

best possible price.

C) Often these arrangements have an all-or-none clause: either all of the shares are sold in the IPO, or the

deal is called off.

D) If the entire issue does not sell out, the underwriter is on the hook.

Answer: D

Explanation: D) If the entire issue does not sell out, the underwriter is off on the hook since this is not a

firm commitment offering. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


23) Which of the following statements regarding firm commitment IPOs is FALSE?

A) If the entire issue does not sell out, the remaining shares must be sold at a lower price and the

underwriter must take the loss.

B) The underwriter purchases the entire issue (at an offer price) and then resells it at a slightly higher

price to interested investors.

C) It is the most common underwriting arrangement.

D) The underwriter guarantees that it will sell all of the stock at the offer price.

Answer: B

Explanation: B) The underwriter purchases the entire issue (at a price slightly lower than the offer price)

and then resells it at the offer price to interested investors. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


24



A) In recent years, the investment banking firm of WR Hambrecht + Company has attempted to change

the IPO process by selling new issues directly to the public using an online auction IPO mechanism called

Open IPO.

B) The lead underwriter is the primary banking firm responsible for managing the deal. The lead

underwriter provides most of the advice and arranges for a group of other underwriters, called the

syndicate, to help market and sell the issue.

C) Because of the potential conflict of interest, the underwriter will not make a market in the stock after

the issue.

D) The SEC requires that companies prepare a registration statement, a legal document that provides

financial and other information about the company to investors, prior to an IPO. Company managers

work closely with the underwriters to prepare this registration statement and submit it to the SEC.

Answer: C

Explanation: C) Many underwriters will commit to make a market in the stock after the issue. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


25) As part of the registration statement, the preliminary prospectus circulates to investors before the

stock is offered. This preliminary prospectus is also called a(n) ________.

A) IPO filing

B) 10-K filing

C) blue whale

D) red herring


Skill: Definition


Author: JN



A) Once the issue price (or offer price) is set, underwriters may invoke another mechanism that allows

them to sell extra shares of more successful offerings—the over-allotment allocation.

B) Before the offer price is set, the underwriters work closely with the company to come up with a price

range that they believe provides a reasonable valuation for the firm.

C) Before an IPO, the company prepares the final registration statement and final prospectus containing

all the details of the IPO, including the number of shares offered and the offer price.

D) In a cash offer, a firm offers the new shares only to existing shareholders.

Answer: D

Explanation: D) In a rights offer, a firm offers the new shares only to existing shareholders. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


25



A) Underwriters appear to use the information they acquire during the book-building stage to

intentionally underprice the IPO, thereby reducing their exposure to losses.

B) The green shoe option restricts an underwriter to issue more stock at the IPO offer price.

C) The lead underwriter usually makes a market in the stock by matching buyers and sellers and assigns

an analyst to cover it.

D) In most cases, the existing shareholders are subject to a 180-day lockup; they cannot sell their shares

for 180 days after the IPO. Once the lockup period expires, they are free to sell their shares.

Answer: B

Explanation: B) The green shoe option allows the underwriter to issue more stock, amounting to 15% of

the original offer size, at the IPO offer price. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


26


28) Luther Industries is in the process of selling shares of stock in an auction IPO. At the end of the

bidding period, Luther's investment bank has received the following bids:

Price ($)

Number of

Shares Bid

$19.40 50,000

$19.25 25,000

$19.10 25,000

$19.00 100,000

$18.75 125,000

$18.50 75,000

$18.25 150,000

$18.00 240,000

$17.75 80,000

$17.60 125,000

$17.35 150,000

$17.15 100,000

$16.90 60,000

$16.75 80,000

$16.50 75,000

$16.25 200,000

What will the offer price of these shares be if Luther is selling 1 million shares?

A) $17.15

B) $17.60

C) $17.35

D) $16.75

Answer: C

Explanation: C)

Price ($)

Number of

Shares Bid

Cumulative

Demand

$19.40 50,000 50,000

$19.25 25,000 75,000

$19.10 25,000 100,000

$19.00 100,000 200,000

$18.75 125,000 325,000

$18.50 75,000 400,000

$18.25 150,000 550,000

$18.00 240,000 790,000

$17.75 80,000 870,000

$17.60 125,000 995,000

$17.35 150,000 1,145,000

$17.15 100,000 1,245,000

$16.90 60,000 1,305,000

$16.75 80,000 1,385,000

$16.50 75,000 1,460,000

$16.25 200,000 1,660,000

27


By looking at cumulative demand, we see that a cumulative demand of 1 million shares corresponds to a

price of $17.35.

Diff: 2 Var: 12

Skill: Analytical


Author: JN


28


29) Luther Industries is in the process of selling shares of stock in an auction IPO. At the end of the

bidding period, Luther's investment bank has received the following bids:

Price ($)

Number of

Shares Bid

$19.70 50,000

$19.25 25,000

$19.10 25,000

$19.00 100,000

$18.75 125,000

$18.50 75,000

$18.25 150,000

$18.00 240,000

$17.75 80,000

$17.40 125,000

$17.15 150,000

$16.95 100,000

$16.80 60,000

$16.75 80,000

$16.50 75,000

$16.25 200,000

The proceeds from the IPO be if Luther is selling 1.25 million shares is closest to ________.

A) $18.9 million

B) $22.1 million

C) $21.0 million

D) $20.0 million

Answer: C

Explanation: C)

Price ($)

Number of

Shares Bid

Cumulative

Demand

$19.70 50,000 50,000

$19.25 25,000 75,000

$19.10 25,000 100,000

$19.00 100,000 200,000

$18.75 125,000 325,000

$18.50 75,000 400,000

$18.25 150,000 550,000

$18.00 240,000 790,000

$17.75 80,000 870,000

$17.40 125,000 995,000

$17.15 150,000 1,145,000

$16.95 100,000 1,245,000

$16.80 60,000 1,305,000

$16.75 80,000 1,385,000

$16.50 75,000 1,460,000

$16.25 200,000 1,660,000

29


By looking at cumulative demand, we see that a cumulative demand of 1.25 million shares corresponds to

a price of $16.80.

So, proceeds = $16.80 × 1,250,000 = $21,000,000 Diff: 2 Var: 36

Skill: Analytical


Author: JN


30) What are some of the advantages of going public?

Answer: Going public provides liquidity and better access to capital. It also gives an opportunity to the

private investors to diversify their portfolio. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


31) What are some of the disadvantages of going public?

Answer: When investors sell their stake and diversify their holdings, they lose their ability to monitor the

company's management, resulting in a loss of control. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


32) What are some of the highlights of Google's IPO process?

Answer: The Google IPO process did not follow traditional IPO process. Rather than rely on their

underwriters, Google used an auction IPO mechanism for distributing their shares. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


14.3 IPO Puzzles

1) Stock issued in an IPO usually trades significantly higher at the end of the first day of trading than the

original IPO price.


Skill: Conceptual


Author: DS


30


2) Newly listed firms tend to perform relatively poorly in the three to five years after their IPOs.


Skill: Conceptual


Author: DS


3) How does the total cost of issuing stock for the first time compare to the costs of other securities?

A) substantially larger than the costs for most other securities

B) about the same as the cost for most other securities

C) substantially less than the cost for a few other securities

D) substantially less than the costs for most other securities


Skill: Conceptual


Author: DS


4) Which of the following is a notable puzzle in IPOs?

A) The number of IPOs is highly underestimated.

B) The number of IPOs is highly cyclical.

C) The number of IPOs is highly seasonal.

D) The number of IPOs is almost the same every year.


Skill: Conceptual


Author: JP


5) The offer price of shares in an IPO is generally less than the price those shares sell for at the end of the

first trading day. Which of the following parties suffer most from this situation?

A) the buyers of shares after the initial offering

B) the underwriters of the IPO

C) the pre-IPO shareholders of the issuing firm

D) the lead underwriter of the IPO


Skill: Conceptual


Author: DS


31


6) How does the size of an issue affect the fees charged by underwriters?

A) Although large issues generally have a smaller spread, the total fees for large number of shares

released is smaller than that for smaller issues.

B) Large issues generally have a similar spread to small issues and thus attract much greater fees.

C) Large issues have a reduced spread, which means that the total fees are generally the same as for

smaller issues.

D) Large issues have substantially larger direct costs and, thus, must charge a larger spread in order to be

profitable for the underwriter.


Skill: Conceptual


Author: DS


7) The cost of issuing an IPO in the U.S. is higher than most other security issuance fees. A typical spread

is ________.

A) 5%

B) 6%

C) 7%

D) 8%


Skill: Conceptual


Author: JP


8) Dusty Corporation is issuing an IPO with an issue price of $15 per share that is expected to raise about

$100 million. Which of the following is likely to be true?

A) The price of the stock will be less than $15 at the close of the first trading day.

B) The cost of the IPO to Dusty will be about $7 million.

C) The stock will perform very well in the three to five years after the issue.

D) None of the above is likely to happen.


Skill: Conceptual


Author: JP


32


9) Which of the following statements concerning the volume and number of IPOs issued over time is

most correct?

A) They are cyclical.

B) They tend to rise over time.

C) They tend to fall over time.

D) They remain approximately the same over time.


Skill: Conceptual


Author: DS


10) Underpricing of an IPO would most likely be greatest in which of the following markets?

A) Australia

B) China

C) Japan

D) United States


Skill: Conceptual


Author: DS


11) Which of the following is NOT one of the four characteristics of IPOs that puzzle financial

economists?

A) On average, IPOs appear to be underpriced.

B) The long-run performance of a newly public company (three to five years from the date of issue) is

superior to the overall market return.

C) The number of issues is highly cyclical.

D) The costs of the IPO are very high, and it is unclear why firms willingly incur such high costs.

Answer: B

Explanation: B) The long-run performance of a newly public company (three to five years from the date

of issue) is inferior to the overall market return. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


12) How does IPO pricing puzzle financial economists?

Answer: On average, IPOs appear to be underpriced because the price at the end of the first trading day

is often substantially higher than the IPO price. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


33


13) How do the transaction costs of IPO puzzle financial economists?

Answer: The costs of IPO are very high and it is unclear why firms willingly incur such high costs. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


14) What is the general long-run performance of an IPO?

Answer: The long-run performance, such as three to five years, for an IPO is poor. That is, on average, a

three- to five-year buy-and-hold strategy appears to be a bad investment. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


14.4 Raising Additional Capital: The Seasoned Equity Offering

1) A cash offer differs from a rights offer in that in the latter shares are offered to both existing

shareholders and investors at large.


Skill: Conceptual


Author: DS


2) The announcement of an SEO usually raises a stock's price.


Skill: Conceptual


Author: DS


3) Managers will try to protect their existing shareholders by selling new shares at a price that correctly

values or overvalues their firm, leading investors to reason that the announcement of an SEO indicates

that a company is over-valued.


Skill: Conceptual


Author: DS


34


4) Moon Company plans to issue 10 million shares in a seasoned equity offering. The owner, Ken Moon,

plans to sell 4 million shares as part of the offering. Which of the following is true regarding the seasoned

equity issue?

A) It is a primary offering.

B) It is a secondary offering.

C) Some shares are primary shares and some shares are secondary shares.

D) None of the above is true regarding this seasoned equity offering.


Skill: Conceptual


Author: JP


5) What is a seasoned equity offering?

A) the sale of shares by the owners of a company

B) the raising of capital through retained earnings

C) the issuing of shares to the public in a proven private company

D) the issuing of shares by a company at a time after its IPO


Skill: Conceptual


Author: DS


6) An equity issue that raises new funds for a publicly traded company is called ________.

A) an initial public offering

B) a seasoned equity offering

C) an underpriced offering

D) a secondary offering


Skill: Conceptual


Author: JP


7) What are the advantages of a rights offer over a cash offer when issuing new shares?

A) It enables a firm to attract new investors from outside its current owners.

B) It enables a firm to issue equity without imposing a loss on current shareholders.

C) It enables a firm to access new sources of capital to fund its growth.

D) It enables a firm to attract new investors by offering them a windfall from the difference between the

price of the issued stock and the price of stock after the offering.


Skill: Conceptual


Author: DS


35


8) Big Box retailing has a market capitalization of $500 million and 4 million shares outstanding. In order

to finance its growth, the management of Big Box plans to raise further capital through a rights issue. All

shareholders will be issued ten rights to purchase ten shares at a price of $1.00 per share. How much

money will this raise, if all shareholders exercise their rights?

A) $20.0 million

B) $40.0 million

C) $60.0 million

D) $80.0 million

Answer: B

Explanation: B) 10 × $1.00 million × 4 = $40.0 million Diff: 1 Var: 15

Skill: Analytical


Author: DS


9) Valiant Industries has 30 million shares of stock outstanding at a price of $28 per share. The company

wishes to raise more money and plans to do so through a rights issue. Every existing stockholder will

receive one right for each share of stock held. For every four rights held by the stockholder, they can buy

one share at a price of $28. If all rights are exercised, how much money will be raised in this offer?

A) $105.0 million

B) $168.0 million

C) $210.0 million

D) $252.0 million

Answer: C

Explanation: C) $28 × 30 million / 4 = $210.0 million Diff: 1 Var: 24

Skill: Analytical


Author: DS


36


10) Big Box retailing has a market capitalization of $500 million and 20 million shares outstanding. In

order to finance its growth, the management of Big Box plans to raise further capital through a rights

issue. All shareholders will be issued ten rights to purchase a new share at a price of $1.00. What will the

price of a share be after the SEO, if all shareholders exercise their rights?

A) $23.82

B) $24.81

C) $23.00

D) $22.82

Answer: D

Explanation: D) No. of new shares issued = 2 million

Total shares = (20 million + 2 million) = 22 million

New capital raised = (20 / 10) × $1.00 = $2 million

Total capitalization =$(500 + 2) = 502 million

Price per share = ($502 / 22) = $22.82 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


11) Chambers Industries has a market capitalization of $800 million and 250 million shares outstanding.

The management of this firm plans to raise further capital through a rights issue. Which of the following

rights schemes will raise the most money, if all shareholders exercise their rights?

A) two rights to purchase one share at $1.60 per share

B) three rights to purchase two shares at $1.80 per share

C) four rights to purchase three shares at $2.00 per share

D) five rights to purchase two shares at $1.50 per share

Answer: C

Explanation: A) Money raised = (250 / 2) × 1 million shares × $1.60 = $200 million

B) Money raised = (250 / 3) × 2 million shares × $1.80 = $300 million

C) Money raised = (250 / 4) × 3 million shares × $2.00 = $375 million

D) Money raised = (250 / 5) × 2 million shares × $1.50 = $150 million Diff: 1 Var: 1

Skill: Analytical


Author: DS


12) Which of the following is an advantage of a cash offer over a rights offer?

A) The underwriter can credibly attest to the issue's quality.

B) The overall costs are lower.

C) There is no loss imposed on the current holders of stock.

D) There are lower underwriting fees.


Skill: Conceptual


Author: DS


37


13) Convex Incorporated sells 10 million shares of stock in an SEO—8 million being primary shares

issued by the company and 2 million being secondary shares sold by investors in the company. At the

time of the sale, Convex's stock was selling at $7.50 per share. If the underwriter charges 4% of the gross

proceeds as a fee, how much money was raised in the sale?

A) $46.08 million

B) $57.60 million

C) $60.48 million

D) $92.16 million

Answer: B

Explanation: B) $7.50 × 96% × 8 million shares = $57.60 million Diff: 1 Var: 50+

Skill: Analytical


Author: DS


14) Braynerd Chemicals sells 40 million shares of stock in an SEO—25 million being primary shares


time of the sale, Braynerd's stock was selling at $21.00 per share. If the underwriter charges 5% of the

gross proceeds as a fee, how much money was raised in the sale?

A) $374.06 million

B) $423.94 million

C) $498.75 million

D) $573.56 million

Answer: C

Explanation: C) 25 million shares × $21.00 × (100% - 5%) = $498.75 million Diff: 1 Var: 50+

Skill: Analytical


Author: DS


15) Parafoil Avionics sells 50 million shares of stock in an SEO—20 million being primary shares issued

by the company and 30 million being secondary shares sold by investors in the company. At the time of

the sale, Parafoil's stock was selling at $13.00 per share. If the underwriter charges 7% of the gross

proceeds as a fee, how much money was raised in the sale?

A) $242 million

B) $254 million

C) $290 million

D) $314 million

Answer: A

Explanation: A) 20 million shares × $13.00 × (100% - 7%) = $241.8 million Diff: 1 Var: 50+

Skill: Analytical


Author: DS


38


16) Parafoil Avionics sells 50 million shares of stock in an SEO—30 million being primary shares issued

by the company and 20 million being secondary shares sold by investors in the company. At the time of

the sale, Parafoil's stock was selling at $11.50 per share. If the underwriter charges 7% of the gross

proceeds as a fee, how much money did existing investors in the company raise in the sale?

A) $213.90 million

B) $224.60 million

C) $855.60 million

D) $866.30 million

Answer: A

Explanation: A) 20 million shares × $11.50 × (100% - 7%) = $213.90 million Diff: 1 Var: 50+

Skill: Analytical


Author: JP


17) Convex Incorporated sells 10 million shares of stock in an SEO—8 million being primary shares


time of the sale, Convex's stock was selling at $8.00. If the underwriter charges 4% of the gross proceeds

as a fee, how much money was raised in the sale?

A) $61.44 million

B) $64.51 million

C) $98.30 million

D) $104.45 million

Answer: A

Explanation: A) $8.00 × (100% - 4%) = $7.68;

Diff: 1 Var: 50+

Skill: Analytical


Author: DS


18) Highlander Homes stock trades at $34 per share and there are 50 million shares outstanding. The

management would like to raise $200 million in an SEO. If the underwriter charges 6% of gross proceeds,

how many shares must it sell?

A) 5.32 million

B) 5.63 million

C) 5.94 million

D) 6.26 million

Answer: D

Explanation: D) $34 × (100% - 6%) = $31.96;

number of shares sold = $200 million / $31.96 = 6.26 million Diff: 1 Var: 36

Skill: Analytical


Author: DS


39



management would like to raise $300 million in an SEO, and current investors would like to sell $100

million of their own stock. If the underwriter charges 6% of gross proceeds, how many shares must it sell

in the total (primary and secondary) offering?

A) 13.04 million

B) 10.30 million

C) 13.73 million

D) 10.98 million

Answer: C

Explanation: C) $31 × (100% - 6%) = $29.14;

Number of shares sold = ($300 million + $100 million) / $29.14 = 13.73 million shares Diff: 1 Var: 50+

Skill: Analytical


Author: JP


20) Neutrino Industries stock trades at $49 per share and there are 120 million shares outstanding. The



A) 7.38 million

B) 7.82 million

C) 8.25 million

D) 8.68 million

Answer: D

Explanation: D) $49 × (100% - 6%) = $46.06;

Number of shares sold = $400 million / $46.06 = 8.68 million shares Diff: 1 Var: 48

Skill: Analytical


Author: DS


21) Criswell Mining stock trades at $19 per share, and there are 200 million shares outstanding. The



A) 5.26 million

B) 5.54 million

C) 8.86 million

D) 9.97 million

Answer: B

Explanation: B) $19 × (100% - 5%) = $18.05;

Number of shares sold = $100 million / $18.05 = 5.54 million shares Diff: 1 Var: 35

Skill: Analytical


Author: DS


40




and all the shares are primary shares sold to new investors, what percentage of the company will be

owned by the new investors?

A) 12.99%

B) 13.76%

C) 14.52%

D) 15.29%

Answer: D

Explanation: D) Sale price of new share = $35 × (100% - 5%) = $33.25;

Number of shares sold = $300 million / $33.25 = 9.02255639 million shares

Percentage owned by new shareholders = 9.02255639 million / (50 million + 9.02255639 million) = 15.29% Diff: 2 Var: 36

Skill: Analytical


Author: DS



management would like to issue a total of 10 million (primary and secondary) shares in an SEO. If the

underwriter charges 5% of gross proceeds, 25% of the shares are primary shares sold to new investors,

and 75% of the shares are secondary shares sold to new investors, what percentage of the company will

be owned by the new investors?

A) 13.33%

B) 18.10%

C) 14.29%

D) 19.05%

Answer: D

Explanation: D) New shares new shares. Percentage of

company owned by new shareholders = 10 million / (50 million + 2.5 million) = 19.05% Diff: 3 Var: 50+

Skill: Analytical


Author: JP


41



A) More often than not, firms return to the equity markets and offer new shares for sale, a type of offering

called a seasoned equity offering (SEO).

