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Corporate Finance Online (McNally)
Chapter 1 Overview of Finance
LO1: Explore the Features of CFO
1) There are no questions in this section.
AACSB: Analytical Thinking
LO2: Explain the World of Finance
1) Finance is
A) the study of investment management.
B) the study of the stock exchange.
C) the study of the capital market and its many players.
D) the study of money management for personal use.
Answer: C
Explanation: C) Finance is the study of the capital market and its many players.
Diff: 1
Section: 2
AACSB: Analytical Thinking
2) What is the purpose of the capital market?
A) To match people with money to entrepreneurs with great business ideas or concepts
B) To more easily regulate the flow of money between parties
C) To make money without trying
D) To allow people to buy shares for retirement
Answer: A
Explanation: A) The capital market matches entrepreneurs with great business ideas or concepts to
people with money.
Diff: 1
Section: 2
AACSB: Analytical Thinking
3) Which of these is not one of the basic questions for corporate finance?
A) How should we raise the money?
B) What are we going to make?
C) What do we do with our profits?
D) How big of a bonus should we get?
Answer: D
Explanation: D) The three questions for corporate finance are: How should we raise the money? What are
we going to make? Do we pay out our profits, or invest them?
Diff: 1
Section: 2
AACSB: Analytical Thinking
1
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4) Which one of these would a financial advisor say is most important?
A) Making decent dough over the long haul
B) Making a quick buck
C) Avoiding paying taxes whenever possible
D) Properly financing a large purchase
Answer: A
Explanation: A) Most importantly, financial advisors help you make decent dough over the long haul.
Diff: 1
Section: 2
AACSB: Analytical Thinking
5) ________ would be the course where you learn to tell the good shares from the bad, and the sure things
from the really risky.
A) Corporate Finance
B) Investments
C) Personal Finance
D) Derivative Securities
Answer: B
Explanation: B) Investments is the course where you learn to tell the good shares from the bad, and the
sure things from the really risky.
Diff: 1
Section: 2
AACSB: Analytical Thinking
LO3: Explain the Financial System
1) Money market securities have maturities of one year or less.
Answer: TRUE
Explanation: Money market securities mature less than 1 year from their issue date.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
2) Regulating the banking institutions is one of the Bank of Canada's duties.
Answer: TRUE
Explanation: The Bank of Canada has 3 duties: 1) Conduct monetary policy 2) Regulate banking
institutions 3) Provide financial services to depository institutions.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
3) T-bonds are money market securities, while T-bills and T-notes are traded in the capital market.
Answer: FALSE
Explanation: T-Bills are instruments of the money market.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
2
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4) Preferred share pays a variable dividend.
Answer: FALSE
Explanation: Preferred shareholders receive a fixed dividend that does not change.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
5) Capital markets have maturities of one year or less.
Answer: FALSE
Explanation: Capital markets are markets in which the securities have an original maturity greater than 1
year.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
6) According to your text, major players in the money market include all of the following EXCEPT
A) the Government of Canada.
B) the Bank of Canada.
C) commercial banks.
D) companies.
E) the Office of the Superintendant of Financial Institutions
Answer: E
Explanation: E) The Office of the Superintendant of Financial Institutions is the primary regulator of
deposit-taking institutions, insurance companies, and pensions. It is not a major player in the money
market.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
7) Which of the following is not considered a capital market security?
A) Mortgage-backed Securities
B) Corporate Bonds
C) Common Shares
D) Foreign Currencies
E) Municipal Bonds
Answer: D
Explanation: D) Foreign currencies are not capital market securities.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
3
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8) The ________ price is ________ the ________ price.
A) bid; above; ask
B) bid; below; ask
C) ask; below; bid
D) ask; above; bid
E) Answers (B) and (D) are correct.
Answer: E
Explanation: E) The ask price is the price the seller wants to receive and the bid price is the price the
buyer is willing to pay.
Diff: 1
Section: 3.5
AACSB: Analytical Thinking
9) A firm raises capital to finance new equipment by selling bonds in the
A) secondary market.
B) primary market.
C) futures market.
D) options market.
E) federal funds market.
Answer: B
Explanation: B) Primary markets are for securities offered for sale for the first time.
Diff: 1
Section: 3.4
AACSB: Analytical Thinking
10) The ________ is the financial market in which securities are initially issued.
A) private placement
B) OTC
C) primary market
D) secondary market
E) NASDAQ
Answer: C
Explanation: C) Primary markets are for securities offered for sale for the first time.
Diff: 1
Section: 3.4
AACSB: Analytical Thinking
11) Money markets are markets for
A) foreign currency exchange.
B) corporate shares.
C) long-term bonds.
D) short-term debt securities.
E) preferred securities.
Answer: D
Explanation: D) In a money market, the securities are short term and highly liquid.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
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12) In the over-the-counter market, dealers are linked with the purchasers and sellers of securities
through the ________ system.
A) NASDAQ
B) TSX
C) AMEX
D) SEC
E) NYMEX
Answer: A
Explanation: A) NASDAQ is a computerized dealer market.
Diff: 1
Section: 3.5
AACSB: Analytical Thinking
13) The over-the-counter market is
A) the New York Stock Exchange.
B) an organized stock exchange.
C) a physical place where securities are bought and sold.
D) an intangible market for unlisted securities.
E) where commodities futures are bought and sold.
Answer: D
Explanation: D) The over-the-counter market is an intangible market for unlisted securities.
Diff: 1
Section: 3.5
AACSB: Analytical Thinking
14) Which of the following statements is true regarding common and preferred shares?
A) Preferred shareholders have more voting power than common shareholders.
B) Common shareholders are guaranteed a fixed dividend.
C) Common shareholders have a more senior claim against assets than preferred shareholders.
D) Preferred shareholders are entitled to their dividends before common shareholders.
E) Common shareholders earn a better return than preferred shareholders.
Answer: D
Explanation: D) Preferred shareholders are entitled to their dividends before common shareholders.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
15) Common shareholders expect to receive a return through capital gains and
A) interest payments.
B) dividends.
C) fixed periodic dividends.
D) coupon payments.
E) receiving shares of preferred shares.
Answer: B
Explanation: B) Common shareholders receive a dividend at the discretion of the board.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
5
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16) What do we call a market in which the price of a security is an accurate estimate by the market of its
true value?
A) Efficient Market
B) Law of One Price
C) Effective Market
D) Primary Market
E) Secondary Market
Answer: E
Explanation: E) One of the most important roles of the secondary market is establishing security prices.
Diff: 1
Section: 3.7
AACSB: Analytical Thinking
17) Shares of ________ are units of ownership interest, or equity, in a corporation.
A) debt
B) common stock
C) bank loans
D) commercial paper
E) debentures
Answer: B
Explanation: B) Shares of common stock represent ownership in a corporation.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
18) ________ are long-term debt instruments business and government use to raise large sums of money.
A) T-bills
B) Bonds
C) Common shares
D) Preferred shares
E) Commercial papers
Answer: B
Explanation: B) Bonds are debt instruments issued by governments and corporations with a maturity of
more than a year.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
19) Which of the following is a role of the secondary market?
A) Keep prices level
B) Give information for securities on sale in the primary market
C) Trade long term securities only
D) Offer securities for sale for the first time
E) Establishing security prices
Answer: E
Explanation: E) One of the most important roles of the secondary market is establishing security prices.
Diff: 1
Section: 3.7
AACSB: Analytical Thinking
6
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20) Which of the following is not a financial intermediary?
A) Investment banks
B) The Government of Canada
C) Hedge funds
D) Insurance companies
E) Thrift institutions
Answer: B
Explanation: B) Financial intermediaries include banks and thrifts, investment banks, pension, mutual,
and hedge funds, and insurance companies.
Diff: 1
Section: 3.1
AACSB: Analytical Thinking
21) Which of the following statements best describes mutual funds?
A) They are illegal in Canada, but popular in Europe.
B) They enable investors to buy many shares of stock in a single firm at a lower cost than using a
stockbroker.
C) They provide good investment returns, but insufficient diversification.
D) They enable many investors with limited funds to buy a diversified portfolio.
E) They appeal only to wealthy investors.
Answer: D
Explanation: D) A mutual fund is a professionally managed pool of money which comes from a
disparate group of investors who exchange their money for shares in the fund.
Diff: 1
Section: 3.1
AACSB: Analytical Thinking
22) The primary role of a financial system is to
A) make savvy investors rich.
B) regulate the banking system.
C) enable financial managers to evaluate investment projects with a system that always selects the correct
opportunity for their firm.
D) channel funds from savers to borrowers who need funds for investment projects.
E) provide employees in financial institutions with a code of ethics.
Answer: D
Explanation: D) The financial system transfers money from suppliers to users.
Diff: 1
Section: 3.1
AACSB: Analytical Thinking
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23) ________ are further divided into two groups: (1) auction, and (2) dealer markets.
A) Secondary markets
B) Primary markets
C) Money markets
D) Capital markets
E) Investment markets
Answer: A
Explanation: A) Secondary markets are further divided into two groups: (1) auction, and (2) dealer
markets.
Diff: 1
Section: 3
AACSB: Analytical Thinking
24) The ________ is a financial relationship created by a number of institutions with arrangements that
allow the suppliers and demanders of long-term funds to make transactions.
A) money market
B) eurobond market
C) bond market
D) capital market
E) futures market
Answer: D
Explanation: D) Capital markets are markets in which securities have an original maturity greater than
one year.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
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LO4: Explain the Structure and Governance of Corporations
1) Agency costs are fees paid by the management of a corporation to compensate any investor that feels it
has suffered a loss due to the agency problem.
Answer: FALSE
Explanation: Agency costs are the loss of shareholder wealth associated with managerial waste and the
cost of resources used to monitor agents' behaviour and align incentives.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
2) Which of the following are agency costs?
I.
II.
III.
IV.
Forgoing an investment opportunity which would add to the market value of the owner's equity
Paying a dividend to each of the existing shareholders
Purchasing new equipment which increases the value of each share of stock
Hiring outside auditors to verify the accuracy of the company financial statements
A) I and III only
B) I and IV only
C) II and III only
D) II and IV only
E) I, II, and IV only
Answer: B
Explanation: B) Agency costs are the loss of the principal's wealth associated with the agent's waste and
cost of resources used to monitor agents' behaviour and align incentives.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
3) What is the principal-agent problem?
A) When the principal misrepresents the agent to the board
B) When an agent does not maximize the utility of the principal
C) The cost of training new agents
D) When an agent misrepresents the principal to the board
Answer: B
Explanation: B) The principal-agent problem is the problem and cost that occurs when an agent does not
maximize the utility of the principal.
Diff: 1
Section: 4
AACSB: Analytical Thinking
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4) Agency costs pose the biggest problem for
A) insiders.
B) shareholders.
C) directors.
D) agents.
E) executives.
Answer: B
Explanation: B) When principals cannot monitor agents, managers have the opportunity to use resources
to benefit themselves and not the shareholders.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
5) In a broad sense, every business asset is ultimately owned by
A) individuals.
B) the federal government.
C) foreign governments.
D) trust funds.
E) none of the above
Answer: A
Explanation: A) In a broad sense, every business asset is ultimately owned by individuals.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
6) Which of the following statements is true?
A) The presence of asymmetric information in financial markets increases the likelihood that these
markets are efficient.
B) Accounting profits are always more important to shareholders than cash flows.
C) Managers should choose investment projects that maximize shareholder wealth.
D) The study of finance only benefits students who aspire to careers in business.
E) Investors should not be compensated with a higher return for owning risky securities since they
should know better than to buy stock in a firm that has uncertain prospects.
Answer: C
Explanation: C) The goal of management is to maximize the share price — in other words, maximize
shareholder wealth.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
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7) Which of the following is an advantage of a partnership?
A) No licence, charter, or agreement legally required
B) Joint liability for company debts
C) Least regulated form of business
D) Ownership is easy to transfer
E) Can raise money using capital markets (debt and equity)
Answer: A
Explanation: A) Advantages of a partnership include no licence, charter, or agreement legally required,
and pay personal taxes on all business income.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
8) At the top of the organizational chart for a corporation is (are) the
A) CEO.
B) Board of Directors.
C) V.P. of Finance.
D) shareholders.
E) Executive Chairman.
Answer: D
Explanation: D) At the top of the organizational chart for a corporation are shareholders, who are owners
of the company.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
9) Which of the following is the best way to prevent an agency problem between shareholders and
managers?
A) Maintain a proportional relationship between a manager's bonus and the number of employees in the
firm.
B) Compensate managers to a significant degree with shares of stock in their firm.
C) Reward managers if they keep costs below the budgeted amount.
D) Pay managers a bonus if their division exceeds its targeted market share.
E) Pay managers a bonus if their division exceeds its quarterly sales target.
Answer: B
Explanation: B) Aligning managers interest with shareholder interest helps prevent the principal-agent
problem.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
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LO5: Explain Five Principle Themes of Finance
1) The higher the probability that the return on an investment will not pay off its averaged promised
value, the higher the expected return must be to induce an investor to invest in it.
Answer: TRUE
Explanation: Higher risk requires higher return.
Diff: 1
Section: 5.2
AACSB: Analytical Thinking
2) A firm's net income is a true representation of cash flows available to the stockholders.
Answer: FALSE
Explanation: Net income is a number meant to represent the average profit available to shareholders.
Diff: 1
Section: 5.4
AACSB: Analytical Thinking
3) $100 today is worth
A) the same as $100 to be received in one year, since the inflation rate has been low recently and funds
received in the near future should have the same purchasing power that they have today.
B) less than $100 to be received in one year, since many people will spend money foolishly today and will
become more careful in their spending habits as they mature.
C) more than $100 to be received in one year, since you can invest the money received today for this
period, leaving you with more than $100 in the future.
D) the same as a future receipt of $100, since the physical characteristics of Canadian currency are
unchanged for long periods of time.
E) less than $100 received by someone ten years ago, since many products have been improved over this
time period.
Answer: C
Explanation: C) A dollar today is worth more than the promise of a dollar next year .
Diff: 1
Section: 5.1
AACSB: Analytical Thinking
4) As the risk of a stock investment increases,
A) return will increase.
B) return will decrease.
C) required rate of return will decrease.
D) required rate of return will increase.
E) the beta approaches zero.
Answer: D
Explanation: D) As the risk of an investment increases, the required return will increase.
Diff: 1
Section: 5.2
AACSB: Analytical Thinking
12
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5) Which of the following statements about risk is false?
A) Risk is one of the determinants of the required return.
B) Risk requires the possibility of at least one outcome less favourable than the expected value.
C) Risk requires the possibility of more than one outcome.
D) High risk should require low return.
Answer: D
Explanation: D) Higher risk requires higher returns.
Diff: 1
Section: 5.2
AACSB: Analytical Thinking
6) The efficient market hypothesis states that
A) requiring firms to issue more stock will reduce volatility.
B) requiring investors to hold securities longer will reduce volatility.
C) electing a pro-business Republican president makes the market more efficient.
D) taxing security returns will raise prices.
E) markets price securities fairly at all times and that new information is rapidly reflected in the price.
Answer: E
Explanation: E) The efficient market hypothesis states that markets price securities fairly at all times and
that new information is rapidly reflected in the price.
Diff: 1
Section: 5.3
AACSB: Analytical Thinking
7) Information asymmetry is
A) false information spread by competitors.
B) when two pieces of information counteract each other.
C) when some know more than others.
D) when information is not reflected properly in the market.
E) incomplete information.