B) Usually, profitable growth opportunities occur throughout the life of a firm, and in some cases it is not

feasible to finance these opportunities out of retained earnings.

C) When a firm issues stock using an SEO, it follows many of the same steps as for an IPO. The main

difference is that a market price for the stock already exists, so the price-setting process is not necessary.

D) A firm's need for outside capital usually ends at the IPO.

Answer: D

Explanation: D) A firm's need for outside capital rarely ends at the IPO. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) Primary shares are new shares issued by the company.

B) Today, investors become informed about the impending sale of stock by the news media, via a road

show, or through the book-building process, so tombstones are purely ceremonial.

C) In a cash offer, a firm offers the new shares to existing shareholders.

D) Historically, intermediaries would advertise the sale of stock (both IPOs and SEOs) by taking out

advertisements in newspapers called tombstones.

Answer: C

Explanation: C) In a rights offer, a firm offers the new shares to existing shareholders. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) In a rights offer, a firm offers the new shares only to existing shareholders.

B) Secondary shares are shares sold by existing shareholders, including the company's founder.

C) If a firm's management is concerned that its equity may be underpriced in the market, by using a

rights offering, the firm can continue to issue equity without imposing a loss on its current shareholders.

D) In the United States, most offers are rights offers.

Answer: D

Explanation: D) In the United States, most offers are cash offers. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


42



A) SEO rights offers have lower costs than cash offers.

B) The decision to raise financing externally usually implies that a firm plans to pursue an investment

opportunity.

C) Although not as costly as IPOs, seasoned offerings are still expensive.

D) Researchers have found that, on average, the market greets the news of an SEO with a price increase.

Answer: D

Explanation: D) Researchers have found that, on average, the market greets the news of an SEO with a

price decrease. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) The one advantage of a cash offer is that the underwriter takes on a larger role and, therefore, can

credibly certify the issue's quality.

B) SEO underwriting fees average about 5% of the proceeds of the issue and, as with IPOs, the variation

across issues of different sizes is relatively small.

C) As with IPOs, evidence suggests that companies overperform following a seasoned offering.

D) Often the value destroyed by the price decline can be a significant fraction of the new money raised

with a SEO.

Answer: C

Explanation: C) As with IPOs, evidence suggests that companies underperform following a seasoned

offering. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


29) Luther Industries currently has 100 million shares of stock outstanding at a price of $25 per share. The

company would like to raise money and has announced a rights issue. Every existing shareholder will be

sent one right per share of stock that he or she owns. The company plans to require twenty rights to

purchase one share at a price of $30 per share. The amount of money that Luther will raise through its

rights offering is closest to ________.

A) $750 million

B) $187.5 million

C) $150 million

D) $600 million

Answer: C

Explanation: C)

Diff: 2 Var: 9

Skill: Analytical


Author: JN


43


30) How many types of seasoned equity offerings are there?

Answer: There are two kinds of seasoned equity offerings: a cash offer and a rights offer. In a cash offer,

a firm offers the new shares to investors at large, while in a rights offer, the firm offers new shares only to

existing shareholders. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


1



Chapter 15 Debt Financing

15.1 Corporate Debt

1) The chief advantage of debt financing over financing through raising equity capital is that the former

does not dilute the current owner's share of the business.


Skill: Conceptual


Author: DS


2) A bond that makes payments in a certain currency contains the risk of holding that currency and so is

priced according to the yields of similar bonds in that currency.


Skill: Conceptual


Author: DS


3) Private debt cannot be in the form of bonds.


Skill: Conceptual


Author: DS


4) By definition, a preferred stock is a form of debt security.


Skill: Conceptual


Author: DS


5) Which of the following is usually a form of public debt?

A) a preferred stock

B) a bank loan

C) a bond issue

D) a revolving line of credit


Skill: Conceptual


Author: DS


2


6) Which of the following is NOT an advantage of private debt over public debt?

A) It is liquid.

B) It need not be registered with the U.S. Securities and Exchange Commission.

C) It has to have interest and principal payments made upon it.

D) It does not dilute the ownership of a firm.


Skill: Conceptual


Author: DS


7) Which of the following terms best describes a loan where a larger line of credit or lower interest rate

has been obtained by providing collateral to back that loan?

A) a term loan

B) a revolving line of credit

C) an asset-backed line of credit

D) a private placement


Skill: Conceptual


Author: DS


8) Which of the following is an advantage of a public bond issue over private placement?

A) It can be tailored to a particular situation.

B) It is less costly to issue.

C) It does not need to be registered with the SEC.

D) It is freely tradable on the bond market.


Skill: Conceptual


Author: DS


9) In terms of public offerings of bonds, what is an indenture?

A) a list of the duties of a trust company representing the bondholders' interests

B) a memorandum that must be produced to describe the details of a bond offering

C) a formal contract that specifies a firm's obligations to the bondholders

D) a schedule of the fees charged by an underwriting company


Skill: Conceptual


Author: DS


3


10) In terms of public offerings of bonds, what is a prospectus?

A) a list of the duties of a trust company representing the bondholders' interests

B) a memorandum that must be produced to describe the details of a bond offering

C) a formal contract that specifies a firm's obligations to the bondholders

D) a schedule of the fees charged by an underwriting company


Skill: Conceptual


Author: DS


11) Smithfield Enterprises issues debt with a maturity of 7 years. In the case of bankruptcy, holders of this

debt may only claim those assets of the firm that are not already pledged as collateral on other debt.

Which of the following best describes this type of corporate debt?

A) a note

B) a mortgage bond

C) an asset-backed bond

D) debenture


Skill: Conceptual


Author: DS


12) Gepps Cross Industries issues debt with a maturity of 25 years. In the case of bankruptcy, holders of

this debt may only claim those assets of the firm that are not already pledged as collateral on other debt.

Which of the following best describes this type of corporate debt?

A) a note

B) a debenture


D) a mortgage bond


Skill: Conceptual


Author: DS


4


13) Athelstone Realty issues debt with a maturity of 20 years. In the case of bankruptcy, holders of this

debt may claim the property held by Athelstone Realty. Which of the following best describes this type of

corporate debt?

A) a note

B) a debenture

C) a mortgage bond

D) an asset-backed bond


Skill: Conceptual


Author: DS


14) Clearview Corporation, a company that deals mainly with the financing and distribution of music,

issues debt with a maturity of 15 years. In the case of bankruptcy, holders of this debt will have claim to

the intellectual property of Clearview. Which of the following best describes this type of corporate debt?

A) a note

B) a debenture

C) a mortgage bond

D) an asset-backed bond


Skill: Conceptual


Author: DS


15) What is a bond's seniority?

A) the bondholder's priority in claiming assets in the event of default

B) clauses restricting a company from issuing new debt

C) the yield to maturity of a bond as compared to bonds of comparable rating

D) the issue price of the bond as compared to its face value


Skill: Conceptual


Author: DS


5


16) A firm issues $225 million in straight bonds at an original issue discount of 2.0% and a coupon rate of

6%. The firm pays fees of 4% on the face value of the bonds. The net amount of funds that the debt issue

will provide for the firm is ________.

A) $200.925 million

B) $211.5 million

C) $222.075 million

D) $232.65 million

Answer: B

Explanation: B)

Diff: 1 Var: 33

Skill: Analytical


Author: DS


17) A firm issues $170 million in straight bonds at par and a coupon rate of 8.5%. The firm pays fees of 2%

on the face value of the bonds. The net amount of funds that the debt issue will provide for the firm is

________.

A) $150 million

B) $158 million

C) $167 million

D) $175 million

Answer: C

Explanation: C) $170 million × (1 - 0.02) = $167 million Diff: 1 Var: 24

Skill: Analytical


Author: DS


18) A firm issues $300 million in straight bonds at an original issue discount of 0.50% and a coupon rate of

7%. The firm pays fees of 2.0% on the face value of the bonds. The net amount of funds that the debt issue

will provide for the firm is closest to which of the following?

A) $248,625,000

B) $263,250,000

C) $277,875,000

D) $292,500,000

Answer: D

Explanation: D) Receipt after discount = $300 million × (1 - 0.005) = $298,500,000;

amount paid in fees = $300 million × 0.02 = $6 million;

net amount of funds = $292,500,000 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


6


19) Which of the following best describes a bond that is issued by a local entity and traded in a local

market, but may be purchased by foreigners?

A) a domestic bond

B) a foreign bond

C) a Eurobond

D) a global bond


Skill: Conceptual


Author: DS


20) Which of the following best describes an international bond that is not denominated in the local

currency of the country in which it is issued?

A) a domestic bond

B) a foreign bond

C) a Eurobond

D) a global bond


Skill: Conceptual


Author: DS


21) Kruller A.G. issues a bond that is offered for sale simultaneously in Europe, the United States, and

Japan. Which of the following best describes this bond?

A) a domestic bond

B) a foreign bond

C) a Eurobond

D) a global bond


Skill: Conceptual


Author: DS


22) Tompkinson's PLC., a British company, issues a bond in U.S. dollars in the United States which is

intended for U.S. investors. Which of the following best describes this bond?

A) a domestic bond

B) a Eurobond

C) a global bond

D) a Yankee bond


Skill: Conceptual


Author: DS


7


23) Eurobonds issued in the United Kingdom could NOT be issued in which of the following

denominations?

A) U.S. dollars

B) euros

C) pounds sterling

D) yen


Skill: Conceptual


Author: DS


24) The face value of bonds is denominated most commonly in which of the following standard

increments?

A) $10

B) $100

C) $1,000

D) $10,000


Skill: Conceptual


Author: DS


25) What kind of corporate debt must be secured by real property?

A) mortgage bonds

B) notes

C) asset-backed bonds

D) debentures


Skill: Definition


Author: JN


26) What kind of corporate debt can be secured by any kind of assets?

A) preferred stocks

B) notes

C) asset-backed bonds

D) debentures


Skill: Definition


Author: JN


8


27) What kind of corporate debt has a maturity of less than ten years?

A) asset-backed bonds

B) debentures

C) notes

D) mortgage bonds


Skill: Definition


Author: JN


28) What kind of unsecured corporate debt has a maturity of less than ten years?

A) mortgage bonds

B) asset-backed bonds

C) debentures

D) notes


Skill: Definition


Author: JN


29) ________ are international bonds that are not denominated in the local currency of the country in

which they are issued.

A) Domestic bonds

B) Yankee bonds

C) Eurobonds

D) Debentures


Skill: Definition


Author: JN


30) Foreign bonds in the United States are known as ________.

A) domestic bonds

B) Yankee bonds

C) Eurobonds

D) foreign bonds


Skill: Definition


Author: JN


9



A) Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in

several different markets simultaneously.

B) In a leveraged buyout (LBO), a group of private investors purchases all the equity of a public

corporation.

C) A term loan is a bank loan that lasts for a specific term.

D) Eurobonds are international bonds that are denominated in European currency.

Answer: D

Explanation: D) Eurobonds are international bonds that are not denominated in the local currency of the

country in which they are issued. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) With registered bonds, on each coupon payment date, the bond issuer consults the firm's registered

owners and mails each bondholder a check (or directly deposits the coupon payment into the owner's

brokerage account).

B) If a coupon bond is issued at a discount, it is called an original issue discount bond.

C) The face value or principal amount of the bond is denominated in standard increments, most often

$1,000.

D) In a public offering, the indenture lays out the terms of the bond issue.


Skill: Conceptual


Author: JN



A) In the event of default, the assets not pledged as collateral for outstanding bonds cannot be used to

pay off the holders of subordinated debentures until all more senior debt has been paid off.

B) Because more than one debenture might be outstanding, the bondholder's priority in claiming assets in

the event of default, known as the bond's seniority, is important.

C) When a firm conducts a subsequent debenture issue that has lower priority than its outstanding debt,

the new debt is known as a subordinated debenture.

D) Most debenture issues contain clauses restricting the company from issuing new debt with equal or

lower priority than existing debt.

Answer: D

Explanation: D) Most debenture issues contain clauses restricting the company from issuing new debt

with equal or higher priority than existing debt. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


10


34) Which of the following statements regarding the private debt market is FALSE?

A) Private debt has the advantage that it avoids the cost of registration.

B) Bank loans are an example of private debt—debt that is not publicly traded.

C) Private debt has the disadvantage of being illiquid.

D) The public debt market is larger than the private debt market.

Answer: D

Explanation: D) The private debt market is larger than the public debt market. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) Almost all bonds that are issued today are registered bonds.

B) The trust company represents the bondholders and makes sure that the terms of the indenture are

enforced.

C) For private placements, the prospectus must include an indenture, a formal contract between the bond

issuer and a trust company.

D) In the case of default, the trust company represents the bondholders' interests.

Answer: C

Explanation: C) For public debt issue, the prospectus must include an indenture, a formal contract

between the bond issuer and a trust company. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) The registered bond system facilitates tax collection because the government can easily keep track of

all interest payments made.

B) Asset-backed bonds and mortgage bonds are secured debt, and specific assets are pledged as collateral

that bondholders have a direct claim to in the event of bankruptcy.

C) Notes typically have longer maturities (more than ten years) than debentures.

D) Although the word "bond" is commonly used to mean any kind of debt security, technically a

corporate bond must be secured.

Answer: C

Explanation: C) Notes typically have shorter maturities (less than ten years) than debentures. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


11


37) A firm issues $200 million in straight bonds at par and a coupon rate of 7%. The firm pays fees of 4.0%

on the face value of the bonds. What is the net amount of funds that the debt issue will provide for the

firm?

A) $182.4 million

B) $211 million

C) $192 million

D) $202 million

Answer: C

Explanation: C) $200 × (1 - 0.04) = $192 million Diff: 1 Var: 49

Skill: Analytical


Author: WC


38) A firm issues $500 million in straight bonds at par and a coupon rate of 5%. The firm pays fees of 2%

on the face value of the bonds. What is the net amount of funds that the debt issue will provide for the

firm?

A) $466 million

B) $490 million

C) $539 million

D) $514.5 million

Answer: B

Explanation: B) $500 × (1 - 0.02) = $490 million Diff: 1 Var: 35

Skill: Analytical


Author: WC


39) A firm issues $525 million in straight bonds at an original issue discount of 2% and a coupon rate of

5%. The firm pays fees of 2% on the face value of the bonds. What is the net amount of funds that the debt

issue will provide for the firm?

A) $580 million

B) $554.4 million

C) $529 million

D) $504 million

Answer: D

Explanation: D) Funds after discount = $525 million × (1 - 0.02) = $514.5 million

Fees = $525 million × 0.02 = $10.5 million

Net funds provided = $514.5 million - $10.5 million = $504 million Diff: 1 Var: 50+

Skill: Analytical


Author: WC


12


40) What is an original issue discount bond?

Answer: An original issue discount bond is a coupon bond issued at a discount. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


41) What are debentures?

Answer: Debentures are unsecured debt with maturities of ten years or longer. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


42) What are notes?

Answer: Notes are unsecured debt with typical maturities less than ten years. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


43) What are secured debt?

Answer: With secured debt, specific assets are pledged as collateral that bondholders have a direct claim

to in the event of bankruptcy. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


15.2 Other Types of Debt

1) There are no questions for this section. Diff: 1 Var: 1

15.3 Bond Covenants

1) Covenants in a bond contract restrict the actions that management of a firm can take that would benefit

the debtholders of a firm at the expense of the equity holders of the firm.


Skill: Conceptual


Author: DS


13


2) Bond covenants tend to increase a bond issuer's borrowing costs.


Skill: Conceptual


Author: DS


3) If a bond covenant is not met, then the bond goes into technical default and the bondholder can

demand immediate repayment or force the company to renegotiate the terms of the bond.


Skill: Conceptual


Author: DS


4) Why do the issuers of bonds not seek to minimize the strength and number of covenants in a bond

agreement?

A) More covenants favor the equity holders that managers work for.

B) More covenants can increase the flexibility of the company issuing bonds.

C) More covenants lower the interest rate investors will require to buy the bond.

D) Less covenants force the company to renegotiate the terms of the bond if they are broken.


Skill: Conceptual


Author: DS


5) Which of the following will have the greatest need of strong bond covenants if it is to receive a high

bond rating?

A) a debenture

B) a mortgage bond


D) a foreign bond


Skill: Conceptual


Author: DS


14


6) A covenant that restricts a company from making loans or otherwise providing credit is best viewed as

a restriction on which of the following?

A) issuing new debt

B) dividends and share repurchases

C) mergers and acquisitions

D) asset disposition


Skill: Conceptual


Author: DS



A) If a bond issuer fails to live up to any covenant, the issuer goes into bankruptcy immediately.

B) The stronger the covenants in the bond contract, the less likely an issuer will default on the bond and

so the lower the interest rate investors will require to buy the bond.

C) Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may

undercut its ability to repay the bonds.

D) Bond agreements often contain covenants that restrict the ability of management to pay dividends.

Answer: A

Explanation: A) If the issuer fails to live up to any covenant, the issuer goes into default. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) By including more covenants, issuers increase their costs of borrowing.

B) Once bonds are issued, equity holders have an incentive to increase dividends at the expense of debt

holders.

C) Covenants may restrict the level of further indebtedness and specify that the issuer must maintain a

minimum amount of working capital.

D) If the covenants are designed to reduce agency costs by restricting management's ability to take

negative-NPV actions that exploit debt holders, then the reduction in the firm's borrowing cost can more

than outweigh the cost of the loss of flexibility associated with covenants.

Answer: A

Explanation: A) By including more covenants, issuers decrease their costs of borrowing. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


15


9) What are bond covenants?

Answer: Bond covenants are restrictive clauses in a bond contract that limit the issuer from taking

actions that may undercut its ability to repay the bonds. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


10) What are the implications of stronger bond covenants?

Answer: While equity holders may prefer as few covenants as possible, stronger bond covenants have

their advantage. Stronger covenants will imply lower interest rates due to a smaller likelihood of default. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


15.4 Repayment Provisions

1) The sole way that a firm can repay its bonds is by making the coupon and principal payments as

specified in the bond contract.


Skill: Conceptual


Author: DS


2) Convertible bonds have a provision that gives the bondholder an option to convert each bond owned

into a fixed number of shares of common stock.


Skill: Conceptual


Author: DS


3) If a company issues both a straight bond and a convertible bond simultaneously, at par, then the

straight bond will have a higher interest rate.


Skill: Conceptual


Author: DS


16


4) What is a call provision?

A) the periodic repurchasing of issued bonds through a sinking fund by the issuer

B) an option to the issuer to repurchase the bonds at a predetermined price

C) the option for the bondholder to convert each bond owned into a fixed number of shares of common

stock

D) a clause in a bond contract that restricts the actions of the issuer that might harm the interests of the

bondholders


Skill: Conceptual


Author: DS


5) When would it make sense for a firm to call a bond issue?

A) when the market price of the bond exceeds the call price, and market interest rates are greater than the

bond's coupon rate

B) when the market price of the bond exceeds the call price, and market interest rates are less than the

bond's coupon rate

C) when the market price of the bond is less than the call price, and market interest rates are greater than

the bond's coupon rate

D) when the market price of the bond is less than the call price, and market interest rates are less than the

bond's coupon rate


Skill: Conceptual


Author: DS


6) In which of the following situations would the yield to worst for a certain bond be that bond's yield to

call?

I. The bond's coupon payments are high relative to market yields.

II. The bond price is at a discount.

III. The likelihood of the bond being called is high.

A) I only

B) II only

C) I and II

D) I and III


Skill: Conceptual


Author: DS


17


7) A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The

bond can be called at par in one year after release or any time after that on a coupon payment date. On

release, it has a price of $104 per $100 of face value. What is the yield to call of this bond when it is

released?

A) 0.60%

B) 1.50%

C) 1.92%

D) 5.47%

Answer: C

Explanation: C) Using a financial calculator, PV = -104, FV = 100, PMT = 6, N = 1;

computing interest = 1.92%; yield to call = 1.92% Diff: 1 Var: 1

Skill: Analytical


Author: DS




release, it has a price of $104 per $100 of face value. What is the yield to maturity of this bond when it is

released?

A) 0.60%

B) 1.92%

C) 4.00%

D) 5.47%

Answer: D

Explanation: D) Using a financial calculator, PV = -104, FV = 100, PMT = 6, N = 10 ;

computing interest = 5.47%; yield to maturity = 5.47% Diff: 1 Var: 1

Skill: Analytical


Author: DS


18




release, it has a price of $104 per $100 of face value. What is the yield to worst of this bond when it is

released?

A) 0.60%

B) 1.92%

C) 4.00%

D) 5.47%

Answer: B

Explanation: B) Using a financial calculator, PV = -104, FV = 100, PMT = 6, N = 1;

computing interest = 1.92%; yield to call = 1.92%

Using financial calculator, PV = -104 FV = 100 PMT = 6 N =10

computing interest = 5.47%; yield to maturity = 5.47%

1.92% is worse than 5.47%; hence, 1.92% is the yield to worst. Diff: 1 Var: 1

Skill: Analytical


Author: DS


10) A company issues a callable (at par) five-year, 7% coupon bond with annual coupon payments. The



released?

A) 1.40%

B) 2.73%

C) 4.71%

D) 5.66%

Answer: B



Skill: Analytical


Author: DS


19





released?

A) 1.40%

B) 2.80%

C) 4.71%

D) 5.66%

Answer: C

Explanation: C) Using a financial calculator, PV = -110, FV = 100, PMT = 7, N = 5;


Skill: Analytical


Author: DS





released?

A) 1.40%

B) -2.73%

C) 3.00%

D) 4.71%

Answer: B


computing interest = -2.73%; yield to call = -2.73%

Using a financial calculator, PV = -110, FV = 100, PMT = 7, N = 5;

computing interest = 4.71%; yield to maturity = 4.71%

-2.73% is worse than 4.71%; hence, -2.73% is the yield to worst. Diff: 1 Var: 1

Skill: Analytical


Author: DS


20


13) A company issues a callable (at par) 20-year, 5% coupon bond with annual coupon payments. The



released?

A) 2.94%

B) 4.11%

C) 5.60%

D) 6.66%

Answer: A

Explanation: A) Using a financial calculator, PV = -102, FV = 100, PMT = 5, N = 1;


Skill: Analytical


Author: DS





released?

A) 2.40%

B) 4.84%

C) 5.60%

D) 6.66%

Answer: B



Skill: Analytical


Author: DS


21





released?

A) 2.94%

B) 4.84%

C) 5.60%

D) 6.66%

Answer: A

Explanation: A) Using a financial calculator, PV = -102, FV = 100, PMT = 5, N = 1;

computing interest = 2.94%

Using a financial calculator, PV = -102, FV = 100, PMT = 5, N = 20;

computing interest = 4.84%

2.94% is worse than 4.84%; hence, 2.94% is the yield to worst. Diff: 1 Var: 1

Skill: Analytical


Author: DS


16) Which of the following statements concerning the use of sinking funds to repurchase a bond issue is

NOT true?

A) A firm should make regular payments into a sinking fund administered by a trustee over the life of the

bond.

B) A firm can reduce the amount of outstanding debt without affecting the cash flows of the remaining

bonds.

C) Payments from the sinking fund are used to repurchase bonds.

D) Bonds can be issued with a sinking fund provision or a call provision, but not both.


Skill: Conceptual


Author: DS


22


17) A firm issues $300 million in ten-year bonds with an annual coupon rate of 8%. The firm uses a

sinking fund to repurchase 10% of the bond issue on each coupon payment date. What payment must

they make on the tenth and final coupon payment?

A) $32 million

B) $38 million

C) $43 million

D) $54 million

Answer: D

Explanation: D) Final coupon payment = 0.08 × $300 million = $24 million;

total payment = $30 million + $24 million = $54 million Diff: 1 Var: 6

Skill: Analytical


Author: DS


18) In which of the following situations does the value of a convertible bond exceed the value of straight

debt or equity by the greatest amount?

A) when the price of the stock is higher than the issuing price

B) when the price of the stock is close to the conversion price

C) when the price of the stock is low

D) when the price of the stock much lower than the conversion price


Skill: Conceptual


Author: DS


19) Which of the following statements about bonds that are both convertible and callable is NOT true?

A) If these bonds are called by the issuer, the holder can choose to convert them rather than let them be

called.

B) Prior to maturity, the value of such bonds will be greater than the shares of stock that bond can be

converted into.

C) The decision to be made by the bondholders when the bonds are called is the same as they would have

to make at maturity.

D) By calling the bonds, the issuer can force bondholders to decide to convert at a time of the issuer's

choice.


Skill: Conceptual


Author: DS


23


20) A bond has a face value of $100 and a conversion ratio of 25. What is the conversion price?

A) $0.25

B) $2.50

C) $4.00

D) $25.00

Answer: C

Explanation: C) $100 / 25 = $4.00 Diff: 1 Var: 16

Skill: Analytical


Author: DS


21) A bond has a face value of $10,000 and a conversion ratio of 530. The stock is currently trading at

$16.50. What is the conversion price?

A) $7.55

B) $16.50

C) $18.87

D) $53.00

Answer: C

Explanation: C) $10,000 / 530 = $18.87 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


22) A bond has a face value of $15,000 and a conversion ratio of 220. The stock is currently trading at

$39.20. What is the conversion price?

A) $3.41

B) $13.64

C) $40.91

D) $68.18

Answer: D

Explanation: D) $15,000 / 220 = $68.18 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


24


23) A bond with a face value of $1,000 is convertible to common stock at a conversion ratio of 60. If the

stock is currently trading at $8.20 per share, the value of the bond is probably closest in value to which of

the following?

A) less than $492.00

B) about $492.00

C) about $1,000

D) above $1666.67

Answer: C

Explanation: C) Conversion value is 60 × $8.20 = $492.00, so bond will likely sell closer to par. Diff: 1 Var: 15

Skill: Analytical


Author: DS


24) Supreme Industries issues the following announcement to holders of an issue of callable, convertible

notes:

"Prior to the close of business on May 17, 2008, holders may convert their Notes into shares of Supreme

Industries common stock at 33.25 shares of Supreme Industries common stock per $1,000 principal

amount of the Notes. Cash will be paid in lieu of fractional shares. On April 16, 2008, the last reported

sale price of Supreme Industries common stock on the NYSE was $21.60 per share."

If on May 17, Supreme Industries is trading as $24.60, what is the value of common stock a holder of a

$1,000 note would receive?

A) $664.20

B) $701.10

C) $817.95

D) $739.85

Answer: C

Explanation: C) Value per share = $1,000 / 33.25 = $30.075188;

Value of common stock received by a holder on a $1,000 note = 33.25 × $24.60 = $817.95 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


25) Which of the following would be most likely to have the lowest price?

A) a straight senior bond

B) a convertible senior bond

C) a callable subordinated bond

D) a straight subordinated bond


Skill: Conceptual


Author: DS


25


26)

Coupon 0%

Conversion Ratio: 215 shares per $1,000 principal amount

Call Date: July 1, 2008

Call Price: Par

Maturity: July 1, 2015

A firm issues the convertible debt shown above. The price of stock in this company on July 1, 2008 is

$4.70. If the bonds are called on this date, which of the following is the action most likely to be taken by a

holder of bond of face value of $10,000?

A) Convert the bond and accept shares with a value of $10,000.

B) Convert the bond and accept shares with a value of $9599.75.

C) Convert the bond and accept shares with a value of $10,105.00.

D) Accept the call price and receive $10,000.

Answer: C

Explanation: C) 2150 × $4.70 = $10,105.00 Diff: 1 Var: 50+

Skill: Analytical


Author: DS


27)

Coupon 0%





$6.00. What is the minimum call price that would make a bondholder prefer to accept the call rather than

convert?

A) par

B) par plus 12%

C) par plus 8%

D) par plus 1.2%

Answer: C

Explanation: C) 180 × $6.00 = $1080.00; Value over the face value = $1080.00 - 1000 = $80

percentage of face value = $80 / 1000 = 8% Diff: 1 Var: 50+

Skill: Analytical


Author: DS


26


28)

Coupon 0%





$15.14. What is the minimum call price that would make a bondholder prefer to accept the call rather

than convert?

A) par plus 3.29%

B) par plus 3.89%

C) par plus 4.49%

D) par plus 5.98%

Answer: D

Explanation: D) 70 × 15.14 = $1059.80; Value over the face value = $1059.80 - 1,000 = $59.80

percentage of face value = $59.80 / $1000 = 5.98% Diff: 1 Var: 50+

Skill: Analytical


Author: DS


29)

Coupon 0%





$37.57. What is the minimum call price that would make a bondholder prefer to accept the call rather

than convert?

A) par

B) par plus 7.5%

C) par plus 9.7%

D) par plus 11.2%

Answer: B

Explanation: B) 286 × $37.57 = $10,745.02; Value over the face value = $10,745.02 - $10,000 = $745.02

percentage of face value = $745.02 / $10,000 = 7.5% Diff: 1 Var: 50+

Skill: Analytical


Author: DS


27


30)

Coupon 0%


Call Price 103.74%



$27.24. What is the minimum conversion ratio that would make a bondholder prefer to convert rather

than accept the call price?

A) 33 shares per $1,000 principal amount

B) 36 shares per $1,000 principal amount

C) 38 shares per $1,000 principal amount

D) 42 shares per $1,000 principal amount

Answer: C

Explanation: C) $1037.4 / $27.24 = 38 shares per $1,000 principal Diff: 1 Var: 50+

Skill: Analytical


Author: DS


31) Which of the following statements is FALSE regarding a call provision?

A) The issuer can repurchase a fraction of the outstanding bonds in the market or it can make a tender

offer for the entire issue.

B) A call provision allows the issuer to repurchase the bonds at a predetermined price.

C) The call price is generally set at or below, and expressed as a percentage of, the bond's face value.

D) A call feature allows the issuer of the bond the right (but not the obligation) to retire all outstanding

bonds on (or after) a specific date (the call date), for the call price.

Answer: C

Explanation: C) The call price is generally set at or above, and expressed as a percentage of, the bond's

face value. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


28



A) When bond yields have increased, by exercising the call on the callable bond and then immediately

refinancing, the issuer can lower its borrowing costs.

B) To understand how call provisions affect the price of a bond, we first need to consider when an issuer

will exercise its right to call the bond.

C) If the call provision offers a cheaper way to retire the bonds the issuer will forgo the option of

purchasing the bonds in the open market and call the bonds instead.

D) An issuer can always retire one of its bonds early by repurchasing the bond in the open market.

Answer: A

Explanation: A) When bond yields have decreased, by exercising the call on the callable bond and then

immediately refinancing, the issuer can lower its borrowing costs. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) The holder of a callable bond faces reinvestment risk precisely when it hurts: when market rates are

lower than the coupon rate she is currently receiving.

B) When yields have risen, the issuer will not choose to exercise the call on the callable bond.

C) The issuer will exercise the call option only when the prevailing market rate exceeds the coupon rate

of the bond.

D) A callable bond is relatively less attractive to the bondholder than the identical non-callable bond.

Answer: C

Explanation: C) The issuer will exercise the call option only when the prevailing market rate is below the

coupon rate of the bond. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) Before the call date, investors anticipate the optimal strategy that the issuer will follow, and the bond

price reflects this strategy.

B) The yield to maturity of a callable bond is calculated as if the bond were called at the earliest

opportunity.

C) A callable bond will trade at a lower price (and therefore a higher yield) than an otherwise equivalent

non-callable bond.

D) The price of a callable bond can be low when yields are high, but does not rise above the call value

when the yield is low.

Answer: B

Explanation: B) The yield to call of a callable bond is calculated as if the bond were called at the earliest

opportunity. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


29



A) The assumption that underlies the yield calculation of a callable bond—that it will not be called—is

not always realistic, so bond traders often quote the yield to call.

B) The yield to call (YTC) is the annual yield of a callable bond assuming that the bond is called at the

earliest opportunity.

C) We can think of the yield to maturity of a callable bond as the interest rate the bondholder receives if

the bond is not called and repaid in full.

D) Because the price of a callable bond is higher than the price of an otherwise identical non-callable

bond, the yield to maturity of a callable bond will be lower than the yield to maturity for its non-callable

counterpart.

Answer: D

Explanation: D) Because the price of a callable bond is lower than the price of an otherwise identical non-

callable bond, the yield to maturity of a callable bond will be higher than the yield to maturity for its non-

callable counterpart. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


36) Which of the following statements regarding sinking fund provisions is FALSE?

A) With a sinking fund, if a bond is trading at below its face value, because the bonds are repurchased at

par, the decision as to which bonds to repurchase is made by lottery.

B) With a sinking fund, instead of repaying the entire principal balance on the maturity date, the

company makes regular payments into a sinking fund administered by a trustee over the life of the bond.

C) Sinking fund provisions usually specify a minimum rate at which the issuer must contribute to the

fund.

D) Because the sinking fund allows the issuer to repurchase the bonds at par, the option to accelerate the

payments is another form of call provision.

Answer: A

Explanation: A) With a sinking fund, if a bond is trading at a premium, because the bonds are

repurchased at par, the decision as to which bonds to repurchase is made by lottery. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


30



A) A convertible bond can be thought of as a regular bond plus a special type of call option called a

warrant.

B) On the maturity date of the bond, the strike price of the embedded warrant in a convertible bond is

equal to the face value of the bond divided by the conversion ratio—that is, the conversion price.

C) Calling a convertible bond transfers the remaining time value of the conversion option from

shareholders to bondholders.

D) If the stock price is low so that the embedded warrant is deep out-of-the-money, the conversion

provision is not worth much and the bond's value is close to the value of a straight bond—an otherwise

identical bond without the conversion provision.

Answer: C

Explanation: C) Calling a convertible bond transfers the remaining time value of the conversion option

from bondholders to shareholders. Diff: 3 Var: 1

Skill: Conceptual


Author: JN


38) A company issues a 10-year, callable bond at par with 8% annual coupon payments. The bond can be

called at par in one year after issue or any time after that on a coupon payment date. The call price is $104

per $100 of face value. What is the yield to call if this bond is called in one year?

A) 7%

B) 12%

C) 10%

D) 4%

Answer: B

Explanation: B) PV = -100, FV = 104, PMT = 8, N = 1;

Compute I / Y = 12% Diff: 1 Var: 30

Skill: Analytical


Author: WC


39) A company issues a 20-year, callable bond at par with a(n) 9% annual coupon payments. The bond

can be called at par in three years or any time after that on a coupon payment date. The call price is $110

per $100 of face value. What is the yield to call?

A) 7%

B) 15%

C) 9%

D) 12%

Answer: D

Explanation: D) PV = -100, FV = 110,

Compute I / Y = 12% Diff: 1 Var: 50+

Skill: Analytical


Author: WC


31


40) When a callable bond sells at a premium, the likelihood of a call is ________ and the yield to worst is

the yield to ________.

A) high, call

B) low, call

C) low, maturity

D) high, maturity


Skill: Conceptual


Author: WC


41) When a callable bond sells at a discount, the bond's coupon rate is ________ than market yields and

the yield to worst is the yield to ________.

A) higher, call

B) lower, maturity

C) lower, call

D) high, maturity


Skill: Conceptual


Author: WC


42) A convertible bond has a face value of $1,000 and a conversion ratio of 50. This bond will sell at a

premium when which of the following occurs?

A) when market rates fall below the bond's coupon rate

B) when the firm's stock sells for more than $20 per share

C) when market rates rise above the bond's coupon rate

D) A and B


Skill: Analytical


Author: WC


43) Which of the following is a type of call provision?

A) sinking fund

B) balloon payment

C) conversion feature

D) indenture


Skill: Conceptual


Author: WC


32


44) A callable bond will typically have a ________ yield than an otherwise identical bond without a call

feature because ________.

A) lower, the firm loses flexibility with a callable bond

B) higher, the firm loses flexibility with a callable bond

C) lower, the option to call a bond is valuable

D) higher, the option to call a bond is valuable


Skill: Analytical


Author: WC


45) What are callable bonds?

Answer: A call feature allows the issuer of the bond the right but not the obligation to retire all

outstanding bonds on or after a specific date (call date) for a specific price (call price). Diff: 1 Var: 1

Skill: Conceptual


Author: SS


46) What is yield to call?

Answer: For callable bonds, yield to call is the annual yield earned by an investor assuming the bond is

called at its earliest opportunity. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


47) What is yield to maturity?

Answer: Yield to maturity is the annual return earned by an investor assuming the bond is held till

maturity. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


48) What is yield to worst?

Answer: Yield to worst is quoted by bond traders as the lower of yield to call or yield to maturity. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


1



Chapter 16 Capital Structure

16.1 Capital Structure Choices

1) Financial managers prefer to choose the same debt level no matter which industry they operate in.


Skill: Conceptual


Author: KB


2) Even if two firms operate in the same industry, they may prefer different choices of debt-equity ratios.


Skill: Conceptual


Author: KB


3) Equity in a firm with no debt is called unlevered equity.


Skill: Definition


Author: KB


4) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its

________.

A) capital structure

B) dividend expense

C) retained earnings

D) paid out capital


Skill: Definition


Author: KB


2


5) A firm's ________ ratio is the fraction of the firm's total value that corresponds to debt.

A) debt-to-equity

B) equity-to-debt

C) debt-to-value

D) liability


Skill: Definition


Author: KB



A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its

capital structure.

B) The most common choices are financing through equity alone and financing through a combination of

debt and equity.

C) A project's net present value (NPV) represents the value to the new investors of a firm created by the

project.

D) When corporations raise funds from outside investors, they must choose which type of security to

issue.

Answer: C

Explanation: C) A project's NPV represents the value to the existing shareholders of a firm created by the

project. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


7) Equity in a firm with debt is called ________.

A) levered equity

B) risk-free equity

C) unlevered equity

D) preferred equity


Skill: Definition


Author: JN


3


8) Equity in a firm with no debt is called ________.

A) levered equity

B) unlevered equity

C) risk-free equity

D) preferred equity


Skill: Definition


Author: JN


9) Which of the following does a firm consider in the choice of securities issued?

A) the tax consequences of the chosen security

B) the transactions costs of the chosen security

C) whether the chosen security will have a fair price in the market

D) All of the above are considered.


Skill: Conceptual


Author: JP


10) What role do industries play in the capital structure choice for a firm?

Answer: Industries are found to have distinct patterns in their capital structures. For example, software

companies such as Microsoft are far less levered than are automobile manufacturers such as Ford Motor

Company. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


11) What is the capital structure of a firm?

Answer: The relative proportion of debt and equity used by a firm is called its capital structure. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


12) What considerations should managers have while deciding on firms' capital structure?

Answer: Managers should first take a look at the industry norm for the firm. Subsequently, they should

consider if the securities issued will receive fair price in the market, have tax consequences, entail

transaction costs, or require a change to future investment opportunities. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


4


16.2 Capital Structure in Perfect Capital Markets

1) According to researchers Modigliani and Miller, with perfect capital markets, the total value of a firm

should not depend on its capital structure.


Skill: Conceptual


Author: KB


2) With perfect capital markets, because different choices of capital structure offer a benefit to investors,

the capital structure affects the value of a firm.


Skill: Conceptual


Author: KB


3) A financial manager makes a choice of the amount and source of capital based on how the choice will

impact the ________.

A) revenue

B) face value of bonds

C) depreciation

D) firm value


Skill: Conceptual


Author: KB


4) Investment cash flows are independent of financing choices in a ________.

A) market with frictions

B) perfect capital market

C) setting with frictions in investment returns

D) firm with leverage


Skill: Conceptual


Author: KB


5


5) A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of

10%, what is the levered value of the firm with perfect capital markets?

A) $20,000

B) $16,000

C) $24,000


Answer: A

Explanation: A) Compute the present value of the cash flow.

$22,000 / (1 + 0.1) = $20,000 Diff: 1 Var: 15

Skill: Analytical


Author: KB


6) A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of


A) $15,855.86

B) $19,819.82

C) $23,783.78


Answer: B

Explanation: B) Compute the present value of the cash flow.

$22,000 / (1 + 0.11) = $19,819.82 Diff: 1 Var: 30

Skill: Analytical


Author: KB


7) A firm will give a one-time cash flow of $24,000 after one year. If the project risk requires a return of


A) $17,454.55

B) $26,181.82

C) $21,818.18


Answer: C

Explanation: C) Compute the present value of the cash flow.