Answer: C
Explanation: C) Information asymmetry is when information is not spread evenly among all participants.
Diff: 1
Section: 5.5
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 2 Financial Statement and Ratio Analysis
LO1: Know the Three Financial Statements Needed for Financial Analysis
1) Using financial information to aid in decision making is called
A) "what-if" analysis.
B) factor analysis.
C) financial analysis.
D) quantitative analysis.
E) managerial economics.
Answer: C
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Explanation: C) Financial analysis is the process of using financial information to assist in investment
and financial decision making.
Diff: 1
Section: 1
AACSB: Analytical Thinking
2) Which of the following is not a commonly used source of information for financial analysis?
A) A consultant's analysis of industry conditions
B) Key employees' guesses about future trends
C) The Securities and Exchange Commission's filings
D) The firm's annual report
E) The economic data from a forecasting firm
Answer: B
Explanation: B) Financial analysis is the process of using financial information to assist in investment and
financial decision making.
Diff: 1
Section: 1
AACSB: Analytical Thinking
3) Which of the following is one of the financial statements critical to financial statement analysis?
A) 8-K
B) SEC registration statement
C) Disclosure
D) 10-Q
E) Statement of Cash Flows
Answer: E
Explanation: E) The three financial statements critical to analysis are the balance sheet, the income
statement, and the statement of cash flows.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
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4) Which of the following is a variation of the accounting identity?
A) Assets - Fixed assets = Equity - Liabilities
B) Owner's equity = Assets - Liabilities
C) Equity - Liabilities = Assets
D) Assets + Equity = Liabilities
E) Assets + Lease obligations = Equity + Liabilities
Answer: B
Explanation: B) Assets = Liabilities + Owners' Equity
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
5) Balance sheets
A) show how the firm raised funds to purchase assets.
B) report a firm's activities over a period of time.
C) describe a firm's cash flows.
D) provide information about a firm's labour costs.
E) may not balance if the firm suffered a net loss.
Answer: A
Explanation: A) Liabilities and owners' equity provide the funds for the purchase of assets.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
6) The right-hand side of the balance sheet shows
A) the cash flow generated by a firm's assets.
B) how the firm financed its assets.
C) the level of accumulated depreciation.
D) profits earned by the firm in the current period.
E) the firm's good will.
Answer: B
Explanation: B) Right-hand side shows liabilities and owners equity.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
7) The ________ is a snapshot of the firm at a particular point in time.
A) income statement
B) statement of cash flows
C) statement of retained earnings
D) balance sheet
E) None of the above
Answer: D
Explanation: D) The balance sheet is a financial snapshot of the firm.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
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8) An income statement contains all of the following EXCEPT
A) revenues.
B) assets.
C) losses.
D) gains.
E) expenses.
Answer: B
Explanation: B) Income statements show revenues—expenses which result in losses or gains.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
9) Which of the following is not included in a cash flow statement?
A) Labour productivity
B) Interest earnings
C) Cash flow from operations
D) Depreciation expense
E) The increase in long-term debt
Answer: A
Explanation: A) The statement of cash flows only deals with cash inflows and outflows.
Diff: 1
Section: 1.3
AACSB: Analytical Thinking
LO2: Know the Goals of Financial Statement Analysis
1) There are no questions in this section.
AACSB: Analytical Thinking
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LO3: Perform Financial Statement Analysis
1) In cross-sectional analysis, a firm's financial ratios are
A) judged against the performance of firms in the same industry.
B) compared with the firm's ratios from the most recent period.
C) compared with ratios from all firms.
D) compared with a general standard.
E) plotted over time to isolate trends.
Answer: A
Explanation: A) Cross sectional analysis is the comparison of one firm to other similar firms.
Diff: 1
Section: 3
AACSB: Analytical Thinking
2) The four-digit codes used by the government to classify firms into industries are known as
A) ratio standards.
B) EIC codes.
C) USIC codes.
D) financial benchmarks.
E) SIC codes.
Answer: E
Explanation: E) Standard Industrial Classification (SIC) codes are four-digit codes given to firms by the
government.
Diff: 1
Section: 3
AACSB: Analytical Thinking
3) When financial ratios are compared to financial ratios from previous years, a ________ is conducted.
A) cross-time
B) SIC code
C) time series
D) cross-sectional
E) None of the above
Answer: C
Explanation: C) A time series analysis involves comparing the firm's current performance to prior
periods.
Diff: 1
Section: 3
AACSB: Analytical Thinking
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4) All of the following are problems with cross-sectional financial analysis EXCEPT that
A) an industry may be dominated by a few firms.
B) annual reports sometimes do not disclose divisional financial data.
C) many firms are conglomerates.
D) it provides no basis for comparison to other firms.
E) there may be no obvious firms to be used for comparison.
Answer: D
Explanation: D) All of these are problems with cross-sectional financial analysis except that it provides
no basis for comparison to other firms.
Diff: 1
Section: 3
AACSB: Analytical Thinking
5) In common-size financial statements,
A) all balance sheet items are divided by total liabilities.
B) total sales are divided by total assets.
C) depreciation expense is divided by total sales.
D) accrued taxes are divided by total sales.
E) net income is divided by total assets.
Answer: C
Explanation: C) Common-sized income statements are prepared by dividing each line item by sales.
Diff: 1
Section: 3.7
AACSB: Analytical Thinking
6) Each of the following is a ratio category EXCEPT
A) productivity ratios.
B) market ratios.
C) liquidity ratios.
D) financing ratios.
E) activity ratios.
Answer: A
Explanation: A) Ratios are grouped into categories: Profitability, Liquidity, Activity, Financing, and
Market.
Diff: 1
Section: 3.1
AACSB: Analytical Thinking
7) ________ ratios measure the efficiency with which assets are converted to sales or cash.
A) Liquidity
B) Activity
C) Profitability
D) Market
E) Financing
Answer: B
Explanation: B) Activity ratios measure the efficiency with which assets are converted to sales or cash.
Diff: 1
Section: 3.4
AACSB: Analytical Thinking
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8) Find the return on assets if net income was $55,000, total assets are $115,000, EBIT was $100,000, and
equity is $75,000.
A) 73.3%
B) 63.1%
C) 87.0%
D) 47.8%
E) 55.0%
Answer: D
Explanation: D) Return on assets =
Return on assets =
= 47.8%
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
9) What is the return on equity if net income was $55,000, total assets are $115,000, EBIT was $100,000,
and equity is $75,000?
A) 47.8%
B) 63.1%
C) 73.3%
D) 87.0%
E) 55.0%
Answer: C
Explanation: C) Return on equity =
Return on equity =
= 73.3%
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
10) Sales for a firm are $500,000, cost of goods sold are $400,000, and interest expenses are $20,000. What
is the gross profit margin?
A) 16.0%
B) 20.0%
C) 4.0%
D) 25.0%
E) 30.0%
Answer: B
Explanation: B) Gross profit margin =
Gross profit margin =
= 20%
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
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11) If net income was $10,000, interest expense was $4,000, and taxes were $1,000, what is the operating
profit margin if sales were $50,000?
A) 28%
B) 30%
C) 22%
D) 10%
E) 20%
Answer: B
Explanation: B) Operating profit margin =
Operating profit margin =
= 30%
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
12) If net income after tax was $10,000, interest expense was $4,000, and taxes were $1,000, what is the net
profit margin if sales were $50,000?
A) 10%
B) 30%
C) 22%
D) 28%
E) 20%
Answer: E
Explanation: E) Net profit margin =
Net profit margin =
= 20%
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
13) The quick ratio improves upon the current ratio by
A) using more up-to-date information.
B) simplifying the calculation.
C) subtracting intangible assets like goodwill.
D) recognizing that inventory is the current asset that is easiest to value.
E) recognizing that inventory is the least liquid current asset.
Answer: E
Explanation: E) Since inventory may not always be easily converted into cash, the quick ratio is a more
conservative measure of liquidity.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
21
Copyright © 2015 Pearson Canada, Inc.
14) What is the quick ratio if cash is $10,000, accounts receivable are $25,000, inventories are $30,000,
accounts payable are $40,000, and accrued payroll is $15,000?
A) 2.00
B) 1.18
C) 0.73
D) 1.13
E) 0.09
Answer: E
Explanation: E) Quick ratio =
Quick ratio =
= 0.09
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
15) What is the current ratio if cash is $10,000, accounts receivable are $25,000, inventories are $30,000,
accounts payable are $40,000, and accrued payroll is $15,000?
A) 2.00
B) 1.18
C) 1.13
D) 0.64
E) 0.73
Answer: B
Explanation: B) Current ratio =
Current ratio =
= 1.18
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
16) The quick ratio is 1.0. Current assets are $100,000 and current liabilities are $80,000. What is the
amount in the inventory account?
A) $20,000
B) $80,000
C) $125,000
D) $180,000
E) Cannot be determined with the information provided.
Answer: A
Explanation: A) Quick ratio =
1=
80,000 = 100,000 - X
X = 20,000
Diff: 3
Section: 3.3
22
Copyright © 2015 Pearson Canada, Inc.
AACSB: Analytical Thinking
17) Find accounts receivable turnover if a firm has an accounts receivable of $80,000, a total asset turnover
of .75, and total assets of $230,000.
A) 2.15
B) 3.8
C) 2.9
D) 1.5
E) .65
Answer: A
Explanation: A) Accounts receivable turnover =
Step 1 - Use total asset turnover to calculate sales.
Total asset turnover =
.75 =
Sales = 172,500
Step 2 - Use the sales figure to solve for accounts receivable turnover.
Accounts receivable turnover =
= 2.15
Diff: 3
Section: 3.4
AACSB: Analytical Thinking
18) Which of the following statements is true?
A) The quick ratio is classified as an activity ratio.
B) Current assets are expected to be converted into cash in less than 2 years.
C) A firm's debt holders prefer a low quick ratio.
D) Activity ratios go hand in hand with liquidity ratios.
E) Lower current ratios are always preferable.
Answer: D
Explanation: D) Activity ratios go hand in hand with liquidity ratios.
Diff: 1
Section: 3.4
AACSB: Analytical Thinking
23
Copyright © 2015 Pearson Canada, Inc.
19) What is a firm's total asset turnover if its fixed assets are $120,000, current assets are $30,000, current
liabilities are $44,000, sales were $200,000, and net income was $75,000?
A) 0.5 times
B) 2.2 times
C) 1.3 times
D) 2.0 times
E) 1.7 times
Answer: C
Explanation: C) Total asset turnover =
Total asset turnover =
= 1.3
Diff: 3
Section: 3.4
AACSB: Analytical Thinking
20) A firm has current assets of $350,000, current liabilities of $200,000, cost of goods sold of $250,000, and
inventory of $75,000. The firm's inventory turnover is
A) 5.0 times.
B) 3.3 times.
C) 2.7 times.
D) 2.0 times.
E) 4.7 times.
Answer: B
Explanation: B) Inventory turnover =
Inventory turnover =
= 3.3
Diff: 2
Section: 3.4
AACSB: Analytical Thinking
21) What is a firms times interest earned if it posts revenues of $200,000, taxes of $35,000, expenses of
$100,000, and interest of $30,000?
A) 3.3 times
B) 2.0 times
C) 2.2 times
D) 0.5 times
E) 1.3 times
Answer: A
Explanation: A) Times interest earned =
Times interest earned =
= 3.3
Diff: 3
Section: 3.5
AACSB: Analytical Thinking
24
Copyright © 2015 Pearson Canada, Inc.
22) If a firm's total asset turnover is low, but its fixed asset turnover is high, which of the following ratios
should an analyst examine to locate the source of the problem?
A) Debt/equity
B) Price/earnings
C) Return on equity
D) Accounts receivable turnover
E) Times interest earned
Answer: D
Explanation: D) Accounts receivable is a part of total assets and is a logical next step to check if fixed
assets turnover is high.
Diff: 1
Section: 3.4
AACSB: Analytical Thinking
23) A firm has sales of $1 million, net income of $250,000, total current assets of $300,000, and accounts
receivable of $200,000. The firm's accounts receivable turnover is
A) 0.33 times.
B) 0.20 times.
C) 1.50 times.
D) 5.00 times.
E) 1.25 times.
Answer: D
Explanation: D) Accounts receivable turnover =
Accounts receivable turnover =
=5
Diff: 2
Section: 3.4
AACSB: Analytical Thinking
24) A firm has accounts receivable of $150,000. During the year, total sales are $500,000, of which $300,000
are cash sales. What is the average collection period?
A) 109.5 days
B) 182.5 days
C) 273.8 days
D) 486.7 days
E) None of the above
Answer: C
Explanation: C) Average collection period =
Average collection period =
= 273.8 days
Diff: 3
Section: 3.4
AACSB: Analytical Thinking
25
Copyright © 2015 Pearson Canada, Inc.
25) What is a firm's debt ratio if its total assets are $135,000, equity is $75,000, current liabilities are
$24,000, and total liabilities are $105,000?
A) 140%
B) 110%
C) 50%
D) 60%
E) 78%
Answer: E
Explanation: E) Debt ratio =
Debt ratio =
= 78%
Diff: 2
Section: 3.5
AACSB: Analytical Thinking
26) Market ratios differ from other ratios because
A) they are based on information not contained in the firm's financial statements.
B) they are the only ratios that may have negative values.
C) they are the most important ratios to shareholders.
D) they are the only ratios that relate equity measures to other variables.
E) they are less precise.
Answer: A
Explanation: A) Market ratios are distinct from other ratios in that they are based, at least in part, on
information not contained in the firm's financial statements.
Diff: 1
Section: 3.6
AACSB: Analytical Thinking
27) If a firm has 100,000 shares of common stock outstanding and has just recorded a $45,000 profit, what
is its price/earnings ratio if its current share price is $35?
A) 0.78
B) 0.45
C) 14.00
D) 45.00
E) 78.00
Answer: E
Explanation: E) PE ratio =
PE ratio =
= 78
Diff: 2
Section: 3.6
AACSB: Analytical Thinking
26
Copyright © 2015 Pearson Canada, Inc.
28) The DuPont analysis calculates ROE as the product of
A) leverage, market value, and turnover.
B) margin, turnover, and leverage.
C) profitability, liquidity, and leverage.
D) activity, leverage, and debt.
E) margin, profitability, and leverage.
Answer: B
Explanation: B) ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier
Diff: 1
Section: 3.8
AACSB: Analytical Thinking
29) All of the following are part of a financial analysis EXCEPT
A) examining the strengths and weaknesses of the firm.
B) performing a means-end analysis.
C) calculating the DuPont ratio.
D) analyzing the competition.
E) performing an industry analysis.
Answer: B
Explanation: B) Financial analysis of a firm includes analyzing the economy, the industry, the
competitors, and the strengths and weaknesses of the firm.
Diff: 1
Section: 3.9
AACSB: Analytical Thinking
30) Ratio interaction refers to
A) using multiple ratios to make a decision.
B) the way ratios are affected by managerial decisions.
C) how ratios affect managerial decisions.
D) the effect one ratio has on another.
E) when a ratio raises a red flag for analysts.
Answer: D
Explanation: D) Ratio interaction refers to the effect one ratio has on another.
Diff: 1
Section: 3.9
AACSB: Analytical Thinking
31) Which type of ratio measures how effectively the firm uses its resources to generate income?
A) Activity
B) Liquidity
C) Profitability
D) Leverage
E) Market
Answer: C
Explanation: C) Profitability ratios measure how effectively the firm uses its resources to generate
income.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
27
Copyright © 2015 Pearson Canada, Inc.