$24,000 / (1 + 0.1) = $21,818.18 Diff: 1 Var: 30

Skill: Analytical


Author: KB


6


8) MM Proposition I states that in a perfect capital market the total value of a firm is equal to the market

value of the ________ generated by its assets.

A) earnings after taxes

B) earnings after interest

C) cash flows after taxes

D) free cash flows


Skill: Definition


Author: KB


9) It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm

because ________.

A) leverage decreases the risk of equity of the firm

B) leverage changes the unlevered cost of equity

C) leverage increases the risk of the equity of the firm

D) cost of debt decreases in this setting


Skill: Conceptual


Author: KB


10) By adding leverage, the returns on a firm are split between debt holders and equity holders, but

equity holder risk increases because ________.

A) interest payments can be rolled over

B) dividends are paid first

C) debt and equity have equal priority

D) interest payments have first priority


Skill: Conceptual


Author: KB


11) In a setting where there is no risk that a firm will default, leverage ________ the risk of equity.

A) increases

B) decreases

C) does not change

D) cannot say for sure


Skill: Conceptual


Author: KB


7


12) A firm requires an investment of $18,000 and will return $25,000 after one year. If the firm borrows

$10,000 at 6%, what is the return on levered equity?

A) 80%

B) 64%

C) 96%

D) 112%

Answer: A

Explanation: A) The firm will owe debt holders the amount borrowed times (1 + rate) after one year.

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


13) A firm requires an investment of $20,000 and will return $26,500 after one year. If the firm borrows

$6000 at 7%, what is the return on levered equity?

A) 35%

B) 52%

C) 43%

D) 61%

Answer: C

Explanation: C) The firm will owe debt holders the amount borrowed times (1+rate) after one year.

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


8


14) A firm requires an investment of $25,000 and will return $36,500 after 1 year. If the firm borrows

$20,000 at 7%, what is the return on levered equity?

A) 162%

B) 202%

C) 242%

D) 283%

Answer: B

Explanation: B) The firm will owe debt holders the amount borrowed times (1 + rate) after one year.

Diff: 2 Var: 50+

Skill: Analytical


Author: KB


15) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, it

is referred to as ________.

A) outside debt

B) retained earnings

C) homemade leverage

D) payout ratio


Skill: Definition


Author: KB


16) A firm requires an investment of $30,000 and borrows $15,000 at 7%. If the return on equity is 19%,

what is the firm's pretax WACC?

A) 13%

B) 6.5%

C) 15.6%

D) 18.2%

Answer: A

Explanation: A) Pretax WACC = rE + rD

Pretax WACC = 19 % × [$15,000 / ($15,000 + $15,000] + 7% × [$15,000 / ($15,000 + $15,000] = 13% Diff: 2 Var: 27

Skill: Analytical


Author: KB


9


17) A firm requires an investment of $36,000 and borrows $12,000 at 9%. If the return on equity is 20%,


A) 8.2%

B) 19.6%

C) 16.3%

D) 22.9%

Answer: C

Explanation: C) Pretax WACC = rE + rD

Pretax WACC = 20% × [$24,000 / ($24,000 + $12,000)] + 9% ×[$12,000 / ($24,000 + $12,000)] = 16.3% Diff: 2 Var: 48

Skill: Analytical


Author: KB


18) A firm requires an investment of $30,000 and borrows $7500 at 7%. If the return on equity is 18%,


A) 7.6%

B) 18.3%

C) 21.4%

D) 15.3%

Answer: D

Explanation: D) Pretax WACC = rE + rD

Pretax WACC = 18% × [$22,500 / ($22,500 + $7500)] + 7% × [$7500 / ($22,500 + $7500)] = 15.3% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


19) A firm has a market value of equity of $30,000. It borrows $7500 at 8%. If the unlevered cost of equity

is 15%, what is the firm's cost of equity capital?

A) 16.75%

B) 6.70%

C) 20.10%

D) 23.45%

Answer: A

Explanation: A) Use MM Proposition II equation, rE = rU + ( rU - rD )

The firm's cost of equity capital = 15% + ($7500 / $30,000)(15% - 8%) = 16.75% Diff: 2 Var: 48

Skill: Analytical


Author: KB


10




A) 9.0%

B) 18.0%

C) 21.6%

D) 25.2%

Answer: B

Explanation: B) Use MM Proposition II equation, rE = rU + ( rU - rD )

The firm's cost of equity capital = 16% + ($7500 / $30,000)(16% - 8%) = 18.0% Diff: 2 Var: 48

Skill: Analytical


Author: KB




A) 8.9%

B) 21.4%

C) 17.8%

D) 24.9%

Answer: C

Explanation: C) Use MM Proposition II equation, rE = rU + ( rU - rD )

The firm's cost of equity capital = 16% + ($8000 / $40,000)(16% - 7%) = 17.8% Diff: 2 Var: 50+

Skill: Analytical


Author: KB


22) Leverage can ________ a firm's expected earnings per share, but does not necessarily increase the

share price.

A) decrease

B) dilute

C) increase

D) never change


Skill: Conceptual


Author: KB


11


23) In general, issuing equity may not dilute the ownership of existing shareholders if ________.

A) the value of new shares is equal to the value of debt

B) the new shares are sold at a fair price

C) the firm has no debt financing

D) the firm uses debt conservatively


Skill: Conceptual


Author: KB


24) Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect

capital markets?

A) All investors hold the efficient portfolio of assets.

B) There are no taxes, transaction costs, or issuance costs associated with security trading.

C) A firm's financing decisions neither change the cash flows generated by its investments, nor do they

reveal new information about them.

D) Investors and firms can trade the same set of securities at competitive market prices equal to the

present value (PV) of their future cash flows.


Skill: Conceptual


Author: JN



A) The Law of One Price implies that leverage will affect the total value of a firm under perfect capital

market conditions.

B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security

holders is equal to the total cash flow generated by the firm's assets.

C) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and

equity, without altering the total cash flows of a firm.

D) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows

generated by its assets and is not affected by its choice of capital structure.

Answer: A

Explanation: A) The Law of One Price implies that leverage will not affect the total value of the firm

under perfect capital market conditions. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


12



A) As long as a firm's choice of securities does not change the cash flows generated by its assets, the

capital structure decision will not change the total value of the firm or the amount of capital it can raise.

B) If securities are fairly priced, then buying or selling securities has a net present value (NPV) of zero

and, therefore, should not change the value of a firm.

C) The future repayments that the firm must make on its debt are equal in value to the amount of the loan

it receives up front.

D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his

or her own portfolio.

Answer: D

Explanation: D) An investor who would like more leverage than the firm has chosen can borrow and add

leverage to his or her own portfolio. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) As long as investors can borrow or lend at the same interest rate as a firm, homemade leverage is a

perfect substitute for the use of leverage by the firm.

B) When investors use leverage in their own portfolios to adjust the leverage choice made by a firm, we

say that they are using homemade leverage.

C) The value of a firm is determined by the present value (PV) of the cash flows from its current and

future investments.

D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to

purchase the equity of a firm.

Answer: D

Explanation: D) The investor can re-create the payoffs of levered equity by borrowing and using the

proceeds to purchase the equity of the firm. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) When a firm borrows significant money to repurchase shares or pay a large cash dividend, the

transaction is called a leveraged recapitalization.

B) MM Proposition I applies to capital structure decisions made at any time during the life of a firm.

C) By choosing positive-NPV projects that are worth more than their initial investment, a firm can

enhance its value.

D) The choice of capital structure does not change the value of a firm if the cost of equity is higher than

the cost of debt.


Skill: Conceptual


Author: JN


13



A) Investors can alter the leverage choice of a firm to suit their personal tastes either by borrowing and

reducing leverage or by holding bonds and adding more leverage.

B) As per MM proposition II, the cost of capital of levered equity is equal to the cost of capital of

unlevered equity plus a premium that is proportional to the debt-equity ratio.

C) The MM propositions imply that the true role of a firm's financial policy is to deal with financial

market imperfections such as taxes and transaction costs.

D) In practice, we will find that capital structure can have an effect on a firm's value.

Answer: A

Explanation: A) Investors can alter the leverage choice of a firm to suit their personal tastes either by

borrowing and increasing leverage or by holding bonds and reducing leverage. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


Use the information for the question(s) below.

Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm

Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X

has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.

30) According to MM Proposition I, the stock price for Firm X is closest to ________.

A) $8.00

B) $24.00

C) $6.00

D) $12.00

Answer: C

Explanation: C) Under MM I, the total value of Firm X and Firm Y must be the same.

Value(Firm Y) = 1,000,000 × $24 = $24 million = Value(Firm X)

Value(levered equity) = value(Firm X) - debt = $24 million - $12 million = $12 million

Price per share = = $6.00

Diff: 2 Var: 1

Skill: Analytical


Author: JN


14


31) Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the

same 5% rate as Firm X. You have $5000 of your own money to invest and you plan on buying Firm Y

stock. Using homemade leverage, how much do you need to borrow in your margin account so that the

payoff of your margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X

stock?

A) $10,000

B) $5,000

C) $2,500

D) $0

Answer: B

Explanation: B) Under MM I, the total value of Firm X and Firm Y must be the same.

Value(Firm Y) = 1,000,000 × $24 = $24 million


So, the leverage ratio of Firm X is 50% equity to 50% debt. To duplicate this in homemade leverage we

need to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin

loan. So, $5,000 is our equity, and we need to match it with $5,000 in a margin loan. Diff: 2 Var: 1

Skill: Analytical


Author: JN



same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm Y

stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your

margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X stock. The number

of shares of Firm Y stock you purchased is closest to ________.

A) 425

B) 1,650

C) 2,000

D) 825

Answer: B



Value(levered equity) = value(Firm Y) - debt = $24 million - $12 million = $12 million

Price = = $6.00

So, the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage we need

to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin loan.

So, $5,000 is our equity and we need to match it with $5,000 in a margin loan. So, the total invested is

$10,000 / $6 per share = 1,667 shares. Diff: 2 Var: 1

Skill: Analytical


Author: JN


15



same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X

stock. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the

payoff of your account will be the same as a $5,000 investment in Firm Y stock?

A) $5,000

B) $0

C) $2,500

D) $4,000

Answer: C

Explanation: C) Under MM I, the total value of Firm X and Firm Y must be the same.




need to have equal proportions in our portfolio, which means we need 50% equity and 50% in the risk-

free asset. So, $5,000 is our total portfolio and we need $2,500 in equity (Firm X stock) and $2,500 in the

risk-free asset. Diff: 2 Var: 1

Skill: Analytical


Author: JN


16



same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X

stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your

account will be the same as a $5,000 investment in Firm Y stock. The number of shares of Firm X stock

you purchased is closest to ________.

A) 100

B) 417

C) 1,650

D) 825

Answer: B




Price per share = = $6.00


need to have equal proportions in our portfolio, which means we need 50% equity and 50% in the risk-

free asset. So $5,000 is our total portfolio and we need $2,500 in equity (Firm X stock) and $2,500 in the

risk-free asset.

= 417 shares

Diff: 2 Var: 1

Skill: Analytical


Author: JN


17


Use the information for the question(s) below.

Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to

use this cash to repurchase shares from its investors and has already announced the stock repurchase

plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are

currently trading at $20 per share.

35) The market value of Luther's non-cash assets is closest to ________.

A) $20 billion

B) $19 billion

C) $25 billion

D) $24 billion

Answer: A

Explanation: A) Non-cash assets = (1.25 billion × $20 per share) - $5 billion = $25 billion - $5 billion

Non-cash assets = $20 billion Diff: 2 Var: 1

Skill: Analytical


Author: JN


36) After the repurchase, how many shares will Luther have outstanding?

A) 0.75 billion

B) 1.0 billion

C) 1.1 billion

D) 1.2 billion

Answer: B

Explanation: B) Shares repurchased = $5 billion / $20 Share = 0.250 billion

Shares outstanding = 1.25 billion - 0.25 billion = 1.0 billion Diff: 2 Var: 1

Skill: Analytical


Author: JN


37) With perfect capital markets, what is the market value of Luther's equity after the share repurchase?

A) $15 billion

B) $10 billion

C) $25 billion

D) $20 billion

Answer: C

Explanation: C) The market value of Luther's equity will not change since it uses cash to purchase its

own stock. Diff: 2 Var: 1

Skill: Analytical


Author: JN


18


38) With perfect capital markets, what is the market price per share of Luther's stock after the share

repurchase?

A) $20

B) $24

C) $15

D) $25

Answer: D

Explanation: D) Market price per share = (1.25 billion × $20 per share) / 1 billion shares

= $25 billion / 1 billion shares = $25 Diff: 2 Var: 1

Skill: Analytical


Author: JN


39) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to

employees valued at $2 billion. The market value of Luther's non-cash assets is closest to ________.

A) $22 billion

B) $20 billion

C) $25 billion

D) $18 billion

Answer: A

Explanation: A) Market value of non-cash assets = (1.25 billion × $20 per share) + $2 billion - $5 billion

cash = $25 billion + $2 billion options - $5 billion cash = $22 billion Diff: 2 Var: 1

Skill: Analytical


Author: JN


40) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to

employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding?

A) 1.15 billion

B) 1.2 billion

C) 0.75 billion

D) 1.1 billion

Answer: A

Explanation: A) $2 billion / $20 Share = 0.10 billion shares repurchased

Shares outstanding = 1.25 - 0.10 = 1.15 billion Diff: 2 Var: 1

Skill: Analytical


Author: JN


19


Consider the following equation for the question(s) below.

E + D = U = A

41) The E in the equation above represents ________.

A) the value of the firm's equity

B) the value of the firm's debt

C) the value of the firm's unlevered equity

D) the market value of the firm's assets


Skill: Conceptual


Author: JN


42) The U in the equation above represents ________.

A) the value of the firm's equity

B) the market value of the firm's assets

C) the value of the firm's unlevered equity

D) the value of the firm's debt


Skill: Conceptual


Author: JN


43) The A in the equation above represents ________.

A) the value of the firm's debt

B) the market value of the firm's assets

C) the value of the firm's equity

D) the value of the firm's unlevered equity


Skill: Conceptual


Author: JN


20



A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's

equity.

B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.

C) We can use MM Proposition I to derive an explicit relationship between leverage and the equity cost of

capital.

D) The total market value of the firm's securities is equal to the market value of its assets, whether the

firm is unlevered or levered.

Answer: B

Explanation: B) Although debt has a lower cost of capital than equity, we can consider this cost in

isolation. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) The levered equity return equals the unlevered return plus an extra "kick" due to leverage.

B) By holding a portfolio of a firm's equity and its debt, we can replicate the cash flows from holding its

levered equity.

C) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium

that is proportional to the market value debt-equity ratio.

D) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its

equity holders.

Answer: B

Explanation: B) By holding a portfolio of a firm's equity and its debt, we can replicate the cash flows from

holding its unlevered equity. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


21



A) If we can identify a comparison firm whose assets have the same risk as the project being evaluated,

and if the comparison firm is levered, then we can use its cost of debt as the cost of capital for the project.

B) We can calculate the cost of capital of a firm's assets by computing the weighted average of the firm's

equity and debt cost of capital, which we refer to as the firm's weighted average cost of capital.

C) The portfolio of a firm's equity and debt replicates the returns we would earn if the firm were

unlevered.

D) When evaluating any potential investment project, we must use a discount rate that is appropriate

given the risk of the project's free cash flow.

Answer: A

Explanation: A) If we can identify a comparison firm whose assets have the same risk as the project being

evaluated, and if the comparison firm is levered, then we can use its unlevered equity cost of capital as

the cost of capital for the project. Diff: 2 Var: 1

Skill: Conceptual


Author: JN



A) With no debt, the WACC is equal to the unlevered equity cost of capital.

B) With perfect capital markets, a firm's WACC is dependent on its capital structure and is equal to its

equity cost of capital only if the firm is unlevered.

C) As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect

is that the firm's WACC is unchanged.

D) As debt has a lower cost of capital than equity, higher leverage lowers a firm's WACC.

Answer: B

Explanation: B) With perfect capital markets, a firm's WACC is independent of its capital structure and is

equal to its equity cost of capital only if the firm is unlevered. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


48) Which of the following statements is TRUE?

A) Holding cash has the opposite effect of leverage on risk and return.

B) We use the market value of a firm's net debt when computing its WACC and unlevered beta to

measure the cost of capital and market risk of the firm's business assets.

C) Since the WACC does not change with the use of leverage, the value of a firm's free cash flow

evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on

its financing choices.

D) Even if a firm's capital structure is more complex, the WACC is calculated by computing the weighted

average cost of only the firm's debt and equity.


Skill: Conceptual


Author: JN


22


49) Which of the following statements is FALSE assuming a perfect market?

A) The unlevered beta measures the market risk of a firm's business activities, ignoring any additional

risk due to leverage.

B) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the

interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no

cash and no debt.

C) The unlevered beta measures the market risk of a firm without leverage, which is equivalent to the

beta of the firm's assets.

D) As the amount of debt decreases, the debt becomes riskier because there is a chance the firm will

default.

Answer: D

Explanation: D) As the amount of debt increases, the debt becomes riskier because there is a chance the

firm will default. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


50) The following equation:

X = rE + rD

can be used to calculate all of the following EXCEPT ________.

A) the cost of capital for a firm's assets

B) the levered cost of preferred equity

C) the unlevered cost of equity

D) the weighted average cost of capital


Skill: Conceptual


Author: JN


51) Which of the following equations would NOT be appropriate to use in a firm with risky debt?

A) rE = rU + (D / E) × (rU - rD)

B) rU = rD + (D / E) × (rU - rD)

C) rE = rU + (D / E) × rU

D) rU = [E / (E + D)]rE +[D / (E + D)]rD


Skill: Conceptual


Author: JN


23


Use next year's Cash Flow Forecast for Blank Company to answer the question(s) below.

Demand Cash Flow

Weak $25,000

Expected $35,000

Strong $45,000

52) Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of

8%. What is the value of the company if the demand is as expected?

A) $23,148.15

B) $32,407.40

C) $41,666.67

D) Cannot be determined with the information given.

Answer: B

Explanation: B) Expected cash flow is $35,000. Discounted for one period,

.

Diff: 1 Var: 1

Skill: Analytical


Author: JP



8%. If the company uses no leverage, what is expected return to equity holders?

A) 8.0%

B) 11.6%

C) 9.33%

D) 30.0%

Answer: A

Explanation: A) Unlevered cost of equity is given at 8%. Diff: 1 Var: 1

Skill: Analytical


Author: JP


24



8%. If the company borrows $10,000 at 5% to make the investment, what is expected return to equity

holders? Assume the demand is as expected.

A) 8.0%

B) 11.6%

C) 9.33%

D) 30.0%

Answer: C

Explanation: C) Expected cash flow is $35,000. Equity costs $22,407.40 initially .

The firm must repay to debt holders, so cash flow to equity is

. Expected return to equity is .

Diff: 2 Var: 1

Skill: Analytical


Author: JP



8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if

demand is weak?

A) 8.0%

B) -37.5%

C) -58.6%

D) 10.28%

Answer: D

Explanation: D) In the weak demand scenario, cash flow is $25,000. Equity costs $13,148.15 initially

.

The firm must repay $10,500 ($10,000 × 1.05) to debt holders, so cash flow to equity is


Diff: 2 Var: 1

Skill: Analytical


Author: JP


25



8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if

demand is strong?

A) 8.0%

B) 8.95%

C) 28.6%

D) 38.0%

Answer: B

Explanation: B) In the strong demand scenario, cash flow is $45,000. Equity costs $31,666.67 initially

($45,000 / 1.08 - $10,000).

The firm must repay $10,500 ($10,000 × 1.05) to debt holders, so cash flow to equity is


Diff: 2 Var: 1

Skill: Analytical


Author: JP


16.3 Debt and Taxes

1) In general, the gain to investors from the tax deductibility of interest payments is referred to as the

interest rate tax shield.


Skill: Definition


Author: KB


2) Suppose a project financed via an issue of debt requires five annual interest payments of $12 million

each year. If the tax rate is 35% and the cost of debt is 5%, what is the value of the interest rate tax shield?

A) 14.55 million

B) $21.82 million

C) $36.37 million

D) $18.18 million

Answer: D

Explanation: D) Value of tax shield each year equals tax rate times the interest payment.

Compute the present value of annuity of payments calculated above.

Tax shield = 0.35 × 12 million = $4.2 million;

Diff: 1 Var: 18

Skill: Analytical


Author: KB


26


3) Suppose a project financed via an issue of debt requires six annual interest payments of $18 million


A) $23.30 million

B) $29.12 million

C) $34.95 million

D) $58.25 million

Answer: B

Explanation: B) Value of tax shield each year equals tax rate times the interest payment.


Tax shield = 0.35 × $18 million = $6.3 million;

Diff: 1 Var: 30

Skill: Analytical


Author: KB


4) Suppose a project financed via an issue of debt requires five annual interest payments of $18 million


A) $20.66 million

B) $31.00 million

C) $25.83 million

D) $51.66 million

Answer: C

Explanation: C) Value of tax shield each year equals tax rate times the interest payment.


Tax shield = 0.35 × $18 million = $6.3 million;

Diff: 1 Var: 30

Skill: Analytical


Author: KB


5) A firm requires an investment of $30,000 and borrows $20,000 at 9%. If the return on equity is 15% and

the tax rate is 30%, what is the firm's WACC?

A) 9.20%

B) 7.36%

C) 11.04%

D) 18.40%

Answer: A

Explanation: A) Use the WACC equation presented in this chapter.

rwacc = rE + rD (1 - TC)

rwacc = 15% × ($10,000 / $30,000) + 9% × (1 - 0.3) × ($20,000 / $30,000) = 9.20%

Diff: 1 Var: 36

Skill: Analytical


Author: KB


27




A) 11.1%

B) 13.9%

C) 16.7%

D) 27.9%

Answer: B

Explanation: B) Use the WACC equation presented in this chapter.


rwacc = 22% × ($30,000 / $60,000) + 9% × (1 - 0.35) × ($30,000 / $60,000) = 13.9%

Diff: 1 Var: 50+

Skill: Analytical


Author: KB




A) 11.2%

B) 9.0%

C) 13.4%

D) 22.4%

Answer: A

Explanation: A) Use the WACC equation presented in this chapter.


rwacc = 14% × ($40,000 / $60,000) + 8% × (1 - 0.3) × ($20,000 / $60,000) = 11.2%

Diff: 1 Var: 47

Skill: Analytical


Author: KB


8) What are some implications of market imperfections?

Answer: Market imperfections such as corporate taxes affect a firm's value and hence play a critical role

in the firm's choice of capital structure. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


28


9) How does the interest paid by a firm affect its value to investors?

Answer: The interest paid by a firm is tax-deductible and is referred to as interest tax shield. This is the

additional amount that a firm would have paid in taxes if it did not have any debt in its capital structure. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


10) What effect does debt have on a firm's weighted average cost of capital?

Answer: In a world with taxes, interest tax shield tends to reduce a firm's weighted average cost of

capital. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


16.4 The Costs of Bankruptcy and Financial Distress

1) A firm that does not have trouble meeting its debt obligations is said to be in financial distress.


Skill: Definition


Author: KB


2) The direct costs of bankruptcy are estimated to be far greater, as a percent of assets, than the indirect

costs of bankruptcy.


Skill: Conceptual


Author: JP


3) A bankruptcy process is complex, time-consuming, and costly. The costs of bankruptcy include

________.

A) dividend payments

B) raw material costs

C) costs of hiring legal experts, appraisers, and auctioneers

D) taxes


Skill: Conceptual


Author: KB


29


4) Aside from direct costs of bankruptcy, a firm may also incur other indirect costs such as ________.

A) loss of customers and loss of suppliers

B) loss of interest receipts

C) loss of dividend receipts

D) increase in raw material costs


Skill: Conceptual


Author: KB


5) What are direct costs of financial distress?

Answer: When a corporation becomes financially distressed, outside professionals, such as legal,

appraisers, auctioneers, and others with experience in distressed assets are generally hired. These are

direct costs of financial distress. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


6) What are indirect costs of financial distress?

Answer: Indirect costs of financial distress are difficult to measure and are often larger than the direct

costs. These costs arise from defaulting on the commitments of a firm with its various constituents. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


16.5 Optimal Capital Structure: The Tradeoff Theory

1) The presence of financial distress costs can explain why firms choose debt levels that are too low to

exploit the interest tax shield.


Skill: Conceptual


Author: KB


2) Differences in the magnitude of financial distress costs and volatility of cash flows across industries do

not impact the choice of leverage.


Skill: Conceptual


Author: KB


30


3) The tradeoff theory of optimal capital structure weighs the benefits of debt against the costs of

________.

A) financial distress

B) interest payments

C) dividend reinvestment

D) input factors


Skill: Definition


Author: KB


4) The Tradeoff Theory suggests that ________.

A) a firm should choose a debt level where the tax savings from increasing leverage are just offset by the

increased probability of incurring the costs of financial distress

B) with higher costs of financial distress, it is optimal for a firm to choose higher leverage

C) differences in the magnitude of financial distress costs and the volatility of cash flows cannot explain

the differences in the use of leverage across industries

D) there is no rational explanation for why firms choose debt levels that are too low to fully exploit the

debt tax shield


Skill: Conceptual


Author: JP


5) One of the factors that determine the present value (PV) of financial distress costs is ________.

A) costs of unpaid interest arrears

B) loss of dividend payments

C) probability of financial distress

D) employee compensation


Skill: Conceptual


Author: KB


31


6) Firms in industries such as real estate tend to have ________ distress costs because of a large

proportion of tangible assets.

A) high

B) low

C) unexpected

D) varying


Skill: Conceptual


Author: KB


7) The probability of financial distress depends on the ________.

A) likelihood that a firm will be unable to meet its debt commitments

B) chance that a firm's raw material costs will increase

C) likelihood of dividend payments

D) likelihood of asset growth


Skill: Definition


Author: KB


8) As the level of debt increases the tax benefits of debt increase until ________.

A) interest costs exceed dividend payments

B) tax shield benefit exceeds distress costs

C) raw material costs exceed dividend payments

D) employee costs exceed interest expense


Skill: Conceptual


Author: KB


9) What are the issues in determining the present value (PV) of financial distress?

Answer: Calculating the precise present value (PV) of financial distress costs is very difficult if not

impossible. However, there are two key qualitative factors that need to be considered: (1) the probability

of financial distress and (2) the magnitude of direct and indirect costs related to financial distress. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


32


10) What are the issues in determining the optimal leverage for a firm?

Answer: While interest tax shield tends to increase the value of a firm , the direct and indirect cost of

financial distress tend to increase with leverage. Thus, there is an optimal leverage where the costs and

benefits are optimized. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


16.6 Additional Consequences of Leverage: Agency Costs and Information

1) The presence of leverage can influence the behavior of the managers of a firm.


Skill: Conceptual


Author: KB


2) Equity-debt holder conflicts are more likely to arise if the risk of financial distress is high.


Skill: Conceptual


Author: JP


3) Agency costs arise when ________.

A) there are high labor costs

B) input costs are higher than interest costs

C) interest costs exceed dividend payments

D) conflicts of interest exist between stakeholders


Skill: Definition


Author: KB


4) Managerial entrenchment means that managers ________ and run the firm for their own best interests.

A) may face little threat of being fired

B) are overseen by equity holders

C) are overseen by debt holders

D) are well compensated


Skill: Definition


Author: KB


33


5) When a firm's investment decisions have different consequences for the value of equity and the value

of debt, managers may take actions ________.

A) to increase debt values

B) to decrease costs of distress

C) that benefit shareholders at the expense of debt holders

D) to reduce fixed costs


Skill: Conceptual


Author: KB


6) The presence of a large amount of debt can encourage shareholders to take excessive risk because

________.

A) equity holders are risk seeking by nature

B) the costs of failure are borne largely by debt holders

C) debt holders are risk seeking

D) firm value increases with risk taking


Skill: Conceptual


Author: KB


7) To reduce agency costs, issuing debt instead of equity provides incentives for managers to run a firm

efficiently because ________.

A) debt increases the funds available to managers to run the firm

B) ownership of managers may remain more concentrated

C) managers may take actions that benefit shareholders but harm creditors and lower the value of the

firm

D) shareholders prefer to decline new projects to save cash, even if their NPVs are positive


Skill: Conceptual


Author: JP


34


8) Under-investment problems refers to the problem that equity holders prefer not to invest in positive-

NPV projects in highly levered firms because ________.

A) future investments are contingent on debt financing

B) projects are contingent on equity financing

C) gains are evenly shared between all stakeholders

D) most of the gains from the investment accrue to debt holders


Skill: Conceptual


Author: KB


9) The use of leverage as a way to signal ________ information to investors is known as the signaling

theory of debt.

A) good

B) bad

C) random



Skill: Definition


Author: KB


10) Asymmetric information implies that ________ may have better information about a firm's cash flows

than other stakeholders.

A) debt holders

B) suppliers

C) managers

D) creditors


Skill: Definition


Author: KB


11) Market timing means that managers may sell ________ when they believe the stock is over-valued

and rely on ________ when the stock is undervalued.

A) debt, shares

B) debt, preferred stock

C) new shares, debt

D) debt, debt


Skill: Conceptual


Author: KB


35


12) The pecking order hypothesis states that managers will have a preference to fund investment by using

________, followed by ________, and will issue ________ as a last resort.

A) debt, equity, retained earnings

B) retained earnings, equity, debt

C) retained earnings, debt, equity

D) debt, retained earnings, equity


Skill: Definition


Author: KB


16.7 Capital Structure: Putting It All Together

1) Managers should make use of the interest tax shield if a firm has ________.

A) consistent taxable income

B) volatility in taxable income

C) consistent dividend payments

D) low tax rates


Skill: Conceptual


Author: KB


2) Managers should consider ________ for external financing when agency costs are significant.

A) long-term debt


C) internal equity

D) short-term debt


Skill: Conceptual


Author: KB


36


3) Managers should not change the capital structure unless it departs significantly from the optimal level

because such a change would ________.

A) reduce dividends

B) incur transactions costs

C) increase fixed costs

D) change incentives of stakeholders


Skill: Conceptual


Author: KB


4) The optimal capital structure depends on ________ such as taxes, distress costs and agency costs.

A) capital market factors

B) market imperfections

C) firm specific risks

D) systematic risks


Skill: Conceptual


Author: KB


1



Chapter 17 Payout Policy

17.1 Cash Distribution to Shareholders

1) The Record Date falls before the Ex-Dividend Date.


Skill: Conceptual


Author: WC


2) The way a firm chooses between alternate uses of free cash flow is referred to as ________.

A) retention ratio

B) payout policy

C) call policy

D) debt policy


Skill: Definition


Author: KB


3) The date on which the board of directors of a company authorizes the dividend is called the ________

date.

A) declaration

B) record

C) ex-dividend

D) distribution


Skill: Definition


Author: KB


4) The firm will pay the dividend to all shareholders of record on a specific date, set by the board, called

the ________ date.

A) declaration

B) record

C) ex-dividend

D) distribution


Skill: Definition


Author: KB


2


5) The date two business days prior to the date on which all shareholders of record receive a payment is

called the ________ date.

A) declaration

B) record

C) ex-dividend

D) distribution


Skill: Definition


Author: KB


6) The date on which a firm pays out dividends is called the ________ date.

A) declaration

B) record

C) ex-dividend

D) distribution


Skill: Definition


Author: KB


7) A one-time payment to shareholders that is much larger than a regular dividend is often referred to as

a(n) ________ dividend.

A) taxable

B) divesting

C) special

D) ex-day


Skill: Definition


Author: KB


8) Dividend payments that are the result of liquidation of assets are known as ________ and are taxed as

capital gains.

A) return of capital

B) rolling dividends

C) alternate payments

D) private earnings


Skill: Definition


Author: KB


3


9) An alternate way to pay investors is when the firm uses cash to buy shares of its own outstanding

stock, also known as ________.

A) dividend investment


C) initial public offering

D) share repurchases


Skill: Definition


Author: KB


10) A firm may announce its intention to buy its own shares in the open market like any other investor,

also known as a(n) ________.

A) open market repurchase

B) tender offer

C) targeted repurchase

D) greenmail


Skill: Definition


Author: KB


11) When a firm offers to buy its shares at a pre specified price during a short time period it is also known

as a(n) ________.

A) open market repurchase

B) tender offer


D) greenmail


Skill: Definition


Author: KB


12) When a firm purchases shares directly from a major shareholder it is also known as a(n) ________.

A) open market purchase

B) tender offer


D) greenmail


Skill: Definition


Author: KB


4


13) A firm may decide to eliminate the threat of a takeover by a major shareholder by purchasing shares

from him at a premium also known as a(n) ________.

A) open market purchase

B) tender offer


D) greenmail


Skill: Definition


Author: KB


14) The date on which the board authorizes the dividend is the ________.

A) declaration date

B) distribution date

C) record date

D) ex-dividend date


Skill: Definition


Author: JN


15) The firm will pay the dividend to all shareholders who are registered owners on a specific date, set by

the board, called the ________.

A) declaration date

B) record date

C) distribution date

D) ex-dividend date


Skill: Definition


Author: JN


16) Anyone who purchases the stock on or after the ________ date will not receive the dividend.

A) distribution

B) record

C) ex-dividend

D) declaration


Skill: Definition


Author: JN


5


17) The firm mails dividend checks to the registered shareholders on the ________.

A) ex-dividend date

B) declaration date

C) distribution date

D) record date


Skill: Definition


Author: JN



A) From an accounting perspective, dividends generally reduce the firm's current (or accumulated)

retained earnings.

B) The way a firm chooses between paying dividends and retaining earnings is referred to as its payout

policy.

C) Most companies that pay dividends pay them semiannually.

D) Occasionally, a firm may pay a one-time, special dividend that is usually much larger than a regular

dividend.

Answer: C

Explanation: C) Most companies that pay dividends pay them at regular quarterly intervals. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


19) A firm can repurchase shares through a(n) ________ in which it offers to buy shares at a prespecified

price during a short time period, generally within 20 days.

A) tender offer

B) open market share repurchase


D) Dutch auction share repurchase


Skill: Definition


Author: JN


6


20) Another method to repurchase shares is the ________, in which the firm lists different prices at which

it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing to sell at

each price.

A) tender offer

B) Dutch auction share repurchase


D) open market share repurchase


Skill: Definition


Author: JN


21) A(n) ________ may occur if a major shareholder desires to sell a large number of shares but the

market for the shares is not sufficiently liquid to sustain such a large sale without severely affecting the

price.

A) open market share repurchase


C) tender offer

D) targeted repurchase


Skill: Definition


Author: JN


22) A(n) ________ is the most common way that firms repurchase shares.

A) targeted repurchase


C) tender offer

D) open market share repurchase


Skill: Definition


Author: JN


7


23) A firm has a total market value of assets of $240 million, of which $24 million is cash. It has debt of

$96 million. If the firm were to repurchase $9.6 million of its stock, what would its new debt-to-equity

ratio be?

A) 142.86%

B) 71.43%

C) 35.71%

D) 85.71%

Answer: B

Explanation: B) Before Repurchase, Assets = $240 million, Debt = $96 million, Equity = $144 million

After Repurchase, Assets = $230.4 million, Debt = $96 million, Equity = $134.4 million

Debt / Equity = $96 million / $134.4 million = 71.43% Diff: 2 Var: 5

Skill: Analytical


Author: WC


24) What choices does a firm have in using its free cash flow?

Answer: A firm has two choices with its free cash flow. It can decide to retain or pay out its free cash

flow. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


25) What are the ways in which a firm can pay out its free cash flow?

Answer: There are two ways a firm can pay out free cash flow to its shareholders. A firm can decide to

repurchase shares or pay dividends to its shareholders. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


26) What are the ways in which a firm can retain its free cash flow?

Answer: There are two ways a firm can retain free cash flow. A firm can decide to invest in new projects

or increase its cash reserves. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


8


27) What are the characteristics of special dividend?

Answer: Special dividends are occasional, one-time payments to shareholders. These are generally larger

than regular dividends. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


28) What are the different ways a firm can repurchase shares?

Answer: There are three possible ways a firm can repurchase. A firm can repurchase using open market

operations, make a tender offer, or make a targeted repurchase. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


17.2 Dividends Versus Share Repurchases in a Perfect Capital Market

1) In a perfect capital market, when a dividend is paid, the share price drops by the amount of the

dividend when the stock begins to trade ex-dividend.


Skill: Conceptual


Author: KB


2) With perfect capital markets, an open market repurchase increases the stock price as the number of

outstanding shares is decreased.


Skill: Conceptual


Author: KB


3) The share price falls when a dividend is paid because the reduction in cash decreases the ________.

A) liabilities of the firm

B) current account of the firm

C) market value of assets

D) equity of the firm


Skill: Conceptual


Author: KB


9


4) Suppose a firm does not pay a dividend but repurchases stock using $28 million of cash, the market

value of the firm decreases by ________.

A) $28 million

B) -$28 million

C) 0


Answer: A

Explanation: A) The reduction in cash decreases the market value of the firm's assets by the same

amount. Diff: 2 Var: 11

Skill: Analytical


Author: KB


5) A firm has a total market value of assets of $300 that includes $40 million of cash and 10 million shares

outstanding. If the firm uses $30 million of its cash to repurchase shares, what is the new price per share?

A) $24.00

B) $36.00

C) $30.00

D) $42.00

Answer: C

Explanation: C) Price per share before repurchase equals total market value of assets divided by number

of shares.

New shares = existing shares - (cash spent divided by price per share in A).

New price per share = (Total market value of assets - cash spent) / (new number of shares outstanding in

B).

Per share price (old) = $300 million / 10 million = $30;

Number of shares left after repurchase = 10 million - ($30 million / $30) = 9 million;

New price per share = ($300 million - $30 million) / 9 million = $30.00 Diff: 2 Var: 15

Skill: Analytical


Author: KB


10


6) A firm has a total market value of assets of $300 million that includes $40 million of cash and 8 million

shares outstanding. If the firm uses $30 million of its cash to repurchase shares, what is the new price per

share?

A) $30.00

B) $37.50

C) $45.00

D) $52.50

Answer: B

Explanation: B) Price per share before repurchase equals total market value of assets divided by number

of shares.



B).

Per share price (old) = $300 million / 8 million = $37.50;

Number of shares left after repurchase = 8 million - ($30 million / $37.5) = 7.2 million;

New price per share = ($300 million - $30 million) / 7.2 million = $37.50 Diff: 2 Var: 27

Skill: Analytical


Author: KB


7) A firm has a total market value of assets of $300 million that includes $60 million of cash and 8 million

shares outstanding. If the firm uses $30 million of its cash to repurchase shares, what is the new price per

share?

A) $37.50

B) $30.00

C) $45.00

D) $52.50

Answer: A

Explanation: A) Price per share before repurchase equals total market value of assets divided by number

of shares.



B).

Per share price (old) = $250 million / 10 million = $37.50;

Number of shares left after repurchase = 8 million - ($30 million / $37.5) = 7.2 million;

New price per share = ($300 - $30) / 7.2 million = $37.50 Diff: 2 Var: 45

Skill: Analytical


Author: KB


11


8) When a firm repurchases shares, the supply of shares is ________, but at the same time, the value of the

firm's assets ________.

A) reduced, declines

B) increased, declines

C) reduced, increase

D) increased, increase


Skill: Conceptual


Author: KB


9) Homemade dividend refers to the process by which an investor ________.

A) can take on more debt

B) chooses between equity and debt

C) can sell shares to create a dividend policy to suit his preferences

D) reinvests dividend payments


Skill: Conceptual


Author: KB


10) A firm has a total market value of assets of $300 million that includes $60 million of cash and 10

million shares outstanding. The firm uses $30 million of its cash to pay dividends. If an investor has 1000

shares, how many shares must he sell to create a homemade dividend of $3,900?

A) 33.33 shares

B) 26.67 shares

C) 40.00 shares

D) 46.67 shares

Answer: A

Explanation: A) Dividend payment = number of shares times dividend per share

Shares sold = (amount needed - dividend payment) / (new price per share)

Old share price = $300 million / 10 million = $30.00;

Dividend payment = $30 million / 10 million = $3.00

New share price = $30.00 - $3.00 = $27.00

Diff: 3 Var: 36

Skill: Analytical


Author: KB


12


11) A firm has $400 million of assets that includes $40 million of cash and 12 million shares outstanding.

The firm uses $40 million of its cash to pay dividends. If an investor has 1000 shares, how many shares

must she sell to create a homemade dividend of $4,900?