32) When would the "return on equity" equal the "return on assets"?
A) Whenever the debt to equity ratio is one
B) Whenever the debt ratio is zero
C) Whenever a firm has positive net worth
D) Whenever the firm has positive net worth and positive net income
Answer: B
Explanation: B) If you recall from the section on the Du Pont Analysis,
ROE = ROA × (1 +
)
So, in order for ROE = ROA the debt to equity ratio must equal zero. Debt in the Du Pont system is equal
to total liabilities. The debt ratio is defined as total liabilities over total assets. If the debt ratio is zero, then
debt in the Du Pont system is zero and D/E = 0.
Diff: 1
Section: 3
AACSB: Analytical Thinking
33) Your banker is concerned about your company's liquidity. Which of the following actions would
increase the firm's current ratio and ease the bank's concern?
A) Sell some inventory for cash.
B) File for bankruptcy.
C) Call your convertible bonds and thereby force the bond holders to become shareholders.
D) Sell some of the firm's long-term bonds and purchase marketable securities.
E) Sell long-term bonds to purchase new machinery.
Answer: D
Explanation: D) The current ratio is calculated as current assets/current liabilities.
Any action to increase current assets and/or decrease current liabilities will improve the ratio. The correct
answer in this case is the choice of selling the long-term bonds and purchasing marketable securities as it
is the option that results in the best net change in either of the current ratio variables (in this case current
assets).
Diff: 2
Section: 3
AACSB: Analytical Thinking
28
Copyright © 2015 Pearson Canada, Inc.
Blockbuster Inc.
Balance Sheet for year-ended Dec 31 ($000's)
ASSETS
Year 1
Year 2
Cash
194,200
200,200
Accounts Receivables
185,800
150,000
Inventory
242,200
202,900
Other Current Assets
177,300
163,300
Total Current Assets
799,500
716,400
Fixed Assets
Long Term Investments
214,100
159,500
PP&E
1,079,400
909,000
Goodwill
6,455,900
5,967,500
Total Fixed Assets
7,749,400
7,036,000
Total Assets
8,548,900
7,752,400
LIABILITIES AND
SHAREHOLDERS' EQUITY
Accounts Payable
1,090,400
1,087,400
Short-term Debt
32,800
181,400
Total Current Liabilities
1,123,200
1,268,800
Long-term Debt
1,417,300
734,900
Total Liabilities
2,540,500
2,003,700
Shareholders' Equity
Common Stock
6,095,200
6,075,800
Retained Earnings
-86,800
-327,100
Total Stockholder Equity
6,008,400
5,748,700
Total Liabilities and
Shareholders' Equity
8,548,900
7,752,400
34)
Blockbuster Inc.
Income Statement for year-ended Dec 31 ($000's)
Year 1
Year 2
Sales
4,969,100
5,157,600
COGS
2,036,000
2,420,700
SG&A
2,390,600
2,532,400
Depreciation
279,000
246,600
Amortization of Intangibles
180,100
176,100
Operating Income (Loss)
83,400
-218,200
Interest Expense
116,500
78,200
Income Before Tax
-33,100
-296,400
Income Tax Expense
45,400
-56,100
Net Income
-78,500
-240,300
Referring to the Blockbuster financial statements, what is the change in ROE from Year 1 to Year 2?
(ΔROE = ROE2 - ROE1)
A) -4.80%
B) -4.18%
29
Copyright © 2015 Pearson Canada, Inc.
C) -2.87%
D) -1.20%
E) -1.17%
Answer: C
Explanation: C) ROE =
ROE Year 1 =
= -1.31%
ROE Year 2 =
= -4.18%
Change = -4.18% --1.31% = -2.87%
Diff: 2
Section: 3
AACSB: Analytical Thinking
35)
Blockbuster Inc.
Income Statement for year-ended Dec 31 ($000's)
Year 1
Year 2
Sales
4,969,100
5,157,600
COGS
2,036,000
2,420,700
SG&A
2,390,600
2,532,400
Depreciation
279,000
246,600
Amortization of Intangibles
180,100
176,100
Operating Income (Loss)
83,400
-218,200
Interest Expense
116,500
78,200
Income Before Tax
-33,100
-296,400
Income Tax Expense
45,400
-56,100
Net Income
-78,500
-240,300
Referring to the Blockbuster financial statements, what is the change in ROA from Year 1 to Year 2?
(ΔROA = ROA2 - ROA1)
A) -8.40%
B) -7.54%
C) -2.18%
D) 8.40%
E) 23.72%
Answer: C
Explanation: C) ROA =
ROA Year 1 =
= -0.92%
ROA Year 2 =
= -3.10%
Change = -3.10% --0.92% = -2.18%
Diff: 2
Section: 3
AACSB: Analytical Thinking
30
Copyright © 2015 Pearson Canada, Inc.
36)
Blockbuster Inc.
Income Statement for year-ended Dec 31 ($000's)
Year 1
Year 2
Sales
4,969,100
5,157,600
COGS
2,036,000
2,420,700
SG&A
2,390,600
2,532,400
Depreciation
279,000
246,600
Amortization of Intangibles
180,100
176,100
Operating Income (Loss)
83,400
-218,200
Interest Expense
116,500
78,200
Income Before Tax
-33,100
-296,400
Income Tax Expense
45,400
-56,100
Net Income
-78,500
-240,300
Referring to the Blockbuster financial statements, which of the following ratios decreased from Year 1 to
Year 2?
I. Equity Multiplier
II. Net Profit Margin
III. Total Asset Turnover
A) I
B) II
C) III
D) I & II
E) II & III
Answer: D
Explanation: D) Equity Multiplier =
Net Profit Margin =
Total Asset Turnover =
Multiplier
NPM
TAT
Year 1
= 8,548,900 / 6,008,400
= 1.42
= -$78,500/$4,969,100
= -1.58%
= 4,969,100 / 8,548,900
= 0.58
Year 2
= 7,752,400 / 5,748,700
= 1.35
= -240,300 / 5,157,600
= -4.66%
= 5,157,600 / 7,752,400
= 0.67
Change
-0.07
-3.08%
+0.09
Diff: 2
Section: 3
AACSB: Analytical Thinking
31
Copyright © 2015 Pearson Canada, Inc.
37)
Blockbuster Inc.
Income Statement for year-ended Dec 31 ($000's)
Year 1
Year 2
Sales
4,969,100
5,157,600
COGS
2,036,000
2,420,700
SG&A
2,390,600
2,532,400
Depreciation
279,000
246,600
Amortization of Intangibles
180,100
176,100
Operating Income (Loss)
83,400
-218,200
Interest Expense
116,500
78,200
Income Before Tax
-33,100
-296,400
Income Tax Expense
45,400
-56,100
Net Income
-78,500
-240,300
Referring to the Blockbuster financial statements, what is the change in Gross Margin from Year 1 to Year
2? (ΔGM = GM2 - GM1)
A) -7.54%
B) -5.96%
C) -2.28%
D) 5.96%
E) 7.54%
Answer: B
Explanation: B) Gross Margin =
Gross Margin Year 1 =
= 0.5903
Gross Margin Year 2 =
= 0.5307
Change = 0.5307 - 0.5903 = -5.96%
Diff: 2
Section: 3
AACSB: Analytical Thinking
32
Copyright © 2015 Pearson Canada, Inc.
38)
Blockbuster Inc.
Income Statement for year-ended Dec 31 ($000's)
Year 1
Year 2
Sales
4,969,100
5,157,600
COGS
2,036,000
2,420,700
SG&A
2,390,600
2,532,400
Depreciation
279,000
246,600
Amortization of Intangibles
180,100
176,100
Operating Income (Loss)
83,400
-218,200
Interest Expense
116,500
78,200
Income Before Tax
-33,100
-296,400
Income Tax Expense
45,400
-56,100
Net Income
-78,500
-240,300
Referring to the Blockbuster financial statements, what is the most important underlying reason for the
change in ROE?
A) Decrease in cost of goods sold
B) Increase in debt caused the debt/equity ratio to rise
C) Increase in sales resulted in an increase in product returns which caused inventory turnover to decline
D) Increase in cost of goods sold caused a big drop in gross margin
E) Decrease in debt
Answer: D
Explanation: D) Cost of goods sold rises from Year 1 to Year 2. Debt falls–it does not rise. Inventory
turnover improves from Year 1 (8.4) to Year 2 (11.9). Gross margin falls substantially due to an increase in
cost of goods sold. Debt declines (as measured by the equity multiplier). The decline is quite small. Had
ROA remained constant at the Year 1 level (-0.92%), the decline in leverage would have caused an
increase in ROE from -1.3% to -1.24%.
Diff: 2
Section: 3
AACSB: Analytical Thinking
33
Copyright © 2015 Pearson Canada, Inc.
Balance Sheet
Molson Coors Inc.
Years 1 & 2 ($000's)
Year 1
Cash & Marketable Securities
309,705
Accounts Receivable
108,732
Inventories
138,577
Other Current Assets
49,515
Total Current Assets
606,529
PP&E, Net
869,710
Intangibles
86,289
Other Assets
177,164
Total Assets
1,739,692
Accounts Payable
222,493
Other current liabilities
210,052
Short-term Debt
85,000
Total Current Liabilities
517,545
Long-term debt
20,000
Other long-term liabilities
250,835
Total liabilities
788,380
Capital Stock
8,922
Retained earnings
954,981
Adjustments
-12,591
Total shareholders' equity
951,312
Total Liabilities & Equity
1,739,692
Income Statement
Molson Coors Inc.
Years 1 & 2 ($000s)
Year 1
Revenues
2,429,462
COGS
1,537,623
Depreciation
121,091
SG&A
619,143
EBIT
151,605
Interest Expense
-14,403
Other income
32,005
Pre-Tax Income
198,013
Income Tax
75,049
Net Income
122,964
Shares outstanding
36,902
Earnings per share
$3.33
Dividends per common share
$0.80
Year 2
59,167
705,426
215,159
74,144
1,053,896
1,380,239
1,256,145
607,131
4,297,411
334,647
669,195
144,049
1,147,891
1,383,392
784,277
3,315,560
28,334
1,086,965
-133,448
981,851
4,297,411
39)
Year 2
3,776,322
2,414,530
230,299
833,208
298,285
49,732
8,047
256,600
94,947
161,653
36,140
$4.47
$0.82
Referring to the Molson Coors financial statements, did ROE rise or fall from Year 1 to Year 2?
A) Rise
34
Copyright © 2015 Pearson Canada, Inc.
B) Fall
Answer: A
Explanation: A) ROE (Year 1) =
ROE (Year 2) =
=
= 12.9%
= 16.5%
ROE rose from Year 1 to Year 2.
Diff: 2
Section: 3
AACSB: Analytical Thinking
40)
Income Statement
Molson Coors Inc.
Years 1 & 2 ($000s)
Year 1
Revenues
2,429,462
COGS
1,537,623
Depreciation
121,091
SG&A
619,143
EBIT
151,605
Interest Expense
-14,403
Other income
32,005
Pre-Tax Income
198,013
Income Tax
75,049
Net Income
122,964
Shares outstanding
36,902
Earnings per share
$3.33
Dividends per common share
$0.80
Year 2
3,776,322
2,414,530
230,299
833,208
298,285
49,732
8,047
256,600
94,947
161,653
36,140
$4.47
$0.82
Referring to the Molson Coors financial statements, what is the change in ROA from Year 1 to Year 2?
(ΔROA = ROA2 - ROA1)
A) -3.3%
B) -2.3%
C) 2.3%
D) 3.5%
E) 3.8%
Answer: A
Explanation: A) ROA =
ROA Year 1 =
= 7.1%
ROA Year 2 =
= 3.8%
Change = 3.8% - 7.1% = -3.3%
Diff: 2
Section: 3
AACSB: Analytical Thinking
35
Copyright © 2015 Pearson Canada, Inc.
41)
Income Statement
Molson Coors Inc.
Years 1 & 2 ($000s)
Year 1
Revenues
2,429,462
COGS
1,537,623
Depreciation
121,091
SG&A
619,143
EBIT
151,605
Interest Expense
-14,403
Other income
32,005
Pre-Tax Income
198,013
Income Tax
75,049
Net Income
122,964
Shares outstanding
36,902
Earnings per share
$3.33
Dividends per common share
$0.80
Year 2
3,776,322
2,414,530
230,299
833,208
298,285
49,732
8,047
256,600
94,947
161,653
36,140
$4.47
$0.82
Referring to the Molson Coors financial statements, what is the Equity Multiplier from the Du Pont
equation (1 + D/E) in Year 2?
A) 2.41
B) 3.95
C) 4.05
D) 4.38
E) 4.58
Answer: D
Explanation: D) 1 + D/E = 1 +
= 4.38
Diff: 2
Section: 3
AACSB: Analytical Thinking
36
Copyright © 2015 Pearson Canada, Inc.
42)
Income Statement
Molson Coors Inc.
Years 1 & 2 ($000s)
Year 1
Revenues
2,429,462
COGS
1,537,623
Depreciation
121,091
SG&A
619,143
EBIT
151,605
Interest Expense
-14,403
Other income
32,005
Pre-Tax Income
198,013
Income Tax
75,049
Net Income
122,964
Shares outstanding
36,902
Earnings per share
$3.33
Dividends per common share
$0.80
Year 2
3,776,322
2,414,530
230,299
833,208
298,285
49,732
8,047
256,600
94,947
161,653
36,140
$4.47
$0.82
Referring to the Molson Coors financial statements, what is Net Profit Margin in Year 1?
A) 4.3%
B) 5.1%
C) 8.0%
D) 8.2%
E) 12.9%
Answer: B
Explanation: B) Profit Margin =
=
= 5.1%
Diff: 2
Section: 3
AACSB: Analytical Thinking
37
Copyright © 2015 Pearson Canada, Inc.
43)
Income Statement
Molson Coors Inc.
Years 1 & 2 ($000s)
Year 1
Revenues
2,429,462
COGS
1,537,623
Depreciation
121,091
SG&A
619,143
EBIT
151,605
Interest Expense
-14,403
Other income
32,005
Pre-Tax Income
198,013
Income Tax
75,049
Net Income
122,964
Shares outstanding
36,902
Earnings per share
$3.33
Dividends per common share
$0.80
Year 2
3,776,322
2,414,530
230,299
833,208
298,285
49,732
8,047
256,600
94,947
161,653
36,140
$4.47
$0.82
Referring to the Molson Coors financial statements, what asset was the main reason for the decline in
Total Asset Turnover between Year 1 and Year 2?
A) Property Plant and Equipment
B) Cash and Marketable Securities
C) Inventory
D) Intangibles
E) Accounts Receivable
Answer: D
Explanation: D) Intangibles increased by over $1B, much more than any other asset.
Diff: 1
Section: 3
AACSB: Analytical Thinking
38
Copyright © 2015 Pearson Canada, Inc.
44)
Income Statement
Molson Coors Inc.
Years 1 & 2 ($000s)
Year 1
Revenues
2,429,462
COGS
1,537,623
Depreciation
121,091
SG&A
619,143
EBIT
151,605
Interest Expense
-14,403
Other income
32,005
Pre-Tax Income
198,013
Income Tax
75,049
Net Income
122,964
Shares outstanding
36,902
Earnings per share
$3.33
Dividends per common share
$0.80
Year 2
3,776,322
2,414,530
230,299
833,208
298,285
49,732
8,047
256,600
94,947
161,653
36,140
$4.47
$0.82
Referring to the Molson Coors financial statements, what is the most important determinant of the change
in ROE?
A) ROA
B) Profit Margin
C) Total Asset Turnover
D) The change in leverage
Answer: D
Explanation: D) Profit Margin, TAT, and ROA all decreased; Leverage increased. Since ROE increased,
the change in leverage is the more important determinant of the change in ROE.
Diff: 1
Section: 3
AACSB: Analytical Thinking
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45)
Income Statement
Molson Coors Inc.
Years 1 & 2 ($000s)
Year 1
Revenues
2,429,462
COGS
1,537,623
Depreciation
121,091
SG&A
619,143
EBIT
151,605
Interest Expense
-14,403
Other income
32,005
Pre-Tax Income
198,013
Income Tax
75,049
Net Income
122,964
Shares outstanding
36,902
Earnings per share
$3.33
Dividends per common share
$0.80
Year 2
3,776,322
2,414,530
230,299
833,208
298,285
49,732
8,047
256,600
94,947
161,653
36,140
$4.47
$0.82
Referring to the Molson Coors financial statements, what reason best explains the change in leverage
between Year 1 and Year 2?
A) Purchase of another company
B) A large dividend to common shareholders
C) An increase in goodwill
D) Relaxation of the collection policy
E) Large amount of capital expenditures in Year 2
Answer: A
Explanation: A) Long term debt increased significantly, and so did Intangibles - this is likely due to the
purchase of another company.
Diff: 1
Section: 3
AACSB: Analytical Thinking
40
Copyright © 2015 Pearson Canada, Inc.
Balance Sheet
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Cash
29.2
A/R
108.2
Inventory
74.0
Total Current Assets
211.4
Fixed Assets, Net
81.6
Goodwill
159.6
Total Assets
452.6
Accounts Payable
46.4
Short-term Debt
23.0
Total Current Liabilities
69.4
Long Term Debt
125.8
Deferred income taxes
14.0
Equity
Share Capital
148.9
Retained Earnings
94.5
Owners' Equity
243.4
Total Liabilities & Equity
452.6
Income Statement
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Sales
381.9
COGS
244.9
SG&A
59.7
Depreciation
13.8
R&D
5.3
EBIT
58.2
Interest Expense
7.3
Earnings before Income Tax
50.9
Income Taxes
17.3
Net Income
33.6
Year 2
21.2
122.6
79.7
223.5
94.1
184.5
502.1
50.5
27.0
77.5
128.5
18.6
151.8
125.7
277.5
502.1
46)
Year 2
416.3
278.9
63.8
15.4
4.3
53.9
7.9
46.0
14.8
31.2
Referring to the CFM Majestic financial statements, did ROE rise or fall from Year 1 to Year 2?
A) Fall
B) Rise
Answer: A
41
Copyright © 2015 Pearson Canada, Inc.
Explanation: A) ROE =
ROE Year 1 =
= 13.80%
ROE Year 2 =
= 11.24%
Change = 11.24% - 13.80% = -2.56%
Diff: 2
Section: 3
AACSB: Analytical Thinking
47)
Income Statement
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Sales
381.9
COGS
244.9
SG&A
59.7
Depreciation
13.8
R&D
5.3
EBIT
58.2
Interest Expense
7.3
Earnings before Income Tax
50.9
Income Taxes
17.3
Net Income
33.6
Year 2
416.3
278.9
63.8
15.4
4.3
53.9
7.9
46.0
14.8
31.2
Referring to the CFM Majestic financial statements, what happened to ROA from Year 1 to Year 2?
A) Increased
B) Decreased
C) Stayed the same
Answer: B
Explanation: B) ROA =
ROA Year 1 =
= 7.42%
ROA Year 2 =
= 6.21%
Change = 6.21% - 7.42% = -1.21%
Diff: 2
Section: 3
AACSB: Analytical Thinking
42
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48)
Income Statement
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Sales
381.9
COGS
244.9
SG&A
59.7
Depreciation
13.8
R&D
5.3
EBIT
58.2
Interest Expense
7.3
Earnings before Income Tax
50.9
Income Taxes
17.3
Net Income
33.6
Year 2
416.3
278.9
63.8
15.4
4.3
53.9
7.9
46.0
14.8
31.2
Referring to the CFM Majestic financial statements, what is the change Equity Multiplier from Year 1 to
Year 2?
A) -1.86
B) -0.05
C) 0.95
D) 1.81
E) 1.86
Answer: B
Explanation: B) Equity Multiplier =
Multiplier
Year 1
= 452.6 / 243.4
= 1.86
Year 2
= 502.1 / 277.5
= 1.81
Change
-0.05
Diff: 2
Section: 3
AACSB: Analytical Thinking
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49)
Income Statement
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Sales
381.9
COGS
244.9
SG&A
59.7
Depreciation
13.8
R&D
5.3
EBIT
58.2
Interest Expense
7.3
Earnings before Income Tax
50.9
Income Taxes
17.3
Net Income
33.6
Year 2
416.3
278.9
63.8
15.4
4.3
53.9
7.9
46.0
14.8
31.2
Referring to the CFM Majestic financial statements, which is the bigger or more important determinant of
the change in ROE?
A) ROA
B) The Equity Multiplier
Answer: A
Explanation: A) ROA is the more important force acting on the decrease in ROE. 1 + D/E stayed constant
during the two years, but what happened was our income went down and our assets went up (i.e. we are
not being as efficient with our assets), therefore ROA is the bigger factor.
Diff: 1
Section: 3
AACSB: Analytical Thinking
44
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50)
Income Statement
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Sales
381.9
COGS
244.9
SG&A
59.7
Depreciation
13.8
R&D
5.3
EBIT
58.2
Interest Expense
7.3
Earnings before Income Tax
50.9
Income Taxes
17.3
Net Income
33.6
Year 2
416.3
278.9
63.8
15.4
4.3
53.9
7.9
46.0
14.8
31.2
Referring to the CFM Majestic financial statements, What is Net Profit Margin in Year 1?
A) 5.0%
B) 6.6%
C) 7.5%
D) 8.8%
E) 9.1%
Answer: D
Explanation: D) Net Profit Margin =
=
= 8.8%
Diff: 2
Section: 3
AACSB: Analytical Thinking
45
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51)
Income Statement
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Sales
381.9
COGS
244.9
SG&A
59.7
Depreciation
13.8
R&D
5.3
EBIT
58.2
Interest Expense
7.3
Earnings before Income Tax
50.9
Income Taxes
17.3
Net Income
33.6
Year 2
416.3
278.9
63.8
15.4
4.3
53.9
7.9
46.0
14.8
31.2
Referring to the CFM Majestic financial statements, is the change between Year 1 and Year 2 in Total
Asset Turnover important in explaining the change in ROA?
A) No
B) Yes
Answer: A
Explanation: A) Total Asset Turnover (TAT) didn't change very much. The big change is the decline in
the net profit margin, which caused a decline in ROA.
Diff: 1
Section: 3
AACSB: Analytical Thinking
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Copyright © 2015 Pearson Canada, Inc.
52)
Income Statement
CFM Majestic Inc.
Years 1 & 2 ($000,000s)
Year 1
Sales
381.9
COGS
244.9
SG&A
59.7
Depreciation
13.8
R&D
5.3
EBIT
58.2
Interest Expense
7.3
Earnings before Income Tax
50.9
Income Taxes
17.3
Net Income
33.6
Year 2
416.3
278.9
63.8
15.4
4.3
53.9
7.9
46.0
14.8
31.2
Referring to the CFM Majestic financial statements, pick the most informative explanation for why ROA
fell.
A) ROA fell because both gross margin fell and Selling, General & Admin expenses as a percentage of
sales fell.
B) ROA fell because Total Asset Turnover fell.
C) ROA fell because the Equity Multiplier fell and because Cost of Goods Sold over Sales rose.
D) ROA fell because Net Income grew more slowly than Total Assets.
E) ROA fell mainly because gross margin fell.
Answer: E
Explanation: E) ROA fell mostly because of the decline in gross margin. The company had a small
increase in sales but the COGS went up a lot. Gross margin fell from 35.87% to 33.01%.
SGA/Sales did fall, but that causes ROA to increase. We observed a decrease in ROA.
Total asset turnover declines by only a small amount. It isn't the main cause of the reduction in ROA and
ROE.
The ROA is not dependent on the equity multiplier.
Diff: 1
Section: 3
AACSB: Analytical Thinking
47
Copyright © 2015 Pearson Canada, Inc.
Tootsie Roll Industries, Inc. has been engaged in the manufacture and sale of candy since 1896. Its
products are sold under the familiar brand names Tootsie Roll, Tootsie Roll Pops, Charms, Blow Pops,
Cella's, Mason Dots and Mason Crows. Tootsie Roll operates four plants in Illinois, New York, Tennessee
and Mexico. Tootsie Roll is traded on the New York Stock Exchange and maintains its head office in
Chicago, Illinois.
Tootsie Roll's financial statements for Year 5 and Year 6 are provided below .
Tootsie Roll Industries Inc.
Balance Sheet
As of December 31, Year 6 ($000s)
Year 6
Cash & marketable securities
36,758
Accounts receivable
16,207
Inventories
22,927
Prepaid expenses
2,037
Total Current Assets
77,929
Net Fixed Assets
32,099
Other assets
49,674
Total Assets
159,702
Accounts payable
8,253
Accrued liabilities
14,298
Total Current Liabilities
22,551
Long-term debt
7,306
Shareholders' Equity
Common stock
6,698
Capital in excess of par
50,820
Retained earnings
72,327
Total Shareholders' Equity
129,845
Total Liabilities & Equity
159,702
53)
Tootsie Roll Industries Inc.
Income Statement
As of December 31, Year 6 ($000s)
Year 6
Net sales
194,299
COGS
103,205
SG&A
54,329
EBIT
36,765
Interest expense
612
Other income (expenses), net
966
Income before income taxes
37,119
Income taxes
14,563
Net Income
22,556
Total Cash dividends
12,316
Shares Outstanding
9,645
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Copyright © 2015 Pearson Canada, Inc.
Average price per share (4th Q)
$36.50
Selected Financial Ratios
Year 6
Industry Avg
Net Profit Margin
8.2%
Total Asset Turnover
1.64
ROA
13.4%
Equity Multiplier
1.42
ROE
19%
Referring to the financial statements for Tootsie Roll, what is the difference between the Industry and
Tootsie for the net profit margin? (Tootsie - Industry)
A) 3.1%
B) 3.4%
C) 5.4%
D) 8.2%
E) 11.6%
Answer: B
Explanation: B) Net Profit Margin =
Industry
NPM
= 8.2%
Year 6
= 22,556 / 194,299
= 11.61%
Difference
+3.4%
Diff: 2
Section: 3
AACSB: Analytical Thinking
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54)
Tootsie Roll Industries Inc.
Income Statement
As of December 31, Year 6 ($000s)
Year 6
Net sales
194,299
COGS
103,205
SG&A
54,329
EBIT
36,765
Interest expense
612
Other income (expenses), net
966
Income before income taxes
37,119
Income taxes
14,563
Net Income
22,556
Total Cash dividends
12,316
Shares Outstanding
9,645
Average price per share (4th Q)
$36.50
Selected Financial Ratios
Year 6
Industry Avg
Net Profit Margin
8.2%
Total Asset Turnover
1.64
ROA
13.4%
Equity Multiplier
1.42
ROE
19%
Referring to the financial statements for Tootsie Roll, what is the difference between the Industry and
Tootsie for total asset turnover? (Tootsie - Industry)
A) -0.20
B) -0.25
C) -0.34
D) -0.38
E) -0.42
Answer: E
Explanation: E) Total Asset Turnover =
Industry
TAT
= 1.64
Year 6
= 194,299 / 159,702
= 1.22
Difference
-0.42
Diff: 2
Section: 3
AACSB: Analytical Thinking
50
Copyright © 2015 Pearson Canada, Inc.
55)
Tootsie Roll Industries Inc.
Income Statement
As of December 31, Year 6 ($000s)
Year 6
Net sales
194,299
COGS
103,205
SG&A
54,329
EBIT
36,765
Interest expense
612
Other income (expenses), net
966
Income before income taxes
37,119
Income taxes
14,563
Net Income
22,556
Total Cash dividends
12,316
Shares Outstanding
9,645
Average price per share (4th Q)
$36.50
Selected Financial Ratios
Year 6
Industry Avg
Net Profit Margin
8.2%
Total Asset Turnover
1.64
ROA
13.4%
Equity Multiplier
1.42
ROE
19%
Referring to the financial statements for Tootsie Roll, what is the difference between the Industry and
Tootsie for return on assets (ROA)? (Tootsie - Industry)
A) -0.70%
B) 0.72%
C) 1.72%
D) 7.00%
E) 14.00%
Answer: B
Explanation: B) ROA =
Industry
ROA
= 13.40%
Year 6
= 22,556 / 159,702
= 14.12%
Difference
0.72%
Diff: 2
Section: 3
AACSB: Analytical Thinking
51
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56)
Tootsie Roll Industries Inc.
Income Statement
As of December 31, Year 6 ($000s)
Year 6
Net sales
194,299
COGS
103,205
SG&A
54,329
EBIT
36,765
Interest expense
612
Other income (expenses), net
966
Income before income taxes
37,119
Income taxes
14,563
Net Income
22,556
Total Cash dividends
12,316
Shares Outstanding
9,645
Average price per share (4th Q)
$36.50
Selected Financial Ratios
Year 6
Industry Avg
Net Profit Margin
8.2%
Total Asset Turnover
1.64
ROA
13.4%
Equity Multiplier
1.42
ROE
19%
Referring to the financial statements for Tootsie Roll, what is the difference between the Industry and
Tootsie for the equity multiplier? (Tootsie - Industry)
A) -0.19
B) -0.17
C) -0.15
D) -0.13
E) -0.11
Answer: A
Explanation: A) Equity Multiplier =
Industry
Multiplier
= 1.42
Year 6
= 159,702 / 129,845
= 1.23
Difference
-0.19
Diff: 2
Section: 3
AACSB: Analytical Thinking
52
Copyright © 2015 Pearson Canada, Inc.
57)
Tootsie Roll Industries Inc.
Income Statement
As of December 31, Year 6 ($000s)
Year 6
Net sales
194,299
COGS
103,205
SG&A
54,329
EBIT
36,765
Interest expense
612
Other income (expenses), net
966
Income before income taxes
37,119
Income taxes
14,563
Net Income
22,556
Total Cash dividends
12,316
Shares Outstanding
9,645
Average price per share (4th Q)
$36.50
Selected Financial Ratios
Year 6
Industry Avg
Net Profit Margin
8.2%
Total Asset Turnover
1.64
ROA
13.4%
Equity Multiplier
1.42
ROE
19%
Referring to the financial statements for Tootsie Roll, what is the difference between the Industry and
Tootsie for the return on equity? (Tootsie - Industry)
A) -2.14%
B) -2.02%
C) -1.81%
D) -1.63%
E) 2.14%
Answer: D
Explanation: D) ROE =
Industry
ROE
= 19%
Year 6
= 22,556 / 129,8455
= 17.37%
Difference
-1.63%
Diff: 2
Section: 3
AACSB: Analytical Thinking
53
Copyright © 2015 Pearson Canada, Inc.
58)
Tootsie Roll Industries Inc.