A) 52.22 shares

B) 41.78 shares

C) 62.67 shares

D) 73.11shares

Answer: A

Explanation: A) Dividend payment = number of shares times dividend per share


Old share price = $400 million / 12 million = $33.33;


New share price = $33.33 - $3.33 = $30.00

Diff: 3 Var: 41

Skill: Analytical


Author: KB


12) A firm has $300 million of assets that includes $40 million of cash and 8 million shares outstanding.

The firm uses $30 million of its cash to pay dividends. If an investor has 1000 shares, how many shares

must he sell to create a homemade dividend of $6,575?

A) 67 shares

B) 100 shares

C) 84 shares

D) 117 shares

Answer: C

Explanation: C) Dividend payment = number of shares times dividend per share


Old share price = $300 million / 8 million = $37.50


New share price = $37.50 - $3.75 = $33.75

Diff: 3 Var: 45

Skill: Analytical


Author: KB


13


13) Danroy Inc. has announced a $7 dividend. If Danroy's last price while trading cum-dividend is $66,

what should its first ex-dividend price be (assuming perfect capital markets)?

A) $59

B) $66

C) $73

D) $80

Answer: A

Explanation: A) $66 - $7 = $59. Diff: 1 Var: 50+

Skill: Analytical


Author: WC


14) Modigliani and Miller Dividend Irrelevance states that in perfect capital markets, holding ________

policy fixed, the firm's choice of dividend policy is irrelevant and does not affect the initial share price.

A) debt

B) investment

C) interest rate

D) equity issuance


Skill: Definition


Author: KB



A) 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.

B) In a perfect capital market, when a dividend is paid, the share price drops by the amount of the

dividend when the stock begins to trade ex-dividend.

C) In perfect capital markets, an open market share repurchase has no effect on the stock price, and the

stock price is the same as the ex-dividend price if a dividend were paid instead.

D) In perfect capital markets, investors are indifferent between the firm distributing funds via dividends

or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method

on their own.

Answer: C

Explanation: C) In perfect capital markets, an open market share repurchase has no effect on the stock

price, and the stock price is the same as the cum-dividend price if a dividend were paid instead. Diff: 1 Var: 1

Skill: Conceptual


Author: JN


14


16) Omicron Technologies has $60 million in excess cash and no debt. The firm expects to generate

additional free cash flows of $48 million per year in subsequent years and will pay out these future free

cash flows as regular dividends. Omicron's unlevered cost of capital is 10% and there are 12 million

shares outstanding. Omicron's board is meeting to decide whether to pay out its $60 million in excess

cash as a special dividend or to use it to repurchase shares of the firm's stock.

Omicron's enterprise value is closest to ________.

A) $384.00 million

B) $576.00 million

C) $960.00 million

D) $480.00 million

Answer: D

Explanation: D)

Diff: 1 Var: 12

Skill: Analytical


Author: JN







Including its cash, Omicron's total market value is closest to ________.

A) $432.00 million

B) $648.00 million

C) $1080.00 million

D) $540.00 million

Answer: D

Explanation: D)

Diff: 1 Var: 12

Skill: Analytical


Author: JN


15







Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. The amount of

the special dividend is closest to ________.

A) $5.00

B) $4.00

C) $6.00

D) $10.00

Answer: A

Explanation: A) Dividend = = $5.00 per share

Diff: 1 Var: 12

Skill: Analytical


Author: JN




cash flows as regular dividends. Omicron's unlevered cost of capital is 8% and there are 10 million shares

outstanding. Omicron's board is meeting to decide whether to pay out its $50 million in excess cash as a

special dividend or to use it to repurchase shares of the firm's stock.

Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. The amount of

the regular yearly dividends in the future is closest to ________.

A) $3.20

B) $4.80

C) $4.00

D) $8.00

Answer: C

Explanation: C) Dividend in future = Free cash flows in future / number of shares outstanding

= $4.00 per share

Diff: 1 Var: 12

Skill: Analytical


Author: JN


16







Assume that Omicron uses the entire $60 million in excess cash to pay a special dividend. Omicron's

cum-dividend price is closest to ________.

A) $39.56

B) $59.33

C) $98.89

D) $49.44

Answer: D

Explanation: D)

Diff: 2 Var: 12

Skill: Analytical


Author: JN







Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. Omicron's ex-

dividend price is closest to ________.

A) $50.00

B) $40.00

C) $60.00

D) $100.00

Answer: A

Explanation: A)

However, once the $50 million in cash is used to pay the dividend, the new market value becomes

Ex-Dividend

Diff: 2 Var: 12

Skill: Analytical


Author: JN


17







Assume that Omicron uses the entire $50 million to repurchase shares. The number of shares that

Omicron will repurchase is closest to ________.

A) 0.73 million

B) 1.09 million

C) 0.9 million

D) 1.82 million

Answer: C

Explanation: C)

Diff: 2 Var: 12

Skill: Analytical


Author: JN


18







Assume that Omicron uses the entire $40 million to repurchase shares. The number of shares that

Omicron will have outstanding following the repurchase is closest to ________.

A) 5.8 million

B) 8.6 million

C) 14.4 million

D) 7.2 million

Answer: D

Explanation: D)

Diff: 2 Var: 12

Skill: Analytical


Author: JN


19







Assume that Omicron uses the entire $60 million to repurchase shares. The amount of the regular yearly

dividends in the future is closest to ________.

A) $3.56

B) $5.34

C) $4.45

D) $8.90

Answer: C

Explanation: C) Enterprise value = PV(Future FCF) = $48 million / 9% = $533.33 million

Dividend = = $4.45 per share

Diff: 3 Var: 12

Skill: Analytical


Author: JN


20







Assume that you own 2500 shares of Omicron stock and that Omicron uses the entire $40 million to

repurchase shares. Suppose you are unhappy with Omicron's decision and would prefer that Omicron

used the excess cash to pay a special dividend. The number of shares that you would have to sell in order

to receive the same amount of cash as if Omicron paid the special dividend is closest to ________ shares.

A) 227.27

B) 272.73

C) 454.55

D) 181.82

Answer: A

Explanation: A) Enterprise value = PV(Future FCF) = $32 million / 8% = $400.00 million

Dividend per share if Omicron uses $40 million to pay dividend = $40 million / 8 million shares = $5 per

share

Dividends that you wanted to

Diff: 3 Var: 12

Skill: Analytical


Author: JN


21







Assume that you own 2500 shares of Omicron stock and that Omicron uses the entire $50 million to pay a

special dividend. Suppose you are unhappy with Omicron's decision and would prefer that Omicron

used the excess cash to repurchase shares. The number of shares that you would have to buy in order to

undo the special cash dividend that Omicron paid is closest to ________ shares.

A) 225.00

B) 337.50

C) 562.50

D) 281.25

Answer: D

Explanation: D)

However, once the $50 million in cash is used to pay the dividend, the new market value becomes

Dividend per share = $50 million / 10 million shares = $5 per share

Dividends that you did not want to

Diff: 3 Var: 12

Skill: Analytical


Author: JN


27) A firm has $75 million of assets that includes $12 million of cash and 25 million shares outstanding. If

the firm uses $12 million of cash to repurchase shares, what is the new price per share?

A) $2.40

B) $1.50

C) $3.00

D) $6.00

Answer: C

Explanation: C)

shares repurchased

Number of shares outstanding after repurchase = 25 million - 4 million = 21 million

Diff: 2 Var: 18

Skill: Analytical


Author: WC


22


28) Which of the following is NOT a method for a firm to payout excess cash to its shareholders?

A) issue new shares

B) issue new shares and pay a high dividend

C) pay a dividend with the excess cash

D) repurchase shares


Skill: Conceptual


Author: WC


29) What is the effect on the stock price when a firm repurchases its shares?

Answer: There is a common misconception that the share price rises when a firm repurchases its shares

due to a decrease in shares outstanding. However, the firm value also declines, as cash is used to buy

those shares. Consequently, both firm value and number of shares decline leaving share price unchanged. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


30) What is the bird-in-the-hand fallacy in dividend theory under perfect capital markets?

Answer: According to Modigliani and Miller under perfect capital markets shareholders can generate an

equivalent homemade dividend at any time by selling shares. Thus the dividend choice of the firm

should not matter. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


17.3 The Tax Disadvantage of Dividends

1) Long-term investors can defer capital gains tax until they sell, and therefore, there is a tax advantage

for share repurchases over dividends.


Skill: Conceptual


Author: KB


23


2) The optimal dividend policy when dividend tax rates exceed capital gains tax rates is to pay dividends

only.


Skill: Conceptual


Author: KB


3) Different investor groups have differing tax preferences that create clientele effects in which dividend

policy of a firm is optimized for the tax preferences of its investors.


Skill: Definition


Author: KB


4) Share repurchases have a tax advantage over dividends because ________.

A) dividend payments are tax deductible

B) share repurchases increase the value of debt

C) capital gains can be deferred by long-term investors

D) repurchases are associated with increased customer loyalty


Skill: Conceptual


Author: KB


5) Historical evidence shows that over the last few decades a larger proportion of firms have used

________ for payouts.

A) repurchases

B) dividends

C) stock reverse splits

D) stock splits


Skill: Conceptual


Author: KB


24


6) The fact that firms continue to issue dividends despite their tax disadvantage is often referred to as the

________.

A) issuance puzzle

B) dividend puzzle

C) payback puzzle

D) policy puzzle


Skill: Definition


Author: KB


7) When a firm pays out a dividend, the share price ________, and when it conducts a share repurchase at

the market price, the share price ________.

A) increases, increases

B) is unchanged, decreases

C) decreases, decreases

D) decreases, is unchanged


Skill: Conceptual


Author: KB


8) Tax rates on dividends and capital gains differ across investors for a variety of reasons including

________.

A) income

B) investment horizon

C) tax jurisdiction

D) all of the above


Skill: Conceptual


Author: KB


9) Corporations enjoy a tax advantage associated with dividends due to ________.

A) personal tax exemptions

B) the 70% exclusion rule

C) laddered tax rates

D) concave tax structure


Skill: Conceptual


Author: KB


25



A) Unlike with capital structure, taxes are not an important market imperfection that influence a firm's

decision to pay dividends or repurchase shares.

B) If dividends are taxed at a higher rate than capital gains, which has been true until the most recent

change to the tax code, shareholders will prefer share repurchases to dividends.

C) Shareholders typically must pay taxes on the dividends they receive. They must also pay capital gains

taxes when they sell their shares.

D) Because long-term investors can defer the capital gains tax until they sell, there is still a tax advantage

for share repurchases over dividends.

Answer: A

Explanation: A) As with capital structure, taxes are an important market imperfection that influence a

firm's decision to pay dividends or repurchase shares. Diff: 1 Var: 1

Skill: Conceptual


Author: JN



A) When a firm pays a dividend, shareholders are taxed according to the dividend tax rate. If the firm

repurchases shares instead, and shareholders sell shares to create a homemade dividend, the homemade

dividend will be taxed according to the capital gains tax rate.

B) When the tax rate on dividends exceeds the tax rate on capital gains, shareholders will pay lower taxes

if a firm uses share repurchases rather than dividends for all payouts.

C) Firms that use dividends will have to pay a lower after-tax return to offer their investors the same

pretax return as firms that use share repurchases.

D) The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no

dividends at all.

Answer: C

Explanation: C) Firms that use dividends will have to pay a higher pretax return to offer their investors

the same after-tax return as firms that use share repurchases. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


26



A) While firms do still pay dividends, substantial evidence shows that many firms have recognized their

tax disadvantage.

B) The fact that firms continue to issue dividends despite their tax disadvantage is often referred to as the

dividend puzzle.

C) At the end of the 1990s, dividend payments exceeded the value of repurchases for U.S. industrial

firms.

D) While evidence is indicative of the growing importance of share repurchases as a part of firms' payout

policies, it also shows that dividends remain a key form of payouts to shareholders.

Answer: C

Explanation: C) At the end of the 1990s, distribution through repurchases exceeded the value of dividend

payments for U.S. industrial firms. Diff: 2 Var: 1

Skill: Conceptual


Author: JN


13) The JRN Corporation will pay a constant dividend of $3 per share per year in perpetuity. Assume that

all investors pay a 25% tax on dividends and that there is no capital gains tax. The cost of capital for

investing in JRN stock is 14%.

The price of a share of JRN's stock is closest to ________.

A) $16.07

B) $12.86

C) $19.29

D) $32.14

Answer: A

Explanation: A) Price per share = Dividend × (1 - tax rate) / cost of capital = $3 × (1 - 25%) / 14% = $16.07 Diff: 1 Var: 18

Skill: Analytical


Author: JN


27


14) The JRN Corporation will pay a constant dividend of $5 per share per year in perpetuity. Assume that

all investors pay a 25% tax on dividends and that there is no capital gains tax. The cost of capital for

investing in JRN stock is 10%.

Assume that management makes a surprise announcement that JRN will no longer pay dividends but

will use the cash to repurchase stock instead. The price of a share of JRN's stock is now closest to

________.

A) $40.00

B) $50.00

C) $60.00

D) $100.00

Answer: B

Explanation: B) In a perfect capital market the dividend or repurchase decision does not impact firm

value. Since the tax rate for repurchases is zero, the stock price would be the same as if the firm paid out

the dividend and the dividends were not taxed, so:

Price per share = Dividend / cost of capital = $5 / 10% = $50.00 Diff: 2 Var: 18

Skill: Analytical


Author: JN


15) The WTC Corporation will pay a constant dividend of $4.20 per share, per year, in perpetuity. If all

investors pay a 20% tax on dividends, there is no capital gains tax, and the cost of capital for investing in

WTC stock is 14%, what is the price for a share of WTC stock?

A) $24.00

B) $19.20

C) $28.80

D) $48.00

Answer: A

Explanation: A) Price of a share = Dividend × (1 - tax rate) / cost of capital = $4.20 × (1 - 0.2) / 0.14 = $24.00 Diff: 1 Var: 36

Skill: Analytical


Author: WC


16) The largest proportion of investors in common stock are ________.

A) mutual funds

B) pension funds

C) corporations

D) individual investors


Skill: Conceptual


Author: WC


28


17) What is the general trend of dividend payments of U.S. corporations over the last few decades?

Answer: The percentage of U.S. firms each year that made payout to shareholders as dividends has been

declining over the last few decades. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


18) What is the general trend over the last few decades of total payouts by firms to shareholders be it

through share repurchase or dividends?

Answer: The general trend of overall payouts by firms to shareholders is declining over the last few

decades. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


19) What is the general trend of share repurchase as a percentage of total payout over the last few

decades?

Answer: The value of share repurchase as a percentage of total payouts to shareholders though initially

small has grown faster than dividends, so that by the late 1990s share repurchases surpassed dividends to

become the largest form of corporate payouts for U.S. industrial firms. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


17.4 Payout Versus Retention of Cash

1) In perfect capital markets, buying and selling securities is a zero-NPV transaction, so retaining cash

versus paying it out does not affect firm value.


Skill: Conceptual


Author: KB


2) Because the dividend tax will be paid whether the firm pays the cash immediately or retains cash and

pays the interest over time, the dividend tax rate does not affect the cost of retaining cash.


Skill: Conceptual


Author: KB


29


3) Palo Alto Enterprises has $200,000 in cash. They wish to invest the money in Treasury bills at 5% and

use the returns to pay dividends to shareholders after a year. Alternatively they can pay a dividend and

allow shareholders to make the investment. In perfect capital markets, which option will shareholders

prefer?

A) immediate cash dividend

B) dividend after one year

C) prefer half from each source

D) indifferent between options


Skill: Conceptual


Author: KB




allow shareholders to make the investment. If corporate tax rates are 30%, which option will shareholders

prefer in perfect capital markets?






Skill: Conceptual


Author: KB





prefer?






Skill: Conceptual


Author: KB


30





prefer?






Skill: Conceptual


Author: KB





prefer?






Skill: Conceptual


Author: KB



use the returns to pay dividends to shareholders after a year. Alternatively, they can pay a dividend and


prefer?






Skill: Conceptual


Author: KB


31


9) When a firm retains cash, it pays corporate tax on the interest it earns and the investor will owe capital

gains tax on the increased firm value—in essence the interest on retained cash is taxed ________.

A) once

B) at a rate of zero

C) twice



Skill: Conceptual


Author: KB


10) Firms may retain large amounts of cash to cover future potential needs that allows a firm to avoid

________.

A) transaction costs and financial distress costs

B) tax payments

C) clientele effects



Skill: Conceptual


Author: KB


11) When a firm has excessive cash, managers may make use of the funds in an inefficient manner. This is

also referred to as the ________ cost of retaining cash.

A) fixed

B) agency

C) interest

D) special


Skill: Definition


Author: KB


32


12) Prada has ten million shares outstanding, generates free cash flows of $ 50 million each year and has a

cost of capital of 10%. It also has $50 million of cash on hand. Prada wants to decide whether to

repurchase stock or invest the cash in a project that generates free cash flows of $5 million each year.

Should Prada invest or repurchase the shares?

A) indifferent between options

B) repurchase

C) invest


Answer: A

Explanation: A) Repurchases do not change stock prices. So the question is whether the project has

positive NPV. NPV of the cash flows at the cost of capital equals 5 / 0.1 - 50 = 0. Diff: 2 Var: 1

Skill: Analytical


Author: KB


13) Prada has nine million shares outstanding, generates free cash flows of $ 40 million each year and has

a cost of capital of 10%. It also has $30 million of cash on hand. Prada wants to decide whether to




B) repurchase

C) invest


Answer: C

Explanation: C) Repurchases do not change stock prices. So the question is whether the project has

positive NPV. NPV of the cash flows at the cost of capital equals

$5 million / 10% - $30 million = $20 million. Diff: 2 Var: 1

Skill: Analytical


Author: KB


33


14) Prada has ten million shares outstanding, generates free cash flows of $ 60 million each year and has a

cost of capital of 10%. It also has $40 million of cash on hand. Prada wants to decide whether to




B) repurchase

C) invest


Answer: B

Explanation: B) Repurchases do not change stock prices. So the question is whether the project has

positive NPV. NPV of the cash flows at the cost of capital equals

$2 million / 10% - $40 million = ($20 million.) Diff: 2 Var: 1

Skill: Analytical


Author: KB


15) According to the ________ theory of payout policy, managers pay out cash only when pressured to do

so by investors.

A) agency

B) supply

C) price pressure

D) managerial entrenchment


Skill: Definition


Author: KB


16) Luther Industries has $6 million in excess cash and 1.2 million shares outstanding. Luther is

considering investing the cash in one-year Treasury bills that are currently paying 6% interest and then

using the cash to pay a dividend next year. Alternatively, Luther can pay the cash out as a dividend

immediately and the shareholders can invest in the Treasury bills themselves. Assume that capital

markets are perfect.

If Luther invests the excess cash in Treasury bills, then the dividend per share next year will be closest to

________.

A) $6.36

B) $5.30

C) $4.24

D) $10.60

Answer: B

Explanation: B) Dividend per share = $6 million × (1 + 0.06) / 1.2 million = $5.30 Diff: 1 Var: 18

Skill: Analytical


Author: JN


34


17) Luther Industries has $7 million in excess cash and 1.2 million shares outstanding. Luther is

considering investing the cash in one-year Treasury bills that are currently paying 5% interest and then

using the cash to pay a dividend next year. Alternatively, Luther can pay the cash out as a dividend

immediately and the shareholders can invest in the Treasury bills themselves. Assume that capital

markets are perfect. If Luther decides to pay the dividend immediately the dividend per share will be


A) $7.00

B) $4.67

C) $5.83

D) $11.67

Answer: C

Explanation: C) Dividend per share = $7 million / 1.2 million shares = $5.83 Diff: 1 Var: 18

Skill: Analytical


Author: JN


18) Consider the following tax rates:

Year

Corporate

Tax Rate

Capital

Gains Rate

Ordinary

Income Rate

Dividend

Rate

1997-2000 35% 20% 40% 40%

2001-2002 35% 20% 39% 39%

2003-2010 35% 15% 35% 15%

In 2006, Luther Incorporated paid a special dividend of $7 per share for the 120 million shares

outstanding. If Luther has instead retained that cash permanently and invested it into Treasury bills

earning 5%, then the present value (PV) of the additional taxes paid by Luther would be closest to

________.

A) $42.00 million

B) $235.20 million

C) $294 million

D) $588.00 million

Answer: C

Explanation: C) PV = = $7 × 120 million shares × 0.35 = $294.00 million

Diff: 2 Var: 18

Skill: Analytical


Author: JN


35


19) Iota Industries is an all-equity firm with 55 million shares outstanding. Iota has $220 million in cash

and expects future free cash flows of $70 million per year. Management plans to use the cash to expand

the firm's operations, which in turn will increase future free cash flows by 10%. Iota's cost of capital is 8%

and assume that capital markets are perfect.