Income Statement
As of December 31, Year 6 ($000s)
Year 6
Net sales
194,299
COGS
103,205
SG&A
54,329
EBIT
36,765
Interest expense
612
Other income (expenses), net
966
Income before income taxes
37,119
Income taxes
14,563
Net Income
22,556
Total Cash dividends
12,316
Shares Outstanding
9,645
Average price per share (4th Q)
$36.50
Selected Financial Ratios
Year 6
Industry Avg
Net Profit Margin
8.2%
Total Asset Turnover
1.64
ROA
13.4%
Equity Multiplier
1.42
ROE
19%
Referring to the financial statements for Tootsie Roll and based on the Du Pont analysis, what main
reasons explain the difference(s) between Tootsie's ROE and the industry average ROE?
I.
II.
III.
IV.
Tootsie does not have enough leverage.
Tootsie has more leverage than the industry.
Tootsie manages their assets poorly - low total asset turnover.
Tootsie manages their assets poorly - high total asset turnover.
A) I
B) III
C) I and III
D) I or IV
E) II or III
Answer: C
Explanation: C) Tootsie has a lower amount of leverage than the industry.
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Tootsie has a much higher net profit margin than the industry (12% v. 8.2%), but this advantage is offset
by poor asset management. The total asset turnover for Tootsie is 1.22 but it is 1.64 for the industry.
Despite the poor asset management, Tootsie has a higher ROA than the industry. But the ROA would be
even higher were it able to take advantage of its higher profitability (net profit margin) through greater
asset management. Thus, total asset turnover and leverage both explain Tootsie's poor ROE relative to the
industry.
Diff: 1
Section: 3
AACSB: Analytical Thinking
55
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59)
Tootsie Roll Industries Inc.
Income Statement
As of December 31, Year 6 ($000s)
Year 6
Net sales
194,299
COGS
103,205
SG&A
54,329
EBIT
36,765
Interest expense
612
Other income (expenses), net
966
Income before income taxes
37,119
Income taxes
14,563
Net Income
22,556
Total Cash dividends
12,316
Shares Outstanding
9,645
Average price per share (4th Q)
$36.50
Selected Financial Ratios
Year 6
Industry Avg
Net Profit Margin
8.2%
Total Asset Turnover
1.64
ROA
13.4%
Equity Multiplier
1.42
ROE
19%
Referring to the financial statements for Tootsie Roll, what amount of leverage (i.e. debt-to-equity) would
Tootsie need to make its year Year 6 return on equity equal (ROE) to the industry average ROE? (Round
to initial ratios to nearest percentage.)
A) 0.3456
B) 0.9200
C) 1.1333
D) 1.4200
E) 1.7632
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Answer: A
Explanation: A) First, compute Tootsie's ROA:
ROA =
ROA =
= 14.12%
ROE = ROA × (1 +
)
=
-1
=
- 1 = 0.3456
Diff: 3
Section: 3
AACSB: Analytical Thinking
60) All else held constant, an increase in leverage should increase the ROE.
Answer: TRUE
Explanation: If you recall from the section on the Du Pont Analysis,
ROE = ROA × (1 +
)
If D/E increases and ROA is unchanged, then ROE will rise.
Diff: 1
Section: 3
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 3 Introduction to the Time Value of Money
LO1: Introduction to Time Value of Money
1) Which of the following problems could not be addressed by using compounding or discounting
techniques?
A) Finding an amount to be invested today to provide a given level of income during retirement
B) Determining how long it should take the population of China to double
C) Finding the growth rate in a firm's dividend payments
D) Calculating the length of time needed for the supply and demand for lendable funds to equate if
interest rates are above the equilibrium level
E) Deciding whether a bank paying interest compounded annually is giving you a better deal than a rate
that compounds daily
Answer: D
Explanation: D) The market will decide when supply and demand will fall back into equilibrium; it
cannot be calculated.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
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2) What is the future value of $124.49 after earning simple interest for five years at an annual rate of 10%?
A) $162.25
B) $186.74
C) $200.49
D) $136.94
E) $175.00
Answer: B
Explanation: B) Step 1 - Calculate the amount of interest to be received in one year.$124.49 × .10 = $12.449.
Step 2 - Multiply the interest times the number of periods; then add that back to the principal.$12.449 × 5
= $62.245. $62.245 + 124.49 = $186.74
Diff: 2
Section: 1.2
AACSB: Analytical Thinking
3) Most people prefer to receive money today rather than ten years from now because
A) U.S. prices have been falling recently and a dollar received today will buy more than one received in
the future.
B) future investment returns are expected to be less variable than current ones.
C) receiving cash today enables one to take advantage of current investment opportunities.
D) people are unsure about their future employment prospects and wish to provide themselves with a
source of future income.
E) most people are afraid they will spend future cash payments foolishly.
Answer: C
Explanation: C) The longer it takes to receive payment, the greater the potential opportunity cost.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
4) The primary difference between simple and compound interest is that
A) simple interest is only paid at the end of the investment period.
B) compound interest entails receiving interest payments on previously earned interest.
C) compound interest is paid up front and not when the investment matures.
D) simple interest is not taxed by the federal government.
E) simple interest earns a higher interest rate on reinvested interest than compound interest.
Answer: B
Explanation: B) Simple interest only earns interest on the principal, while compound interest earns
interest on previously earned interest.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
5) Compute the simple interest earned on a 1-year $200 deposit that earns 6% per year.
A) $6
B) $60
C) $120
D) $12
E) $200
Answer: D
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Explanation: D) $200 × .06 = $12
Diff: 2
Section: 1.2
AACSB: Analytical Thinking
6) The rate of interest agreed upon contractually charged by a lender or promised by a borrower is the
________ interest rate.
A) effective
B) nominal
C) discounted
D) continuous
Answer: B
Explanation: B) The quoted rate of interest is the nominal rate.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
7) The amount of money that would have to be invested today at a given interest rate over a specific
period in order to equal a future amount is called
A) future value.
B) present value.
C) future value interest factor.
D) present value interest factor.
Answer: B
Explanation: B) The present value is the amount you need to save at a given interest rate to equal a
desired future sum.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
8) When the amount earned on a deposit has become part of the principal at the end of a specified time
period the concept is called
A) discount interest.
B) compound interest.
C) primary interest.
D) future value.
Answer: B
Explanation: B) Interest that is compounded is added back to the principal amount to earn additional
interest over time.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
9) A college received a contribution to its endowment fund of $2 million. They can never touch the
principal, but they can use the earnings. At an assumed interest rate of 9.5 percent, how much can the
college earn to help its operations each year?
A) $95,000
B) $19,000
C) $190,000
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D) $18,000
E) $9,500
Answer: C
Explanation: C) $2,000,000 × 9.5% = $190,000
Diff: 2
Section: 1.2
AACSB: Analytical Thinking
10) If the present value of a perpetual income stream is increasing, the discount rate must be
A) increasing.
B) decreasing.
C) changing unpredictably.
D) keeping pace with inflation.
Answer: A
Explanation: A) If the present value of a perpetuity is increasing, the discount rate must be decreasing.
Diff: 1
Section: 1.1
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LO2: Calculate the Future Value of a Sum
1) $1,200 is deposited today into an account paying 6% interest compounded semiannually. How much
interest will have been earned after 25 years?
A) $3,950.24
B) $1,312.53
C) $20,904.19
D) $5,260.69
E) $4,060.69
Answer: E
Explanation: E) FV = PV ×
FV = 1200
= $5260.69
Int earned = $5260.69 - $1200 = $4,060.69
Diff: 2
Section: 2.5
AACSB: Analytical Thinking
2) The price of a Wendy's Bacon Cheeseburger is $.99, the same as it was five years ago. Had the price of
this sandwich increased at the same 3% annual rate as U.S. consumer prices did over the last five years,
what would its price be today?
A) $1.15
B) $1.02
C) $1.12
D) $1.22
E) $ .84
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = .99 × (1.03)5 = $1.15
Using a financial calculator:
N = 5, I/Y = 3, PV = -.99, PMT = 0, cpt FV = $1.15
Diff: 2
Section: 2.1
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3) At an effective annual interest rate of 20%, how many years will it take a given amount to triple in
value? (Round to the closest year.)
A) 5
B) 8
C) 6
D) 10
E) 9
Answer: C
Explanation: C) Using a financial calculator:
I/Y = 20, PV = -1, PMT = 0, FV = 3, cpt N = 6.03
Diff: 2
Section: 2.4
AACSB: Analytical Thinking
4) If you presently have $6,000 invested at a rate of 15%, how many years will it take for you investment
to triple? (Round up to obtain a whole number of years if necessary.)
A) 2
B) 4
C) 6
D) 8
E) 10
Answer: D
Explanation: D) Using a financial calculator:
I/Y = 15, PV = -6,000, PMT = 0, FV = 18,000, cpt N = 7.86
Diff: 2
Section: 2.4
AACSB: Analytical Thinking
5) A bank pays a quoted annual (nominal) interest rate of 8%. However, it pays interest (compounded)
daily using a 365-day year. What is the effective annual rate of return?
A) 7.86%
B) 7.54%
C) 8.57%
D) 8.33%
E) 9.21%
Answer: D
Explanation: D) Effective interest rate =
Effective interest rate =
-1
- 1 = 8.33%
Diff: 2
Section: 2.6
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6) You plan to invest $2,500 in a money market account which will pay an annual stated (nominal)
interest rate of 8.75%, but which compounds interest on a weekly basis. If you leave this money on
deposit for one year (52 weeks), what will be your ending balance when you close the account?
A) $2,583.28
B) $2,611.72
C) $2,681.00
D) $2,703.46
E) $2,728.40
Answer: E
Explanation: E) FV = PV ×
FV = 2,500 × (1 +
= $2,728.40
Using a financial calculator:
N = 52, I/Y = .168269, PV = -2500, cpt FV = $2,728.40
Diff: 2
Section: 2.5
AACSB: Analytical Thinking
7) You have just borrowed $20,000 to buy a new car. The loan agreement calls for 60 monthly payments of
$444.89 each to begin one month from today. If the interest is compounded monthly, then what is the
effective annual rate on this loan?
A) 12.68%
B) 14.12%
C) 12.00%
D) 13.25%
E) 15.08%
Answer: A
Explanation: A) Step 1 - Solve for the nominal interest rate.
PV = PMT × [1 - (1 - i)-n] / i
20,000 = 444.89 × [1 - (1 - i)-60] / i
i = 12%
Step 2 - Convert the nominal rate into an effective interest rate.
Effective interest rate =
Effective interest rate =
-1
- 1 = 12.68%
Diff: 3
Section: 2.6
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8) Bank A offers a 2-year certificate of deposit (CD) that pays 10 percent compounded annually. Bank B
offers a 2-year CD that is compounded semi-annually. The CDs have identical risk. What is the stated, or
nominal, rate that Bank B would have to offer to make you indifferent between the two investments?
A) 9.67%
B) 9.76%
C) 9.83%
D) 9.87%
E) 9.93%
Answer: B
Explanation: B) Effective interest rate =
.10 =
-1
-1
1.10 =
1.0488 =
.0488 =
i = 9.76%
Diff: 3
Section: 2.6
AACSB: Analytical Thinking
9) The future value of $200 received today and deposited at 8 percent compounded semi-annually for
three years is
A) $380.
B) $158.
C) $253.
D) $252.
E) $248.
Answer: C
Explanation: C) FV = PV ×
FV = 200 × (1.04)6 = $253
Using a financial calculator:
N = 6, I/Y = 4, PV = -200, PMT = 0, cpt FV = $253
Diff: 2
Section: 2.5
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10) $1,200 is received at the beginning of year 1, $2,200 is received at the beginning of year 2, and $3,300 is
received at the beginning of year 3. If these cash flows are deposited at 12 percent, their combined future
value at the end of year 3 is
A) $6,700.
B) $17,000.
C) $12,510.
D) $7,504.
E) $8,141.
Answer: E
Explanation: E) Take the future value of each cash flow and then add them together:
FV = PV × (1 + i)n
FV = 1,200 × (1.12)3 = $1,685.91
FV = 2,200 ×(1.12)2 = $2,759.68
FV = 3,300 × (1.12)1 = $3,696
1,685.91 + 2,759.68 + 3,696 = $8,141.59
Diff: 2
Section: 2.2
AACSB: Analytical Thinking
11) The future value of a dollar ________ as the interest rate increases and ________ the farther in the
future an initial deposit is to be received.
A) decreases; decreases
B) decreases; increases
C) increases; increases
D) increases; decreases
Answer: C
Explanation: C) Higher interest rates and more compounding periods increase the future value of a
dollar.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
12) The future value of $100 received today and deposited in an account for four years paying semiannual
interest of 6 percent is
A) $450.
B) $126.
C) $889.
D) $134.
E) $124.
Answer: B
Explanation: B) FV = PV ×
FV = 100 × (1.03)8 = $126.68
Using a financial calculator:
N = 8, I/Y = 3, PV = -100, PMT = 0, cpt FV = $126.68
Diff: 2
Section: 2.5
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13) The future value of $200 received today and deposited for three years in an account which pays
semiannual interest of 8 percent is
A) $253.
B) $252.
C) $158.
D) $134.
E) $248.
Answer: A
Explanation: A) FV = PV ×
FV = 200 × (1.04)6 = $253.06
Using a financial calculator:
N = 6, I/Y = 4, PV = -200, PMT = 0, cpt FV = $253.06
Diff: 2
Section: 2.5
AACSB: Analytical Thinking
14) Joe expects to receive a gift of $1,000 when he graduates one year from today. Joe can invest his gift at
6% compounded annually and he would like to use the funds in four years to purchase an engagement
ring for Mabel. How much will he have in four years to spend on a ring?
A) $1,191.02
B) $1,180.00
C) $1,200.00
D) $1,262.48
E) $1,175.00
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = 1,000 × (1.06)3 = $1,191.02
Using a financial calculator:
N = 3, I/Y = 6, PV = -1000, PMT = 0, cpt FV = $1,191.02
Diff: 2
Section: 2.1
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15) Molly Costner deposits $2,500 in her chequing account today. Her chequing account pays interest of
2.5% compounded annually. Assuming Molly does not withdraw any funds and does not deposit any
additional funds, how much will be in her account in 25 years?
A) $4,096.54
B) $3,750.00
C) $4,102.52
D) $4,634.86
E) $4,062.50
Answer: D
Explanation: D) FV = PV × (1 + i)n
FV = 2,500 × (1.025)25 = $4,634.86
Using a financial calculator:
N = 25, I/Y = 2.5, PV = -2500, PMT = 0, cpt FV = $4,634.86
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
16) Kayla hopes to purchase a new car in five years. If she deposits $10,000 today in an account that pays
7% compounded quarterly, how much will she be able to spend on the new car in five years?
A) $14,025.52
B) $10,700.00
C) $14,147.78
D) $13,500.00
E) $15,000.00
Answer: C
Explanation: C) FV = PV ×
FV = 10,000 × (1.0175)20 = $14,147.78
Using a financial calculator:
N = 20, I/Y = 1.75, PV = -10,000, PMT = 0, cpt FV = $14,147.78
Diff: 2
Section: 2.5
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17) If interest rates are 5%, which of the following will produce the largest amount of money in four
years?
A) $500 earning simple interest
B) $400 with interest compounded annually
C) $300 with interest compounded semiannually
D) $100 with interest compounded quarterly
E) $25 with interest compounded monthly
Answer: A
Explanation: A) FV = PV ×
FV500 = 500 × .05 × 4 + 500 = $600
FV400 = 400 × (1.05)4 = $486.20
FV300 = 300 × (1.025)8 = $365.52
FV100 = 100 × (1.0125)16 = $121.99
FV25 = 25 × (1.0042)48 = $30.52
Diff: 2
Section: 2.5
AACSB: Analytical Thinking
18) What is the effective interest rate of 4% compounded quarterly?
A) 4.60%
B) 4.80%
C) 4.16%
D) 4.06%
E) 4.76%
Answer: D
Explanation: D) Effective interest rate =
Effective interest rate =
-1
- 1 = 4.06%
Diff: 2
Section: 2.6
AACSB: Analytical Thinking
19) At 15% interest compounded annually, approximately how long will it take Walter to double his
money?
A) About five years
B) About three years
C) About seven years
D) About fifteen years
E) About fifty years
Answer: A
Explanation: A) Using a financial calculator:
I/Y = 15, PV = -1, PMT = 0, FV = 2, cpt N = 4.96
Diff: 2
Section: 2.4
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20) How much will you need in 30 years to have the same purchasing power that $150 has today, if
inflation averages 4% per year?
A) $486.51
B) $180.00
C) $120.00
D) $169.08
E) $330
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = 150 × (1.04)30 = $486.51
Using a financial calculator:
N = 30, I/Y = 4, PV = -150, PMT = 0, cpt FV = $486.51
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
21) $100 is received at the beginning of year 1, $200 is received at the beginning of year 3. If these cash
flows are deposited at 12 percent, their combined future value at the end of year three is (Round to the
nearest whole dollar)
A) $672 .
B) $536.
C) $427.
D) $364.
E) $336.
Answer: D
Explanation: D) Step 1 - Calculate the future value of each cash flow.
FV = PV × (1 + i)n
FV100 = 100 × (1.12)3 = 140.49
FV200 = 200 × (1.12)1 = 224
Step 2 - Add the values together.
140.49 + 224 = 364.49 or $364
Diff: 2
Section: 2.2
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22) You have some money on deposit in a bank account which pays a nominal (or quoted) rate of 8.0944
percent, but with interest compounded daily (using a 365 day year). Your friend owns a security which
calls for the payment of $10,000 after 27 months. The security is just as safe as your bank deposit, and
your friend offers to sell it to you for $8,000. If you buy the security, by how much will the effective
annual rate of return on your investment change?
A) 1.87%
B) 1.53%
C) 2.00%
D) 0.96%
E) 0.44%
Answer: C
Explanation: C) Step 1 - Compute the effective rate for the bank account.
Effective interest rate =
-1
Effective interest rate =
- 1 = 8.43%
Step 2 - Compute the nominal rate for the security.
Nominal interest rate =
-1
Nominal interest rate =
- 1 = 9.96%
Step 3 - Convert the nominal rate into an effective rate.
Effective interest rate =
- 1 = 10.47%
Step 4 - Compare the two rates.
10.47% - 8.43% ≈ 2%
Diff: 3
Section: 2.6
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23) If $100 is placed in an account that earns a nominal 4%, compounded quarterly, what will it be worth
in 5 years?
A) $122.02
B) $105.10
C) $135.41
D) $120.90
E) $117.48
Answer: A
Explanation: A) FV = PV ×
FV = 100
= $122.02
On a financial calculator: N = 20, I/Y = 1, PV = -100, cpt FV = $122.02
Diff: 2
Section: 2.5
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24) When you turned 20, you deposited $1,500 into an account paying interest that is compounded
quarterly. You just turned 30, and there is now $2,233.30 in the account. What nominal annual interest
rate is the account paying?
A) 1.00%
B) 4.00%
C) 4.06%
D) 16.24%
E) 3.75%
Answer: B
Explanation: B) i =
i=
- 1 = 4.06% (effective)
Effective interest rate =
.046 =
-1
-1
-1
1.046 =
1.0099 =
.0099 =
i = 4%
Using a financial calculator:
N = 40, PV = -1,500, PMT = 0, FV = 2,233.30, cpt I/Y = 1 1 × 4 = 4.00%
Diff: 3
Section: 2.3
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25) A firm's stock price is $25 per share and is expected to grow at a 5% compound annual rate. What
should the stock price per share be in five years?
A) $26.25
B) $125.00
C) $75.00
D) $31.91
E) $69.66
Answer: D
Explanation: D) FV = PV × (1 + i)n
FV = 25 × (1.05)5 = $31.91
Using a financial calculator:
N = 5, I/Y = 5, PV = -25, PMT = 0, cpt FV = $31.91
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
26) Casey has $1,000 to invest and would like to buy a $3,000 jet-ski in four years. If interest is
compounded annually, what interest rate will she have to receive to reach her goal?
A) 300%
B) 16%
C) 32%
D) 3%
E) 7%
Answer: C
Explanation: C) i =
i=
-1
- 1 = .3161 or 32%
Using a financial calculator:
N = 4, PV = -1,000, PMT = 0, FV = 3,000, cpt I/Y = 31.61 or 32%
Diff: 2
Section: 2.3
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27) If a US Saving bond can be purchased for $29.50 and has a maturity value at the end of 25 years of
$100, what is the annual rate of return on the bond?
A) 5 percent
B) 6 percent
C) 7 percent
D) 8 percent
E) 4 percent
Answer: A
Explanation: A) i =
i=
-1
- 1 = 5%
Using a financial calculator:
N = 25, PV = -29.50, PMT = 0, FV = 100, cpt I/Y = 5%
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
28) If a United States saving bond can be purchased for $14.60 and has a maturity value at the end of 25
years of $100, what is the annual rate of return on the bond?
A) 6 percent
B) 7 percent
C) 8 percent
D) 9 percent
E) 10 percent
Answer: C
Explanation: C) i =
i=
-1
- 1 = 8%
Using a financial calculator:
N = 25, PV = -14.60, PMT = 0, FV = 100, cpt I/Y = 8%
Diff: 2
Section: 2.3
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29) Gary has $1,400 to invest with the goal of having $4,000 available to purchase a used car. If he can
earn 12% compounded semiannually on his investment, how long will he have to wait to acquire his car?
A) Eighteen years
B) Nine years
C) Eighteen months
D) Nine months
E) Four years
Answer: B
Explanation: B) Using a financial calculator:
I/Y = 6, PV = -1400, PMT = 0, FV = 4000, cpt N = 18 semiannual periods, or nine years
Diff: 2
Section: 2.4
AACSB: Analytical Thinking
30) The Vanguard Windsor II mutual fund had a net asset value of $15.07 at the beginning of 1992 and
$24.04 at the beginning of 1997. What was the approximate average annual growth rate in this measure
over this period? (Round to the nearest whole number)
A) 60%
B) 8%
C) 10%
D) 18%
E) 15%
Answer: C
Explanation: C) i =
i=
-1
- 1 = 9.79%
Using a financial calculator:
N = 5, PV = -15.07, PMT = 0, FV = 24.04, cpt I/Y = 9.79%
Diff: 2
Section: 2.3
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31) Kathy deposited $100 in a savings account that paid 8% interest, compounded annually. How much
compound interest did she earn after 2 years?
A) $15.64
B) $16.64
C) $8.08
D) $8.00
E) $8.64
Answer: B
Explanation: B) FV = PV × (1 + i)n
FV = 100 × (1.08)2 = $116.64
$116.64 - 100 = $16.64
Using a financial calculator:
N = 2, I/Y = 8, PV = -100, PMT = 0, cpt FV = $116.64116.64 - 100 = $16.64
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
32) What is the future value of $16.54 after two years if these funds can be invested to earn 5.5%,
compounded annually?
A) $18.24
B) $18.36
C) $18.58
D) $18.50
E) $18.41
Answer: E
Explanation: E) FV = PV × (1 + i)n
FV = 16.54 × (1.055)2 = $18.41
Using a financial calculator:
N = 2, I/Y = 5.5, PV = -16.54, PMT = 0, cpt FV = $18.41
Diff: 2
Section: 2.1
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33) The future value of $200 received today and deposited at 8 percent for three years is (Round to the
nearest whole dollar)
A) $248.
B) $252.
C) $158.
D) $200.
E) $249.
Answer: B
Explanation: B) FV = PV × (1 + i)n
FV = 200 × (1.08)3 = $251.94
Using a financial calculator:
N = 3, I/Y = 8, PV = -200, PMT = 0, cpt FV = $251.94
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
34) The rate of interest actually paid or earned, is the ________ interest rate
A) effective
B) nominal
C) discounted
D) continuous
Answer: A
Explanation: A) When interest is compounded, the amount of interest paid increases resulting in the
effective rate of interest.
Diff: 1
Section: 2.6
AACSB: Analytical Thinking
35) At an inflation rate of 9 percent, the purchasing power of $1 would be cut in half in 8.04 years. How
long to the nearest year would it take the purchasing power of $1 to be cut in half if the inflation rate
were only 4 percent?
A) 12 years
B) 15 years
C) 18 years
D) 20 years
E) 23 years
Answer: C
Explanation: C) Using a financial calculator:
I/Y = 4, PV = -1, PMT = 0, FV = 2, cpt N = 17.67
Diff: 2
Section: 2.4
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36) The future value of $100 received today and deposited at 6 percent for four years is (Round to the
nearest whole dollar)
A) $126.
B) $79.
C) $124.
D) $116.
E) $106.
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = 100 × (1.06)4 = $126.25
Using a financial calculator:
N = 4, I/Y = 6, PV = -100, PMT = 0, cpt FV = $126.25
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
37) Charlene owns stock in a company which has consistently paid a growing dividend over the last five
years. The first year Charlene owned the stock, she received $1.71 per share and in the fifth year, she
received $2.89 per share. What is the growth rate of the dividends over the last five years? (Round to the
nearest whole number)
A) 7 percent
B) 14 percent
C) 12 percent
D) 5 percent
E) 11 percent
Answer: B
Explanation: B) i =
i=
-1
- 1 = 14.02%
Using a financial calculator:
N = 4, PV = -1.71, PMT = 0, FV = 2.89, cpt I/Y = 14.02%
Diff: 2
Section: 2.3
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38) Julian was given a gold coin originally purchased for $1 by his great grandfather 50 years ago. Today
the coin is worth $450. The rate of return realized on the sale of this coin is approximately equal to
A) 7.5%.
B) 13%.
C) 50%.
D) 10%.
E) 15%.
Answer: B
Explanation: B) i =
i=
-1
- 1 = 13%
Using a financial calculator:
N = 50, PV = -1, PMT = 0, FV = 450, cpt I/Y = 13%
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
39) Young Sook owns stock in a company which has consistently paid a growing dividend over the last
10 years. The first year Young Sook owned the stock, she received $4.50 per share and in the 10th year,
she received $4.92 per share. What is the growth rate of the dividends over last 10 years?
A) 5 percent
B) 4 percent
C) 2 percent
D) 1 percent
E) 3 percent
Answer: D
Explanation: D) i =
i=
-1
- 1 = 1%
Using a financial calculator:
N = 9, PV = -4.5, PMT = 0, FV = 4.92, cpt I/Y = .996 or 1%
Diff: 2
Section: 2.3
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40) Given some amount to be received several years in the future, if the interest rate increases, the present
value of the future amount will be
A) higher.
B) lower.
C) stay the same.
D) cannot tell.
E) variable.
Answer: B
Explanation: B) With the same future value, a rise in interest rates will decrease the present value of the
amount.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
41) As the discount rate increases without limit, the present value of the future cash inflows
A) gets larger without limit.
B) stays unchanged.
C) approaches zero.
D) gets smaller without limit, i.e. approaches minus infinity.
Answer: C
Explanation: C) A rise in the discount rate will decrease the present value of the amount, bringing it
closer to zero as it increases.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
42) You deposited ($1,000) in a savings account that pays 8 percent interest, compounded quarterly,
planning to use it to finish your last year in college. Eighteen months later, you decide to go to the Roshy
Mountains to become a ski instructor rather than continue in school, so you close out your account. How
much money will you receive? (Round to the nearest whole dollar)
A) $1,171
B) $1,126
C) $1,082
D) $1,163
E) $1,008
Answer: B
Explanation: B) FV = PV ×
FV = 1,000 × (1.02)6 = $1,126.16
Using a financial calculator:
N = 6, I/Y = 2, PV = -1,000, PMT = 0, cpt FV = $1,126.16
Diff: 2
Section: 2.5
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43) In 1958 the average tuition for one year at an Ivy League school was $1,800. Thirty years later, in 1988,
the average cost was $13,700. What was the growth rate in tuition over the 30-year period?
A) 12%
B) 9%
C) 6%
D) 7%
E) 8%
Answer: D
Explanation: D) i =
i=
-1
- 1 = 7%
Using a financial calculator:
N = 30, PV = -1,800, PMT = 0, FV = 13,700, cpt I/Y = 6.999 or 7%
Diff: 2
Section: 2.3
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44) In its first year of operations, 1980, the Gourmet Cheese Shoppe had earning per share of $0.26. Four
years later, in 1984, EPS was up to $0.38, and 7 years after that, in 1991, EPS was up to $0.535. It appears
that the first four years represented a supernormal growth situation and since then a more normal
growth rate has been sustained. What are the rates of growth for the earlier period and for the later
period? (Round to the nearest whole number)
A) 6%; 5%
B) 6%; 3%
C) 10%; 8%
D) 10%; 5%
E) 12%; 7%
Answer: D
Explanation: D) i =
i=
-1
- 1 = 10%
Using a financial calculator:
N = 4, PV = -.26, PMT = 0, FV = .38, cpt I/Y = 9.95 or 10%
i=
i=
-1
- 1 = 5%
Using a financial calculator:
N = 7, PV = -.38, PMT = 0, FV = .535, cpt I/Y = 5%
Diff: 3
Section: 2.3
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45) Suppose you put $100 into a savings account today, the account pays a nominal annual interest rate of
6 percent, but compounded semiannually, and you withdraw $100 after 6 months. What would your
ending balance be 20 years after the initial $100 deposit was made?
A) $226.20
B) $115.35
C) $62.91
D) $9.50
E) $3.00
Answer: D
Explanation: D) Step 1 - Calculate the amount of interest earned on the $100 before withdrawal.
100 × .03 = $3
Step 2 - Use $3 as the present value and calculate the future value.
FV = PV ×
FV = 3 × (1.03)39 = $9.50
Using a financial calculator:
N = 39, I/Y = 3, PV = -3, PMT = 0, cpt FV = $9.50
Diff: 3
Section: 2.5
AACSB: Analytical Thinking
46) You can deposit your savings at the Darlington National Bank, which offers to pay 12.6 percent
interest compounded monthly, or at the Barlett Bank, which will pay interest of 11.5 percent compounded
daily. (Assume 365 days in a year.) Which bank offers the higher effective annual rate?
A) Darlington National Bank
B) Barlett Bank
C) Both banks offer the same effective rate.
D) Cannot be determined from the information provided.
E) Workable only if the banks use the same compounding period.
Answer: A
Explanation: A) Effective interest rate =
-1
Effective interest rate of Darlington Bank =
Effective interest rate of Barlett Bank =
- 1 = 13.35%
- 1 = 12.19%
Diff: 2
Section: 2.6
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47) A recent advertisement in the financial section of a magazine carried the following claim: "Invest your
money with us at 14 percent, compounded annually, and we guarantee to double your money sooner
than you imagine." Ignoring taxes, how long would it take to double your money at a nominal rate of 14
percent, compounded annually?
A) 3.66 years
B) 5.29 years
C) 7.00 years
D) 10.24 years
E) 14.00 years
Answer: B
Explanation: B) Using a financial calculator:
I/Y = 14, PV = -1, PMT = 0, FV = 2, cpt N = 5.29
Diff: 2
Section: 2.4
AACSB: Analytical Thinking
48) Drexel Corporation has been enjoying a phenomenal rate of growth since its inception one year ago.