The value of Iota, if they use the $220 million to expand, is closest to ________.

A) $1155.00 million

B) $1925.00 million

C) $962.50 million

D) $770.00 million

Answer: C

Explanation: C) Value = = $962.50 million

Diff: 2 Var: 50+

Skill: Analytical


Author: JN


17.5 Signaling with Payout Policy

1) Firms can change dividends at any time, and in practice they vary the sizes of their dividends very

frequently.


Skill: Conceptual


Author: KB


2) The practice of maintaining relatively constant dividends is called ________.

A) dividend calibration

B) dividend rollover

C) dividend smoothing

D) dividend rollbacks


Skill: Definition


Author: KB


36


3) The idea that dividend changes reflect managers' views about a firm's future earnings prospects is

called the ________ hypothesis.

A) signaling

B) predictor

C) instrumental



Skill: Definition


Author: KB


4) Empirical evidence about the behavior of financial managers suggests that firms ________ repurchase

activity and they ________ dividend payments.

A) smooth, smooth

B) smooth, do not smooth

C) do not smooth, do not smooth

D) do not smooth, smooth


Skill: Conceptual


Author: KB


17.6 Stock Dividends, Splits, and Spin-offs

1) In a stock split or stock dividend, the company issues additional shares rather than cash to its

shareholders.


Skill: Definition


Author: KB


2) In a stock dividend, each shareholder who owns the stock before the ex-dividend date receives

________ from the firm.

A) additional shares

B) additional shares and stock

C) cash only

D) shares for partial cash payment


Skill: Definition


Author: KB


37


3) The typical reason for a stock split is to ________.

A) allow for growth in the company assets

B) allow liabilities to grow

C) increase earnings per share

D) keep the share price in a range


Skill: Conceptual


Author: KB


4) A firm can distribute shares of a subsidiary in a transaction referred to as a(n) ________.

A) merger

B) spin-off

C) acquisition

D) cash disbursement


Skill: Definition


Author: KB


5) CCR stock is currently trading at $60.73 per share. If CCR issues a 25% stock dividend, its new share

price would be ________.

A) $48.58

B) $38.87

C) $97.17

D) $58.30

Answer: A

Explanation: A) New share price = $60.73 / (1 + 0.25) = $48.58 Diff: 1 Var: 50+

Skill: Analytical


Author: WC


6) Which of the following is an advantage of a spin-off versus selling a subsidiary and distributing the

cash?

A) A spin-off increases the transaction costs associated with selling the subsidiary.

B) Shareholders must immediately pay capital gains taxes versus ordinary income taxes on the value of

the spin-off.

C) A spin-off guarantees a lower cost of capital.

D) The spin-off is not taxed as a cash distribution.


Skill: Conceptual


Author: WC


38


17.7 Advice for the Financial Manager

1) Repurchases and special dividends are useful for making ________ and ________ distributions to

shareholders.

A) small, frequent

B) small, infrequent

C) large, infrequent

D) large, frequent


Skill: Conceptual


Author: KB


2) Because ________ are seen as an implicit commitment, they send a ________ signal of financial strength

to shareholders.

A) regular dividends, strong

B) dividends, weak

C) repurchases, strong

D) repurchases, weak


Skill: Conceptual


Author: KB


3) Future investment plans are important determinants of payout policy because of ________.

A) signal to investors

B) costs of raising new capital

C) stock price depreciation

D) debt holder restrictions


Skill: Conceptual


Author: KB


39


4) The financial manager should ________.

A) try to maximize the after-tax payout to the shareholders, for a given payout amount

B) try to minimize the firm's earnings per share

C) never pay dividend as a payout policy

D) only repurchase shares as a payout policy


Skill: Conceptual


Author: WC


1



Chapter 18 Financial Modeling and Pro Forma Analysis

18.1 Goals of Long-Term Financial Planning

1) The goal of the financial manager is to maximize the value of the shareholders' stake in the firm.

Answer: TRUE

Diff: 1 Var: 1

Skill: Conceptual


Author: KB


2) Long term financial planning helps a financial manager in budgeting but has little to do with

understanding how the business operates.


Skill: Conceptual


Author: KB


3) Long term financial planning allows a financial manager to understand the business by ________

between sales, costs, capital investments and financing.

A) increasing the spread between

B) identifying linkages

C) decreasing the spread between

D) identify wastage


Skill: Conceptual


Author: KB


4) If a firm is planning an expansion or changes in how it manages its inventory, long term financial

planning can help determine the impact on the firm's ________.

A) debt financing

B) capital investment

C) free cash flows

D) all of the above


Skill: Conceptual


Author: KB


2


5) Building a model for long-term forecasting reveals points in the future where the firm will need

________ when retained earnings are not enough to fund planned future investments.

A) external financing

B) stock dividends

C) dividend payments

D) mergers


Skill: Conceptual


Author: KB


6) Building a model for long-term forecasting reveals points in the future where the firm will have

________.

A) excess cash that can be used for dividends, debt repayment, or stock repurchases

B) cash needs that must be funded with external financing

C) a need for expanding property, plant and equipment to meet increases in capacity

D) all of the above


Skill: Conceptual


Author: JP


18.2 Forecasting Financial Statements: The Percent of Sales Method

1) Forecasting a balance sheet with percent of sales method requires two passes—a first pass to determine

financing needs and a second pass that shows the sources and amounts of financing.


Skill: Conceptual


Author: KB


2) The ________ method assumes that as sales grow, many income statement and balance sheet items will

grow, remaining the same percent of sales.

A) percent of income

B) percent of liabilities

C) percent of sales

D) percent of assets


Skill: Definition


Author: KB


3


3) While the assets and accounts payable of a firm may reasonably be expected to grow with sales,

________ will not naturally grow with sales.

A) cash

B) supplier credit

C) long term debt

D) cost of sales


Skill: Conceptual


Author: KB


4) Which of the following accounts may reasonably be expected to grow with sales?

I. Accounts Receivable

II. Accounts Payable

III. Property, Plant and Equipment

IV. Inventory

V. Long-Term Debt

A) I, II, and III

B) I, II, and V

C) I, II and IV

D) III and V

Answer: C

Diff: 1 Var: 1

Skill: Conceptual


Author: JP


5) Calgary Doughnuts had sales of $200 million in 2007. Its cost of sales were $160 million. If sales are

expected to grow at 10% in 2008, compute the forecasted costs using the percent of sales method.

A) $160 million

B) $170 million

C) $173 million

D) $176 million

Answer: D

Explanation: D) Next year sales = current sales times (1 + growth rate)

Cost of sales next year = Next year sales × (last year costs / last year sales)

Next year sales = $200 million × (1 + 10%) = $220 million;

Cost of sales next year = $220 million × ($160 million / $200 million) = $176 million Diff: 1 Var: 1

Skill: Analytical


Author: KB


4




A) $80 million

B) $84 million

C) $88 million

D) $96 million

Answer: B

Explanation: B) Next year sales = current sales times (1 + growth rate)



Cost of sales next year = $120 million × ($70 million / $100 million) = $84 million Diff: 1 Var: 1

Skill: Analytical


Author: KB




A) $210 million

B) $215 million

C) $225 million

D) $230 million

Answer: D

Explanation: D) Next year sales = current sales times (1 + growth rate)



Cost of sales next year = $345 million × ($200 million / $300 million) = $230 million

Diff: 1 Var: 1

Skill: Analytical


Author: KB


5


Use the information about Billy's Burgers to answer the following question(s):

Billy's Burgers

Figures in $

millions

Income

Statement 2010 Balance Sheet 2010

Net Sales 246.0 Assets

Costs exc. Dep. 187.0 Cash 8.0

EBITDA 59.0 Accts. Rec. 21.0

Depreciation 17.2 Inventories 23.0

EBIT 41.8

Total Current

Assets 52.0

Interest 12.0 Net PP&E 145.0

Pretax Income 29.8 Total Assets 197.0

Taxes 10.4

Net Income 19.4

Liabilities and

Equity

Accts. Payable 18.0

Long-Term

Debt 82.0

Total

Liabilities 100.0

Total

Stockholders'

Equity 97.0

Total

Liabilities and

Equity 197.0

8) Using the percent of sales method, and assuming 20% growth in sales, estimate Billy's Burgers'

depreciation for 2011.

A) $17.2 million

B) $50.8 million

C) $12.0 million

D) $20.6 million

Answer: D

Explanation: D) Dep. For 2011 = Sales of 2011 × (Depreciation of 2010 / Sales of 2010) = ($246 million ×

120%) × ($17.2 million / $246 million) = $20.6 million Diff: 1 Var: 1

Skill: Analytical


Author: JP


6


9) Using the percent of sales method, and assuming 20% growth in sales and no change in interest

expense, estimate Billy's Burgers' Pretax Income for 2011.

A) $23.28 million

B) $35.76 million

C) $24.84 million

D) $38.16 million

Answer: D

Explanation: D) Pretax income = EBIT - Interest

Pretax income = ($41.8 million × (1 + 20%) - $12 million = $38.16 million Diff: 1 Var: 1

Skill: Analytical


Author: JP


10) Using the percent of sales method, and assuming 20% growth in sales and no change in interest

expense, estimate Billy's Burgers' Net Income for 2011.

A) $23.28 million

B) $35.76 million

C) $24.84 million

D) $28.16 million

Answer: C

Explanation: C) Net Income = (EBIT - Interest) × (1 - tax rate)

Net Income = [(41.8 million) × (100% + 20%) - $12 million] × (1 - $10.4 million / $29.8 million) = $24.84

million Diff: 1 Var: 1

Skill: Analytical


Author: JP



Accounts Receivable for 2011.

A) $21.0 million

B) $25.2 million

C) $18.0 million

D) $21.6 million

Answer: B

Explanation: B) Accounts Receivable = $21 million × (1 + 20%) = $25.2 million Diff: 1 Var: 1

Skill: Analytical


Author: JP


7



Accounts Payable for 2011.

A) $21.0 million

B) $25.2 million

C) $18.0 million

D) $21.6 million

Answer: D

Explanation: D) $18 million × (1 + 20%) = $21.6 million

Diff: 1 Var: 1

Skill: Analytical


Author: JP


13) ________ is the amount of additional external financing needed to fund planned increases in assets.

A) Net new financing

B) Equity issuance

C) Debt issuance

D) Preferred stock issuance


Skill: Definition


Author: KB


14) The asset and liability side of a pro forma balance sheet projection will not balance, in general, unless

we make assumptions about how ________ and ________ will grow with sales.

A) dividends, equity

B) coupons, debt

C) debt, equity

D) dividends, preferred stock


Skill: Conceptual


Author: KB


15) The amount of dividends a company pays will affect the ________ it has to finance future growth.

A) debt


C) current liabilities

D) current ratio

Answer: B

Diff: 1 Var: 1

Skill: Conceptual


Author: KB


8


16) When making long term plans, any increases in ________ and ________ reflect capital structure

decisions that require managers to actively raise capital.

A) debt, equity

B) debt, assets

C) assets, equity

D) current ratio, equity


Skill: Conceptual


Author: KB


17) A services firm does all its business in cash only. The firm projects a cash balance of $2,000 in its

account after all taxes and costs are paid. The owners plan to invest $5,000 and pay a dividend of $1000.

How much net new financing is needed?

A) $4,000

B) $5,000

C) $6,000

D) $7,000

Answer: A

Explanation: A) Net new financing = Investment + dividend - cash on hand

Net new financing = $5,000 + $1,000 - $2,000 = $4,000 Diff: 2 Var: 1

Skill: Analytical


Author: KB



account after all taxes and costs are paid. The owners plan to invest $8,000 and pay a dividend of $1000.


A) $4,000

B) $5,000

C) $6,000

D) $7,000

Answer: C

Explanation: C) Net new financing = Investment + dividend - cash on hand


Skill: Analytical


Author: KB


9



account after all taxes and costs are paid. The owners plan to invest $7,000 and pay a dividend of $1,000.


A) $4,000

B) $5,000

C) $6,000

D) $7,000

Answer: A

Explanation: A) Net new financing = Investment + dividend - cash on hand


Skill: Analytical


Author: KB


20) LG Inc. has done a long-term forecast of its balance sheet. The projected total assets for the next year

are $200 million. The current liabilities are projected to be $100 million and other long term liabilities are

$70 million. How much net new financing is needed in the following year?

A) $18 million

B) $22 million

C) $25 million

D) $30 million

Answer: D

Explanation: D) Net new financing = Projected amount of Total Assets - (Current + Long-term Liabilities)

Net new financing = $200 - ($100 + $70) = $30 million

Diff: 2 Var: 1

Skill: Analytical


Author: KB




$70 million. How net new financing is needed in the following year?

A) $58 million

B) $60 million

C) $65 million

D) $70 million

Answer: B

Explanation: B) Net new financing = Projected amount of Total Assets - (Current + Long-term Liabilities)

Net new financing = $300 - ($170 + $70) = $60 million Diff: 2 Var: 1

Skill: Analytical


Author: KB


10




$30 million. How much net new financing is needed in the following year?

A) $18 million

B) $22 million

C) $25 million

D) $30 million

Answer: D

Explanation: D) Net new financing = Projected amount of Total Assets - (Current + Long Term

Liabilities).

Net new financing = $100 - ($40 + $30) = $30 million Diff: 2 Var: 1

Skill: Analytical


Author: KB


23) What is net new financing?

Answer: Net new financing is the amount of additional external financing required to pay for planned

increase in assets. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


24) How do we compute net new financing?

Answer: Net new financing is computed as the difference between projected assets and projected

liabilities and equity.

Diff: 1 Var: 1

Skill: Conceptual


Author: SS


25) What is common starting point for forecasting?

Answer: A common starting point for forecasting is the percent of sales method. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


26) What is the implied assumption in percent of sales method?

Answer: The percent of sales method assumes that as sales grow, many income statement and balance

sheet items grow at the same at the same percent of sales rate.

Diff: 1 Var: 1

Skill: Conceptual


Author: SS


11


18.3 Forecasting a Planned Expansion

1) One of the shortcomings of the percent of sales method is that it does not account for the fact that

capacity changes are lumpy and not incremental.


Skill: Conceptual


Author: KB


2) The percent of sales method relies on the idea that capacity increases are ________, even though in

practice such increases are ________.

A) incremental, lumpy

B) incremental, incremental

C) lumpy, incremental

D) lumpy, lumpy

Answer: A

Diff: 1 Var: 1

Skill: Conceptual


Author: KB


3) The market size for Loppins is 60 million units. If SPI Inc. has a market share of 20% and the average

sales price is $3 per Loppin, what is the dollar amount of sales of SPI?

A) $32 million

B) $36 million

C) $38 million

D) $42 million

Answer: B

Explanation: B) Sales = Market size × Market share × Average sale price

Sales = 60 million units × 20% × $3 = $36 million Diff: 1 Var: 1

Skill: Analytical


Author: KB


12




A) $40 million

B) $42 million

C) $45 million

D) $48 million

Answer: D

Explanation: D) Sales = Market size × Market share × Average sale price


Skill: Analytical


Author: KB




A) $32 million

B) $48 million

C) $58 million

D) $62 million

Answer: B

Explanation: B) Sales= Market size × Market share × Average sale price


Skill: Analytical


Author: KB


6) When the projected liabilities and equity are greater than the assets, the firm can plan to ________.

A) retain extra cash

B) pay dividends

C) retire debt

D) all of the above


Skill: Conceptual


Author: KB


13



Ideko Sales and Operating Cost Assumptions

Year 2005 2006 2007 2008 2009 2010 Sales Data Growth/Year

1 Market Size (000 units) 5.0% 10,000 10,500 11,025 11,576 12,155 12,763

2 Market Share 1.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0%

3 Average Sales Price

($/unit) 2.0% 75.00 76.50 78.03 79.59 81.18 82.81

Cost of Goods Data

4 Raw Materials ($/unit) 1.0% 16.00 16.16 16.32 16.48 16.65 16.82

5 Direct Labor Costs ($/unit) 4.0% 18.00 18.72 19.47 20.25 21.06 21.90

Operating Expense

and Tax Data

6 Sales and Marketing

(% sales) 15.0% 16.5% 18.0% 19.5% 20.0% 20.0%

7 Administrative (% sales) 18.0% 15.0% 15.0% 14.0% 13.0% 13.0%

8 Tax Rate 35.0% 35.0% 35.0% 35.0% 35.0% 35.0%

7) Based upon Ideko's Sales and Operating Cost Assumptions, what production capacity will Ideko

require in 2009?

A) 1,505,000 units

B) 1,115,000 units

C) 1,323,000 units

D) 1,701,700 units

E) 1,914,000 units

Answer: D

Explanation: D) Production volume each year can be estimated by multiplying the total market size and

Ideko's market share from the table above, so production capacity required = 12,155,000 units × 14% =

1,701,700 units

Diff: 1 Var: 1

Skill: Analytical


Author: JN


14



require in 2007?

A) 1,505,000 units

B) 1,323,000 units

C) 1,914,000 units

D) 1,115,000 units

E) 1,702,000 units

Answer: B

Explanation: B) Production volume each year can be estimated by multiplying the total market size and


1,323,000 units Diff: 1 Var: 1

Skill: Analytical


Author: JN



require in 2008?

A) 1,702,000 units

B) 1,323,000 units

C) 1,504,880 units

D) 1,914,000 units

E) 1,115,000 units

Answer: C

Explanation: C) Production volume each year can be estimated by multiplying the total market size and


1,504,880 units Diff: 1 Var: 1

Skill: Analytical


Author: JN


15


Use the tables for the question(s) below.

Pro Forma Income Statement for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015 Income Statement ($ 000)

1 Sales 75,000 88,358 103,234 119,777 138,149 158,526

2 Cost of Goods Sold

3 Raw Materials (16,000) (18,665) (21,593) (24,808) (28,333) (32,193)

4 Direct Labor Costs (18,000) (21,622) (25,757) (30,471) (35,834) (41,925)

5 Gross Profit 41,000 48,071 55,883 64,498 73,982 84,407

6 Sales and Marketing (11,250) (14,579) (18,582) (23,356) (27,630) (31,705)

7 Administrative (13,500) (13,254) (15,485) (16,769) (17,959) (20,608)

8 EBITDA 16,250 20,238 21,816 24,373 28,393 32,094

9 Depreciation (5,500) (5,450) (5,405) (6,865) (7,678) (7,710)

10 EBIT 10,750 14,788 16,411 17,508 20,715 24,383

11 Interest Expense (net) (75) (6,800) (6,800) (6,800) (7,820) (8,160)

12 Pretax Income 10,675 7,988 9,611 10,708 12,895 16,223

13 Income Tax (3,736) (2,796) (3,364) (3,748) (4,513) (5,678)

14 Net Income 6,939 5,193 6,247 6,960 8,382 10,545

Pro Forma Balance Sheet for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015

Balance Sheet ($ 000) Assets

1 Cash and Cash Equivalents 6,164 7,262 8,485 9,845 11,355 13,030

2 Accounts Receivable 18,493 14,525 16,970 19,689 22,709 26,059

3 Inventories 6,165 6,501 7,613 8,854 10,240 11,784

4 Total Current Assets 30,822 28,288 33,067 38,388 44,304 50,872

5 Property, Plant, and Equipment 49,500 49,050 48,645 61,781 69,102 69,392

6 Goodwill 72,332 72,332 72,332 72,332 72,332 72,332

7 Total Assets 152,654 149,670 154,044 172,501 185,738 192,597

Liabilities

8 Accounts Payable 4,654 5,532 6,648 7,879 9,110 10,448

9 Debt 100,000 100,000 100,000 115,000 120,000 120,000

10 Total Liabilities 104,654 105,532 106,648 122,879 129,110 130,448


11 Starting Stockholders' Equity 48,000 44,138 47,396 49,621 56,628

12 Net Income 5,193 6,247 6,960 8,382 10,545

13 Dividends (2,000) (9,055) (2,989) (4,735) (1,375) (5,024)

14 Capital Contributions 50,000 --- --- --- --- ---

15 Stockholders' Equity 48,000 44,138 47,396 49,621 56,628 62,149

16 Total Liabilities and Equity 152,654 149,670 154,044 172,501 185,738 192,597

16


10) The amount of net working capital for Ideko in 2010 is closest to ________.