Currently, its assets total $100,000. If growth continues at the current rate of 12% compounded quarterly,
what will total assets be in 2 1/2 years? (Round to the nearest whole dollar)
A) $142,571
B) $126,678
C) $148,016
D) $136,855
E) $134,392
Answer: E
Explanation: E) FV = PV ×
FV = 100,000 × (1.03)10 = $134,391.64
Using a financial calculator:
N = 10, I/Y = 3, PV = -100,000, PMT = 0, cpt FV = $134,391.64
Diff: 2
Section: 2.5
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49) Your grandparents bought their collection of one hundred silver dollars at face value in 1952. If they
appreciated at a rate of 3% per year, how much were they worth in 2006?
A) $493.41
B) $262.00
C) $479.04
D) $508.21
E) $518.00
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = 100 × (1.03)54 = $493.41
Using a financial calculator:
N = 54, I/Y = 3, PV = -100, PMT = 0, cpt FV = $493.41
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
50) Your current investment will mature in 2 years for $30,000, at which time you will reinvest the funds
for 10 more years at 7% per year. What will be the value of your investment at the end of the 12th year?
A) $59,014.54
B) $55,153.78
C) $61,985.74
D) $67,565.75
E) $52,734.41
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = 30,000 × (1.07)10 = $59,014.54
Using a financial calculator:
N = 10, I/Y = 7, PV = -30,000, PMT = 0, cpt FV = $59,014.54
Diff: 2
Section: 2.1
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51) Your Godmother established a $3,000 bank account for you when you were born. For the first 10 years
the interest rate on the account was 10%. It has been 7.5% since then. You are now 25 years old and would
like to withdraw the funds. How much money do you have?
A) $23,023.70
B) $18,295.02
C) $32,504.12
D) $25,828.32
E) $23,445.80
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = 3,000 × (1.10)10 × (1.075)15 = $23,023.70
Using a financial calculator:
N = 10, I/Y = 10, PV = -3,000, PMT = 0, cpt FV = $7,781.23
N = 15, I/Y = 7.5, PV = -7,781.23, PMT = 0, cpt FV = $23,023.70
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
52) You have come across an investment opportunity that will give you $51,725.29 in 14 years if you put
up $12,000 today. Calculate the annual return on this investment.
A) 11%
B) 10%
C) 12%
D) 13%
E) 9%
Answer: A
Explanation: A) i =
i=
-1
- 1 = 11%
Using a financial calculator:
N = 14, PV = -12,000, PMT = 0, FV = 51,725.29, cpt I/Y = 10.999 or 11%
Diff: 2
Section: 2.3
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53) Henry purchased stock in Nortel Networks for $120 per share. Unfortunately the stock did not
perform very well in the 3 years that Henry has owned it as it is now trading at $3.93 per share. Feeling
that the value of the stock will only continue to drop, Henry sold his shares today. What annual rate of
return did Henry make on his investment?
A) -68%
B) -66%
C) -67%
D) -69%
E) -70%
Answer: A
Explanation: A) i =
i=
-1
- 1 = -68%
Using a financial calculator:
N = 3, PV = -120, PMT = 0, FV = 3.93, cpt I/Y = -68%
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
54) Jordan will need $20,000 at the end of 6 years to put a down payment on a house. What rate of return
will he need to earn if he can invest $12,250 today?
A) 8.5%
B) 7.5%
C) 8.0%
D) 9.0%
E) 9.5%
Answer: A
Explanation: A) i =
i=
-1
- 1 = 8.5%
Using a financial calculator:
N = 6, PV = -12,250, PMT = 0, FV = 20,000, cpt I/Y = 8.5%
Diff: 2
Section: 2.3
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55) Jordan will need $20,000 at the end of 6 years to put a down payment on a house. What rate of return
will he need to earn if he can invest $9,110 today?
A) 14.0%
B) 13.0%
C) 13.5%
D) 14.5%
E) 15.0%
Answer: A
Explanation: A) i =
i=
-1
- 1 = 14%
Using a financial calculator:
N = 6, PV = -9,110, PMT = 0, FV = 20,000, cpt I/Y = 14%
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
56) You currently have $48,000 in your bank account, which pays annual interest of 5%, and you are
saving up to buy a brand new $150,000 Jaguar convertible. In how many years will you have enough
money to buy the car?
A) 26.0 years
B) 25.0 years
C) 18.0 years
D) 20.0 years
E) 24.0 years
Answer: E
Explanation: E) Using a financial calculator:
I/Y = 5%, PV = -48,000, PMT = 0, FV = 150,000, cpt N = 23.35 or 24 years
Diff: 2
Section: 2.4
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57) How long does it take for your money to double when invested at the rate of 3% (with annual
compounding)?
A) Depends on how much money you start with.
B) 26 years
C) 23 years
D) 25 years
E) 24 years
Answer: E
Explanation: E) Using a financial calculator:
I/Y = 3%, PV = -1, PMT = 0, FV = 2, cpt N = 23.45 or 24 years
Diff: 2
Section: 2.4
AACSB: Analytical Thinking
58) You invest $2,500 today at an interest rate of 20% compounded annually. How much will you
accumulate after 35 years?
A) $1,476,670.57
B) $1,230,558.81
C) $1,506,203.98
D) $1,772,004.69
E) $1,974,367.39
Answer: A
Explanation: A) FV = PV × (1 + i)n
FV = 2,500 × (1.20)35 = $1,476,670.57
Using a financial calculator:
N = 35, I/Y = 20, PV = -2,500, PMT = 0, cpt FV = $1,476,670.57
Diff: 2
Section: 2.1
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59) You have $253.05 today. A friend wants to borrow that money from you and pay you back $310 at the
end of 3 years. What rate of return (per annum) will you earn from the loan?
A) 7.0%
B) 7.2%
C) 6.8%
D) 7.4%
E) 7.6%
Answer: A
Explanation: A) i =
i=
-1
- 1 = 7%
Using a financial calculator:
N = 3, PV = -253.05, PMT = 0, FV = 310, cpt I/Y = 7%
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
60) You have $602.42 today. You want to accumulate $1,320 by investing your money. You have
identified an investment that will generate a return of 4% per annum. How long will you have to invest
(in years) in order to accumulate your desired total?
A) 20 years
B) 17 years
C) 19 years
D) 21 years
E) 22 years
Answer: A
Explanation: A) Using a financial calculator:
I/Y = 4%, PV = -602.42, PMT = 0, FV = 1,320, cpt N = 20 years
Diff: 2
Section: 2.4
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61) You put $100 in a bank for a fixed two year term. The interest rate on the loan is 8% per annum,
compounded semi-annually. Because the term is fixed, you are not allowed to withdraw interest at any
point. What is the total amount of interest earned in the final half-year of the term?
A) $4.00
B) $4.50
C) $4.67
D) $4.16
E) $4.33
Answer: B
Explanation: B) Step 1 - Calculate the future value of the last two periods.
FV = PV ×
FV = 100 × (1.04)4 = $116.99
Using a financial calculator:
N = 4, I/Y = 4, PV = -100, PMT = 0, cpt FV = $116.99
FV = 100 × (1.04)3 = $112.49
Using a financial calculator:
N = 3, I/Y = 4, PV = -100, PMT = 0, cpt FV = $112.49
Step 2 - Take the difference between the future values to find how much interest was earned in the last
period.
116.99 - 112.49 = $4.50
Diff: 3
Section: 2.1
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62) You deposit $100 in a bank for a fixed 7 year term. Interest on the deposit is calculated every half-year
(m = 2) at the rate of 5% per half-year (i/m = 5%). Because the term is fixed, you are not allowed to
withdraw interest at any point. You earn interest in the final compounding period of the term. How
much of that interest is earned off of earlier interest (as opposed to earned off of the principal)?
A) $4.43
B) $9.43
C) $4.90
D) $5.00
E) $9.90
Answer: A
Explanation: A) Step 1 - Calculate the future value at the end of the period.
FV = PV ×
FV = 100 × (1.05)13 = $188.56
Using a financial calculator:
N = 13, I/Y = 5, PV = -100, PMT = 0, cpt FV = $188.56
Step 2 - Find how much interest has been earned.
188.56 - 100 = $88.56
Step 3 - Calculate how much interest will be earned off of that interest.
88.56 × .05 = $4.428 or $4.43
Diff: 3
Section: 2.5
AACSB: Analytical Thinking
63) Shylock Bank offers a savings account with a nominal rate of 7% and daily compounding. What is the
effective rate of the account? (Assume a 365 day year.)
A) 7.25%
B) 7.00%
C) 7.50%
D) 7.10%
E) 7.05%
Answer: A
Explanation: A) Effective interest rate =
Effective interest rate =
-1
- 1 = 7.25%
Diff: 2
Section: 2.6
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64) Shylock Bank offers a savings account with a nominal rate of 9% and quarterly compounding. What is
the effective rate of the account?
A) 9.31%
B) 9.00%
C) 9.20%
D) 9.42%
E) 8.63%
Answer: A
Explanation: A) Effective interest rate =
Effective interest rate =
-1
- 1 = 9.31%
Diff: 2
Section: 2.6
AACSB: Analytical Thinking
65) Shylock Bank offers a savings account with an effective interest rate of 9% and quarterly
compounding. What is the nominal rate (APR) on the account?
A) 8.71%
B) 8.00%
C) 7.55%
D) 6.00%
E) 7.70%
Answer: A
Explanation: A) Effective interest rate =
.09 =
-1
-1
1.09 =
1.02177 =
.02177 =
i = 8.71%
Diff: 2
Section: 2.6
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66) Shylock Bank offers a savings account with an effective interest rate of 15% and weekly
compounding. What is the nominal rate (APR) on the account?
A) 14.00%
B) 16.16%
C) 14.05%
D) 16.08%
E) 15.00%
Answer: A
Explanation: A) Effective interest rate =
.15 =
-1
-1
1.15 =
1.00269 =
.00269 =
i = 14%
Diff: 2
Section: 2.6
AACSB: Analytical Thinking
67) In order to open up your new business you need to take out a loan. First Bank charges 6%
compounded quarterly, and Second Bank charges 6.5% compounded semi-annually. From which bank
would you prefer to obtain your loan?
A) First Bank
B) Second Bank
C) Indifferent
Answer: A
Explanation: A) Effective interest rate =
Effective interest rate for First Bank =
Effective interest rate for Second Bank =
-1
- 1 = 6.14%
- 1 = 6.61%
Diff: 2
Section: 2.6
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68) If you could borrow at 9.5% compounded semi-annually or at 9.4% compounded monthly, which
would you prefer?
A) 9.5% compounded semi-annually
B) Indifferent
C) 9.4% compounded monthly
Answer: A
Explanation: A) Effective interest rate =
-1
Effective interest rate for semi-annual =
- 1 = 9.73%
Effective interest rate for monthly =
- 1 = 9.82%
Diff: 2
Section: 2.6
AACSB: Analytical Thinking
69) Leon's has a "Don't Pay For One Year" event on right now at the store, so you purchase an Italian,
hand-stitched leather sofa. You will pay $1,267.99 for the sofa in one year. Leon's charges 18% annual
interest compounded monthly on overdue payments. If you forget and don't pay for the sofa until 6
months after payment is due, how much will you pay for the sofa at that time?
A) $1,386.48
B) $1,516.03
C) $1,657.70
D) $1,452.06
E) $1,377.39
Answer: A
Explanation: A) FV = PV ×
FV = 1,267.99 × (1.015)6 = $1,386.48
Using a financial calculator:
N = 6, I/Y = 1.5, PV = -1,267.99, PMT = 0, cpt FV = $1,386.48
Diff: 2
Section: 2.5
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70) You wish to deposit $7,000 in an account at the Shylock Bank. The bank pays interest at a nominal
annual rate of 10% compounded quarterly. What is the effective interest rate offered by Shylock?
A) 10.38%
B) 10.00%
C) 9.65%
D) 11.21%
E) 10.47%
Answer: A
Explanation: A) Effective interest rate =
Effective interest rate =
-1
- 1 = 10.38%
Diff: 2
Section: 2.6
AACSB: Analytical Thinking
71) You wish to deposit $7,000 in an account at the Shylock Bank. The bank pays interest at a nominal
annual rate of 10% compounded quarterly. What is the future value in the account after seven years?
A) $13,975.47
B) $13,641.02
C) $13,336.23
D) $14,726.68
E) $14,055.44
Answer: A
Explanation: A) FV = PV ×
FV = 7,000 × (1.025)28 = $13,975.47
Using a financial calculator:
N = 28, I/Y = 2.5, PV = -7,000, PMT = 0, cpt FV = $13,975.47
Diff: 2
Section: 2.5
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72) You wish to deposit $7,000 in an account at the Shylock Bank. The bank pays interest at a nominal
annual rate of 10% compounded monthly. What is the future value in the account after seven years?
A) $14,055.44
B) $13,975.47
C) $13,641.02
D) $13,336.23
E) $14,726.68
Answer: A
Explanation: A) FV = PV ×
FV = 7,000 × (1.0083333)84 = $14,055.44
Using a financial calculator:
N = 84, I/Y = .833333, PV = -7,000, PMT = 0, cpt FV = $14,055.44
Diff: 2
Section: 2.5
AACSB: Analytical Thinking
73) What is the future value of the following cash flows in year 5 with an interest rate of 6%?
Year
1
2
3
4
5
Cash Flow
$200
$400
$600
$800
$1000
A) $3,251.06
B) $3,446.13
C) $3,067.04
D) $3,000.00
E) $3,180.00
Answer: A
Explanation: A) Take the future value of each cash flow and then add them together:
FV = PV × (1 + i)n
FV = 200 × (1.06)4 = $252.49
FV = 400 × (1.06)3 = $476.41
FV = 600 × (1.06)2 = $674.16
FV = 800 × (1.06)1 = $848
252.49 + 476.41 + 674.16 + 848 + 1,000 = $3,251.06
Diff: 2
Section: 2.2
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74) The table shows a series of deposits at different dates into a savings account. If the account pays 10.5%
interest (compounded annually), what is their future value at year 6?
Year
1
2
3
4
5
Cash Flow
$35,000
$7,000
$13,000
$15,000
$5,000
A) $109,477.35
B) $99,074.53
C) $75,000.00
D) $107,569.55
E) $97,790.50
Answer: A
Explanation: A) Take the future value of each cash flow and then add them together:
FV = PV × (1 + i)n
FV = 35,000 × (1.105)5 = $57,660.64
FV = 7,000 × (1.105)4 = $10,436.31
FV = 13,000 × (1.105)3 = $17,540.02
FV = 15,000 × (1.105)2 = $18,315.38
FV = 5,000 × (1.105)1 = $5,525
57,660.64 + 10,436.31 + 17,540.02 + 18,315.38 + 5,525 = $109,477.35
Diff: 2
Section: 2.2
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75) You have the opportunity to purchase an insurance policy for your newborn son. You must make the
payments shown in the table. After his fifth birthday no more payments are required. If your son reaches
the age of 60, then the insurance company will pay him $90,000. Alternatively, you could invest the
money in a savings account. Your banker promises to pay you interest at the rate of 8% for the first 5
years (from now until your son's fifth birthday), but only promises 4% every year after that. Should you
buy the policy or invest in the savings account?