A) $26,200

B) $35,195

C) $30,510

D) $29,420

Answer: A

Explanation: A) Net Working Capital = Total Current Assets - Current Liabilities (Accounts Payable)

= $30,822 - $4,654 = $26,168

Diff: 2 Var: 1

Skill: Analytical


Author: JN



A) $30,510

B) $22,750

C) $28,170

D) $35,195

Answer: B

Explanation: B) Net Working Capital = Total Current Assets - Current Liabilities (Accounts Payable) =

$28,288 - $5,532 = $22,756 Diff: 2 Var: 1

Skill: Analytical


Author: JN



A) $35,195

B) $42,420

C) $22,170

D) $26,420

Answer: D

Explanation: D) Net Working Capital = Total Current Assets - Current Liabilities (Accounts Payable) =

$33,067 - $6,648 = $26,419 Diff: 2 Var: 1

Skill: Analytical


Author: JN


17


13) The amount of the decrease in net working capital for Ideko in 2011 is closest to ________.

A) $4,090

B) $4,685

C) $3,410

D) $5,230

Answer: C

Explanation: C) Decrease in NWC = NWC(2011) - NWC(2010)

$22,756 - $26,168 = -$3,412

Diff: 3 Var: 1

Skill: Analytical


Author: JN


14) The amount of the increase in net working capital for Ideko in 2012 is closest to ________.

A) $4,685

B) $4,920

C) $3,665

D) $5,230

Answer: C

Explanation: C) Increase in NWC = NWC(2012) - NWC(2011)

$26,419 - $22,756 = $3,663 Diff: 3 Var: 1

Skill: Analytical


Author: JN


15) With the proper changes it is believed that Ideko's credit policies will extend a 60 days credit period to

accounts receivables. The forecasted accounts receivable for Ideko in 2012 is closest to ________.

A) $14,525

B) $16,970

C) $22,710

D) $19,690

Answer: B

Explanation: B) Accounts receivable = 60 days ×

60 days × $103,234 / 365 days = $16,970

Diff: 2 Var: 1

Skill: Analytical


Author: JN


18


16) With the proper changes it is believed that Ideko's credit policies will extend a 60 days credit period to

accounts receivables. The forecasted accounts receivable for Ideko in 2013 is closest to ________.

A) $14,525

B) $19,690

C) 22,710

D) $16,970

Answer: B

Explanation: B) Accounts receivable = 60 days ×

60 days × $119,777 / 365 days = $19,690 Diff: 2 Var: 1

Skill: Analytical


Author: JN


17) What is minimum required cash?

Answer: The minimum required cash represents the minimum level of cash needed to keep the business

running smoothly, allowing for the daily variations in the timing of income and expenses. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


18) What are a firm's options when it generates more cash than planned?

Answer: The firm can use excess cash to build-up extra cash reserves, pay down debt, distribute as

dividends or repurchase shares. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


18.4 Growth and Firm Value

1) The maximum growth rate that a firm can achieve without issuing new equity or by increasing its debt

to equity ratio is the firm's sustainable growth rate.

Answer: TRUE

Diff: 1 Var: 1

Skill: Definition


Author: KB


19


2) Internal growth rate indicates whether a planned investment will increase or decrease firm value.

Answer: FALSE

Diff: 1 Var: 1

Skill: Conceptual


Author: KB


3) The sustainable growth rate assumes that the firm will raise no new debt financing.


Skill: Conceptual


Author: JP


4) Internal growth rate assumes that the firm can finance investments via sale of debt.


Skill: Definition


Author: KB


5) ________ is the maximum growth rate a firm can achieve without resorting to external financing.

A) Return on equity

B) Sustainable growth rate

C) Retention rate

D) Internal growth rate

Answer: D

Diff: 1 Var: 1

Skill: Definition


Author: KB


6) A firm has $50 million in equity and $20 million of debt, it pays dividends of 30% of net income, and

has a net income of $10 million. What is the firm's internal growth rate?

A) 9%

B) 10%

C) 11%

D) 12%

Answer: B

Explanation: B) Internal growth rate = (net income / beginning assets) × (1 - payout ratio)

Internal growth rate = ($10 million) / ($50 million + $20 million) × (100% - 30%) = 10% Diff: 1 Var: 1

Skill: Analytical


Author: KB


20




A) 12.2%

B) 13.3%

C) 14.1%

D) 15.2%

Answer: B


Internal growth rate = ($10 million) / ($40 million + $20 million) × (100% - 20%) = 13.33% Diff: 1 Var: 1

Skill: Analytical


Author: KB




A) 6%

B) 7%

C) 8%

D) 9%

Answer: B


Internal growth rate = ($10 million ) / ($70 million + $30 million) × (100% - 30%) = 7%

Diff: 1 Var: 1

Skill: Analytical


Author: KB



has a net income of $5 million. What is the firm's sustainable growth rate?

A) 18%

B) 19%

C) 20%

D) 21%

Answer: C

Explanation: C) Sustainable growth rate = (net income / beginning equity) × (1 - payout ratio)

Sustainable growth rate = ($5 million / $20 million) × (100% -20%) = 20% Diff: 1 Var: 1

Skill: Analytical


Author: KB


21




A) 12%

B) 13%

C) 14%

D) 15%

Answer: C

Explanation: C) Sustainable growth rate = (net income / beginning equity) × (1 - payout ratio)

Sustainable growth rate = ($10 million / $50 million) × (100% - 30%) = 14% Diff: 1 Var: 1

Skill: Analytical


Author: KB




A) 7%

B) 8%

C) 9%

D) 10%

Answer: D

Explanation: D) Sustainable growth rate = (net income / beginning equity) × (1 - payout ratio)

Sustainable growth rate = ($10 million / $80 million) × (100% - 20%) = 10%

Diff: 1 Var: 1

Skill: Analytical


Author: KB


12) A firm expects growth next year to be 12%. Its sustainable growth rate is 10%. Which of the following

is true?

A) The firm will need to raise additional debt such that its debt to equity ratio will increase.

B) The firm may be able to keep its debt to equity ratio the same by reducing dividends (assuming they

are projected to be high enough).

C) The firm will need to raise additional capital through a stock issue.

D) The firm will have excess cash to increase dividends, pay back debt, or repurchase equity.


Skill: Conceptual


Author: JP


22


13) A firm expects growth next year to be 10%. Its sustainable growth rate is 12%. Which of the following

is true?

A) The firm will need to raise additional debt such that its debt to equity ratio will increase.

B) The firm may be able to keep its debt to equity ratio the same by reducing dividends (assuming they

are projected to be high enough).

C) The firm will need to raise additional capital through a stock issue.

D) The firm will have excess cash to increase dividends, pay back debt, or repurchase equity.

Answer: D

Diff: 2 Var: 1

Skill: Conceptual


Author: JP


18.5 Valuing the Expansion

1) Total working capital rather than changes in working capital has implications for cash flows.


Skill: Conceptual


Author: KB


2) For valuing a planned expansion, in addition to forecasting cash flows we need to estimate the firm's

continuation value.

Answer: TRUE

Diff: 1 Var: 1

Skill: Conceptual


Author: KB


3) Compute the after-tax interest expense for a firm with Interest on Excess Cash = $1,000, Interest on

Debt = $5,000, and a tax rate of 30%.

A) $2,500

B) $2,800

C) $3,100

D) $3,300

Answer: B

Explanation: B) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)

After-tax interest expense = (1 - 0.3) × (5,000 -1,000) = $2,800 Diff: 1 Var: 1

Skill: Analytical


Author: KB


23




A) $2,500

B) $2,800

C) $3,100

D) $3,500

Answer: D

Explanation: D) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)

After-tax interest expense = (1 - 0.3) × (7,000 - 2,000) = $3,500 Diff: 2 Var: 1

Skill: Analytical


Author: KB




A) $2,100

B) $2,200

C) $2,500

D) $2,700

Answer: A

Explanation: A) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)

After-tax interest expense = (1 - 0.3) × (8,000 - 5,000) = $2,100

Diff: 1 Var: 1

Skill: Analytical


Author: KB


6) Given the following data for a given period, compute the free cash flow to the firm:

Net Income = $10,000

After-tax Interest Expense = $1,000

Depreciation = $1,000

Increase in NWC = $1,000

Capital Expenditures = $2,000

A) $9,000

B) $9,500

C) $9,700

D) $9,900

Answer: A

Explanation: A) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in

NWC - Capital expenditures

Free cash flow = 10,000 + 1,000 + 1,000 - 1,000 - 2,000 = $9,000

Diff: 2 Var: 1

Skill: Analytical


Author: KB


24



Net Income = $12,000

After-tax Interest Expense = $2,000

Depreciation = $1,000



A) $10,000

B) $11,000

C) $12,000

D) $13,000

Answer: C

Explanation: C) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in


Free cash flow = 12,000 + 2,000 + 1,000 - 2,000 - 1,000 = $12,000 Diff: 2 Var: 1

Skill: Analytical


Author: KB



Net Income = $5,000

After-tax Interest Expense = $500

Depreciation = $500



A) $3,000

B) $3,500

C) $3,700

D) $3,900

Answer: A

Explanation: A) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in


Free cash flow = 5,000 + 500 + 500 - 1,000 - 2,000 = $3,000 Diff: 2 Var: 1

Skill: Analytical


Author: KB


25


9) What is the free cash flow to equity holders for a firm with free cash flow of $7000, after-tax interest

expense of $1,000, and an increase in debt of $3,000?

A) $6,000

B) $7,000

C) $8,000

D) $9,000

Answer: D

Explanation: D) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt

Free cash flow to equity= $7,000 - $1,000 + $3,000 = $9,000 Diff: 2 Var: 1

Skill: Analytical


Author: KB


10) What is the free cash flow to equity holders for a firm with free cash flow of $11,000, after-tax interest


A) $7,000

B) $8,000

C) $9,000

D) $11,000

Answer: D

Explanation: D) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt

Free cash flow to equity= $11,000 - $2,000 + $2,000 = $11,000

Diff: 2 Var: 1

Skill: Analytical


Author: KB


11) What is the free cash flow to equity holders for a firm with free cash flow of $9,000, after-tax interest


A) $6,000

B) $7,000

C) $8,000

D) $9,000

Answer: B

Explanation: B) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt

Free cash flow to equity = $9,000 - $3,000 + $1,000 = $7,000 Diff: 2 Var: 1

Skill: Analytical


Author: KB


26


12) The estimate of a firm's value at the end of the forecast horizon using a valuation multiple is also

called its ________.

A) fixed value

B) payback value

C) terminal value



Skill: Definition


Author: KB


13) Pledrea Inc. has EBITDA at the forecast horizon of $10,000. Its EBITDA multiple is 11. What is the

terminal value of the firm at the forecast horizon?

A) $100,000

B) $110,000

C) $120,000

D) $130,000

Answer: B

Explanation: B) Terminal value = EBITDA at horizon × EBITDA multiple

Terminal value = $10,000 × 11 = $110,000 Diff: 1 Var: 1

Skill: Analytical


Author: KB




A) $100,000

B) $110,000

C) $120,000

D) $130,000

Answer: D

Explanation: D) Terminal value = EBITDA at horizon × EBITDA multiple


Skill: Analytical


Author: KB


27




A) $100,000

B) $110,000

C) $120,000

D) $130,000

Answer: C

Explanation: C) Terminal value = EBITDA at horizon × EBITDA multiple


Skill: Analytical


Author: KB


16) Compute the value of a firm with free cash flows of $4,000, $4,500, and $5,000 over the next three

years, a terminal firm value of $60,000 after three years, and the unlevered cost of capital is 10%. Assume

that the interest rate tax shield is zero.

A) $56,191

B) $57,234

C) $58,098

D) $59,123

Answer: A

Explanation: A) Compute the present value of the free cash flows and the terminal value.

Using CF keys of a financial calculator, CF1 = 4,000, CF2 = 4,500, CF3 = 5,000 + 60,000;

PV at interest rate of 10 = $56,191

Diff: 2 Var: 1

Skill: Analytical


Author: KB





A) $26,191

B) $27,234

C) $31,033

D) $39,343

Answer: C

Explanation: C) Compute the present value of the free cash flows and the terminal value.


PV at interest rate of 15 = $31,033 Diff: 2 Var: 1

Skill: Analytical


Author: KB


28





A) $36,109

B) $37,098

C) $38,745

D) $40,263

Answer: D

Explanation: D) Compute the present value of the free cash flows and the terminal value.


PV at interest rate of 10 = $40,263 Diff: 2 Var: 1

Skill: Analytical


Author: KB


19) A firm has interest expense of $6,500 each year for ten years. If the tax rate is 35% and the discount

rate is 6%, compute the value of the interest rate tax shield.

A) $16,744

B) $16,424

C) $16,578

D) $16,987

Answer: A

Explanation: A) Tax shield for each year = interest expense × tax rate

Tax shield for each year = 6,500 × 0.35 = $2,275

Present value of 10 tax shield flows each equal to interest expense times tax rate.

Using a financial calculator at interest rate of 6%, PMT = 2,275, N = 10, equals $16,744.

Diff: 2 Var: 1

Skill: Analytical


Author: KB




A) $5,744

B) $5,918

C) $5,268

D) $6,987

Answer: C

Explanation: C) Tax shield for each year = interest expense × tax rate

Tax shield for each year = 2,500 × 0.30 = $750


Using a financial calculator at interest rate of 7%, PMT = 750, N = 10, equals $5,268. Diff: 2 Var: 1

Skill: Analytical


Author: KB


29




A) $7,091

B) $7,514

C) $8,220

D) $8,716

Answer: C

Explanation: C) Tax shield for each year = interest expense × tax rate

Tax shield for each year = 3,500 × 0.35 = $1,225


Using a financial calculator at interest rate of 8%, PMT = 1,225, N = 10, equals $8,220.

Diff: 2 Var: 1

Skill: Analytical


Author: KB


30


Use the tables for the question(s) below.

Pro Forma Income Statement for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015 Income Statement ($ 000)

1 Sales 75,000 88,358 103,234 119,777 138,149 158,526

2 Cost of Goods Sold

3 Raw Materials (16,000) (18,665) (21,593) (24,808) (28,333) (32,193)

4 Direct Labor Costs (18,000) (21,622) (25,757) (30,471) (35,834) (41,925)

5 Gross Profit 41,000 48,071 55,883 64,498 73,982 84,407

6 Sales and Marketing (11,250) (14,579) (18,582) (23,356) (27,630) (31,705)

7 Administrative (13,500) (13,254) (15,485) (16,769) (17,959) (20,608)

8 EBITDA 16,250 20,238 21,816 24,373 28,393 32,094

9 Depreciation (5,500) (5,450) (5,405) (6,865) (7,678) (7,710)

10 EBIT 10,750 14,788 16,411 17,508 20,715 24,383

11 Interest Expense (net) (75) (6,800) (6,800) (6,800) (7,820) (8,160)

12 Pretax Income 10,675 7,988 9,611 10,708 12,895 16,223

13 Income Tax (3,736) (2,796) (3,364) (3,748) (4,513) (5,678)

14 Net Income 6,939 5,193 6,247 6,960 8,382 10,545

Pro Forma Balance Sheet for Ideko, 2010-2015

Year 2010 2011 2012 2013 2014 2015

Balance Sheet ($ 000) Assets

1 Cash and Cash Equivalents 6,164 7,262 8,485 9,845 11,355 13,030

2 Accounts Receivable 18,493 14,525 16,970 19,689 22,709 26,059

3 Inventories 6,165 6,501 7,613 8,854 10,240 11,784

4 Total Current Assets 30,822 28,288 33,067 38,388 44,304 50,872

5 Property, Plant, and Equipment 49,500 49,050 48,645 61,781 69,102 69,392

6 Goodwill 72,332 72,332 72,332 72,332 72,332 72,332

7 Total Assets 152,654 149,670 154,044 172,501 185,738 192,597

Liabilities

8 Accounts Payable 4,654 5,532 6,648 7,879 9,110 10,448

9 Debt 100,000 100,000 100,000 115,000 120,000 120,000

10 Total Liabilities 104,654 105,532 106,648 122,879 129,110 130,448


11 Starting Stockholders' Equity 48,000 44,138 47,396 49,621 56,628

12 Net Income 5,193 6,247 6,960 8,382 10,545

13 Dividends (2,000) (9,055) (2,989) (4,735) (1,375) (5,024)

14 Capital Contributions 50,000 --- --- --- --- ---

15 Stockholders' Equity 48,000 44,138 47,396 49,621 56,628 62,149

16 Total Liabilities and Equity 152,654 149,670 154,044 172,501 185,738 192,597

31


22) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation enterprise value of Ideko

in 2015 is closest to ________.

A) $152.812 million

B) $272.799 million

C) $301.173 million

D) $181.072 million

Answer: B

Explanation: B) Continuation enterprise value = EBITDA × EBITDA Multiple = 32.094 × 8.5 = $272.799

million Diff: 1 Var: 1

Skill: Analytical


Author: JN


23) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation enterprise value of Ideko

in 2015 is closest to ________.

A) $181.279 million

B) $152.799 million

C) $272.187 million

D) $301.684 million

Answer: D

Explanation: D) Continuation enterprise value = EBITDA × EBITDA Multiple

= $32.094 million × 9.4 = $301.684 million Diff: 1 Var: 1

Skill: Analytical


Author: JN


24) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation EV/Sales ratio of Ideko in

2015 is closest to ________.

A) 1.7

B) 1.9

C) 1.6

D) 1.8

Answer: A

Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple

EV/Sales = = 1.7

Diff: 2 Var: 1

Skill: Analytical


Author: JN


32


25) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation EV/Sales ratio of Ideko in

2015 is closest to ________.

A) 1.9

B) 1.7

C) 1.6

D) 1.8

Answer: A

Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple

= $32.094 million × 9.4 = $301.683 million

EV/Sales = = 1.90

Diff: 2 Var: 1

Skill: Analytical


Author: JN


26) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation unlevered price-earnings

ratio of Ideko in 2015 is closest to ________.

A) 25.9

B) 16.4

C) 14.5

D) 19.0

Answer: A

Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 8.5

P/E = = 25.9

Diff: 2 Var: 1

Skill: Analytical


Author: JN


27) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation unlevered price-earnings


A) 17.2

B) 16.4

C) 14.5

D) 28.6

Answer: D

Explanation: D) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 9.4

P/E = = 28.6

Diff: 2 Var: 1

Skill: Analytical


Author: JN


33


28) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation levered price-earnings


A) 19.0

B) 17.2

C) 16.4

D) 14.5

Answer: D

Explanation: D) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 8.5

Continuation equity value = Continuation enterprise value - Debt

P/E = = 14.50

Diff: 2 Var: 1

Skill: Analytical


Author: JN


29) Assuming that Ideko has an EBITDA multiple of 9.4, then the continuation levered price-earnings


A) 17.2

B) 14.5

C) 19.0

D) 16.4

Answer: A

Explanation: A) Continuation enterprise value = EBITDA × EBITDA Multiple = $32.094 million × 9.4

Continuation equity value = Continuation enterprise value - Debt

P/E= = 17.2

Diff: 2 Var: 1

Skill: Analytical


Author: JN


30) Is total net working capital or incremental net working capital more relevant for calculation of free

cash flow?

Answer: When calculating free cash flows from earnings, only incremental change in net working capital

should be subtracted rather than subtracting total net working capital. Subtracting total net working

capital will reduce free cash flows leading to the understatement of Net Present Value. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


34


31) Why is EBITDA multiple used for valuation rather than sales or earnings?

Answer: In most settings, EBITDA multiple is more reliable than sales or earnings multiple because it

accounts for the firm's operating efficiency and is not affected by leverage differences between firms. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


32) How do we know if expansion is a good idea for the firm?

Answer: We compare a firm's value with expansion to its value without expansion to find whether

expansion is a good idea or not. Diff: 1 Var: 1

Skill: Conceptual


Author: SS


Fundamentals of Corporate Finance, 4e (Berk/DeMarzo/Harford ...

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