First birthday
Second birthday
Third birthday
Fourth birthday
Fifth birthday
$600
$650
$700
$750
$800
A) Yes, buy the policy.
B) No, do not buy the policy.
C) The policy and the savings account have the same future value.
Answer: A
Explanation: A) Step 1 - Take the future value of each cash flow and then add them together:
FV = PV × (1 + i)n
FV = 600 × (1.08)4 = $816.29
FV = 650 × (1.08)3 = $818.81
FV = 700 × (1.08)2 = $816.48
FV = 750 × (1.08)1 = $810
816.29 + 818.81 + 816.48 + 810 + 800 = $4,061.58
Step 2 - Use the future value of the first five birthday cash flows to find the future value of the remaining
fifty-five years.
FV = 4,061.58 × (1.04)55 = $35,117.91
$35,117.91 < $90,000 so take the policy
Diff: 3
Section: 2.2
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LO3: Calculate the Present Value of a Sum
1) Suzanne has identified a project with the following cash flows. What is the present value of the cash
flows at time 0 if the interest rate is 9%?
Year
1
2
3
4
Cash Flow
$2,000
$650
$375
$1,200
A) $3,521.63
B) $3,230.86
C) $3,838.58
D) $4,225.00
E) $3,488.90
Answer: A
Explanation: A) Find the present value of each cash flow and then add them together.
PV =
PV =
= $1,834.86
PV =
= $547.09
PV =
= $289.57
PV =
= $850.11
1,834.86 + 547.09 + 289.57 + 850.11 = $3,521.63
Diff: 2
Section: 3.2
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2) Suzanne has identified a project with the following cash flows. What is the present value of the cash
flows at time 0 if the interest rate is 17%?
Year
1
2
3
4
Cash Flow
$2,000
$650
$375
$1,200
A) $3,058.75
B) $3,578.74
C) $2,614.32
D) $4,225.00
E) $3,521.63
Answer: A
Explanation: A) Find the present value of each cash flow and then add them together.
PV =
PV =
= $1,709.40
PV =
= $474.83
PV =
= $234.14
PV =
= $640.38
1,709.40 + 474.83 + 234.14 + 640.38 = $3,058.75
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
3) You have determined the profitability of a planned project by finding the present value of all the cash
flows from that project. Which of the following would cause the project to look more appealing in terms
of the present value of those cash flows?
A) The discount rate decreases.
B) The cash flows are extended over a longer period of time, but the total amount of the cash flows
remains the same.
C) The discount rate increases.
D) The cash flows occur over the same time period and total the same amount, but the cash flows are
larger toward the end of the project.
E) The cash flows are extended over a longer period of time and the total amount of the cash flows
remains the same, but the cash flows are larger toward the end of the project.
Answer: A
Explanation: A) A decreasing discount rate will increase the present value of the project's cash flows.
Diff: 1
Section: 3.4
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AACSB: Analytical Thinking
4) What is the present value of $2,000 to be received in six years if interest rates are 8% compounded
semiannually? (Round to the nearest whole dollar)
A) $1,258
B) $1,249
C) $1,852
D) $1,158
E) $1,923
Answer: B
Explanation: B) PV =
PV =
= $1,249.19
Using a financial calculator:
N = 12, I/Y = 4, PMT = 0, FV = -2000, cpt PV = $1,249.19
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
5) Approximately how much must Tiffany invest today to accumulate $10,000 in ten years if she can earn
10% compounded annually? (Round to the nearest whole dollar)
A) $4,225
B) $3,753
C) $5,349
D) $3,855
E) $2,973
Answer: D
Explanation: D) PV =
PV =
= $3,855.43
Using a financial calculator:
N = 10, I/Y = 10, PMT = 0, FV = -10,000, cpt PV = $3,855.43
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
6) Current assets values may be estimated by calculating
A) the future value of all cash flows expected from the asset.
B) a sum of all cash flows forecasted from the use and/or sale of the asset.
C) the present value of all future cash flows expected from the asset.
D) the cash flows expected from the asset without adjusting for the time value of money.
E) only the present value of the cash flows to be received in the first two years since later cash flows are
too uncertain to be considered.
Answer: C
Explanation: C) The value of any asset is the sum of all its future cash flows discounted back to today.
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Diff: 1
Section: 3.1
AACSB: Analytical Thinking
7) Penny just won the state lottery that offers a choice of payments. She may opt for either receiving
$1,000,000 today or $2,000,000 at the end of ten years. If she can invest her funds at 5% annually, which is
the better choice?
A) The later payment since $1,000,000 invested at 5% for ten years will be worth $1,500,000.
B) The immediate payment since the present value of the $2,000,000 payment is $1,200,000.
C) The earlier payment since the future value of $1,000,000 in ten years is $1,628,894.
D) The earlier payment since the present value of the $2,000,000 payment is $876,000.
E) The later payment since the present value of the $2,000,000 payment is $1,227,827.
Answer: E
Explanation: E) PV =
PV =
= $1,227,827
Using a financial calculator:
N = 10, I/Y = 5, PMT = 0, FV = -2,000,000, cpt PV = $1,227,826.51
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
8) How much does Ralph need to invest today to have $150,000 in five years if he will earn 8% interest
compounded quarterly on his investment? (Round to the nearest whole dollar)
A) $100,946
B) $102,041
C) $101,351
D) $73,171
E) $105,453
Answer: A
Explanation: A) PV =
PV =
= $100,945.70
Using a financial calculator:
N = 20, I/Y = 2, PMT = 0, FV = -150,000, cpt PV = $100,945.70
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
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9) Your grandfather has left you $150,000 in a trust fund that you cannot have for another seven years.
You have decided that you really need this money now to pay for your college expenses. Your attorney
offers you $80,000 for an assignment of the proceeds of the trust. If you can get a student loan at 10%,
should you accept your attorney's offer?
A) No, because the $150,000 is worth more than $80,000 today.
B) No, because the $150,000 is worth less than $80,000 today.
C) Yes, because the $150,000 is worth more than $80,000 today.
D) Yes, because the $150,000 is worth less than $80,000 today.
Answer: D
Explanation: D) PV =
PV =
= $76,973.72
Using a financial calculator:
N = 7, I/Y = 7, PMT = 0, FV = -150,000, cpt PV = $76,973.72
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
10) The present value of $100 to be received 10 years from today, assuming an opportunity cost of 9
percent, is (Round to the nearest whole dollar)
A) $236.
B) $699.
C) $42.
D) $75.
E) $50.
Answer: C
Explanation: C) PV =
PV =
= $42.24
Using a financial calculator:
N = 10, I/Y = 9, PMT = 0, FV = -100, cpt PV = $42.24
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
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11) The present value of $200 to be received 10 years from today, assuming an opportunity cost of 10
percent, is (Round to the nearest whole dollar)
A) $50.
B) $200.
C) $518.
D) $77.
E) $150.
Answer: D
Explanation: D) PV =
PV =
= $77.11
Using a financial calculator:
N = 10, I/Y = 10, PMT = 0, FV = -200, cpt PV = $77.11
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
12) In 6 years you are going to need $1,000 dollars. How much will you need to invest today at 7% in
order to save the money you need?
A) $666.34
B) $712.99
C) $622.75
D) $704.23
E) $646.99
Answer: A
Explanation: A) PV =
PV =
= $666.34
Using a financial calculator:
N = 6, I/Y = 7, PMT = 0, FV = -1,000, cpt PV = $666.34
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
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13) You want to have $14,521 at the end of four years. How much do you have to invest today to
accumulate that total if you can earn 6% compounded annually?
A) $11,501.99
B) $12,192.11
C) $11,524.60
D) $11,287.51
E) $11,853.46
Answer: A
Explanation: A) PV =
PV =
= $11,501.99
Using a financial calculator:
N = 4, I/Y = 6, PMT = 0, FV = -14,521, cpt PV = $11,501.99
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
14) You want to have $55,230 at the end of seven years. How much do you have to invest today to
accumulate that total if you can earn 14% compounded annually?
A) $22,071.97
B) $19,361.38
C) $20,763.00
D) $22,092.00
E) $22,074.34
Answer: A
Explanation: A) PV =
PV =
= $22,071.97
Using a financial calculator:
N = 7, I/Y = 14, PMT = 0, FV = -55,230, cpt PV = $22,071.97
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
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15) You have just won $50,000 on your Scratch and Win ticket, but you won't be awarded the money until
your 40th birthday, 20 years from now. If the appropriate discount rate is 15%, what is the present value
of your winnings?
A) $3,055.01
B) $3,513,27
C) $2,656.53
D) $3,048.78
E) $3,067.49
Answer: A
Explanation: A) PV =
PV =
= $3,055.01
Using a financial calculator:
N = 20, I/Y = 15, PMT = 0, FV = -50,000, cpt PV = $3,055.01
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
16) A real estate agent wants you to buy a plot of land today for $60,000 and he promises that you can sell
it back to him in 7 years for $100,000. If you can earn 9% on alternative investments, then what is the
present value of the sales proceeds? Is this a worthwhile investment?
A) $54,703.42; it is not a worthwhile investment.
B) $54,703.42; it is a worthwhile investment.
C) $61,294.51; it is not a worthwhile investment.
D) $61,294.51; it is a worthwhile investment.
E) $60,000; not enough information.
Answer: A
Explanation: A) PV =
PV =
= $54,703.42
Using a financial calculator:
N = 7, I/Y = 9, PMT = 0, FV = -100,000, cpt PV = $54,703.42
54,703.42 < 60,000 so this is not a worthwhile investment
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
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17) Your aunt dies and leaves you $1M in her will, but it must stay in trust for 10 years. You want to
spend it now, so you go to the Bank to borrow against the bequest. You offer the $1M to repay interest
and principal at the end of ten years. The Bank wants to earn 5% on its loan, so how much will it offer
you today?
A) $613,913.25
B) $617,283.95
C) $675,564.17
D) $558,394.78
E) $1,000,000.00
Answer: A
Explanation: A) PV =
PV =
= $613,913.25
Using a financial calculator:
N = 10, I/Y = 5, PMT = 0, FV = -1,000,000, cpt PV = $613,913.25
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
18) In 6 years you are going to need $1,000 dollars. How much will you need to invest today at 7% in
order to save the money you need?
A) $666.34
B) $630.17
C) $790.31
D) $670.66
E) $596.27
Answer: A
Explanation: A) PV =
PV =
= $666.34
Using a financial calculator:
N = 6, I/Y = 7, PMT = 0, FV = -1,000, cpt PV = $666.34
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
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19) Leon's has a "Don't Pay For One Year" event on right now at the store, so you purchase an Italian,
hand-stitched leather sofa. You will pay $1,267.99 for the sofa in one year. You have a savings account
that pays 3% annual interest. How much must you deposit in your account today in order to have
enough money to pay for the sofa in one year?
A) $1,231.06
B) $1,267.99
C) $1,195.20
D) $1,230.56
E) $1,337.21
Answer: A
Explanation: A) PV =
PV =
= $1,231.06
Using a financial calculator:
N = 1, I/Y = 3, PMT = 0, FV = -1,267.99, cpt PV = $1,231.06
Diff: 2
Section: 3.1
AACSB: Analytical Thinking
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20) Consider the two investments shown in the table. Find the present value of each at Year 0 assuming
an interest rate of 5%. What is the percentage difference in the present values (with Investment 1 as the
base of the percentage)?
Year
0
1
2
3
Investment #1
$0
$100
$100
$1,100
Investment #2
$0
$100
$1,100
$0
A) -3.8%
B) -2.6%
C) 3.5%
D) 4.3%
E) -4%
Answer: A
Explanation: A) Step 1 - Find the present value of each investment.
PV =
=
+
+
= $1,136.16
=
+
= $1,092.97
Step 2 - Find the percentage difference between the two investments.
= -3.8%
Diff: 3
Section: 3.2
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 4 Annuities and Loans
LO1: Find the Future Value of Streams of Payments
1) There are no questions in this section.
AACSB: Analytical Thinking
LO2: Find the Present Value of Streams of Payments
1) There are no questions in this section.
AACSB: Analytical Thinking
LO3: Find Solutions to Advanced TVM Problems
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1) There are no questions in this section.
AACSB: Analytical Thinking
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LO4: Understand Balloon and Amortized Loans
1) Culligan Ltd. sells its Gold Series water softener for $1700. It also offers a 48 month lease with end of
month payments of $34. At the end of the 48 month term customers have to make a final lump sum 'buyout' payment. After the buy-out the customer owns their water softener. Culligan advertises its financing
rate of 5.9% APR. What buyout makes this a fair deal?
A) $249.44
B) $293.22
C) $315.65
D) $342.41
Answer: C
Explanation: C) We know the following about the Culligan lease:
Principal = $1700
Down Payment = $0
PMT = $34 at the end of each month
Term = 48 months
i = 5.9%
m = 12
i/m = 0.49167%
Unlike a car lease which requires payments at the beginning of the month, Culligan requires payments be
made at the end of the month. You must multiply the payment by the PVIFA in the equation of value for
a lease, and not the PVIFADue.
Principal0 = Down Payment + PMT × PVIFA + Buyout × PVIF
$1700 = $0 + $34 × PVIFA(0.49167%, 48) + Buyout × PVIF(0.49167%, 48)
$1700 = $34 × 42.6636 + Buyout × 0.79024
Buyout = $315.65
Diff: 4
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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2) You are looking to lease a Chrysler 300. The lease rate is 4%, the term is 36 months, and the buyout at
the end of the term is $18,000. The lease calls for monthly (beginning-of-month) payments. The Chrysler
300 has a MSRP of $45,000. What are the monthly lease payments?
A) $794.50
B) $854.30
C) $1328.58
D) $2065.33
Answer: B
Explanation: B) We know the following about the Chrysler lease:
Principal = $45,000
Buyout = $18,000
Down Payment = $0
Term = 36 months
i = 4.0%
m = 12
i/m = 0.3333%
Input these values into the equation of value for a lease, and solve for the unknown payment (PMT):
Principal0 = Down Payment + PMT × PVIFADue + Buyout × PVIF
$45,000 = $0 + PMT × PVIFADue(0.3333%, 36) + $18,000 × PVIF(0.3333%, 36)
$45,000 = PMT × 33.9837 + $18,000 × 0.8871
PMT = $854.30
Diff: 3
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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3) What are the monthly (beginning of month) lease payments for a BMW 535i, given the information
provided in the table below?
Model
Horse Power
MSRP
Down Payment
Buyout
Term
Lease Rate
BMW 535i
300hp
$69,800
$0
$36,296
36 months
6.9%
A) $1,175
B) $1,235
C) $1,345
D) $1,939
Answer: B
Explanation: B) We know the following about the BMW lease:
Principal = $69,800
Buyout = $36,296
Down Payment = $0
Term = 36 months
i = 6.9%
m = 12
i/m = 0.5750%
Input these values into the equation of value for a lease, and solve for the unknown payment (PMT):
Principal0 = Down Payment + PMT × PVIFADue + Buyout × PVIF
$69,800 = $0 + PMT × PVIFADue(0.5750%, 36) + $36,296 × PVIF(0.5750%, 36)
$69,800 = PMT × 32.620968 + $36,296 * 0.8135
PMT = $1,235.58
Diff: 3
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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4) You want to lease a Hudson Eight Coupe which sells for $36,990. The lease has a term of 36 months at a
rate of 9.5% APR. At the end of the term the buyout for the lease is 40% of the purchase price. What are
the monthly lease payments?
A) $705.36
B) $821.57
C) $1,175.59
D) $3,285.48
Answer: B
Explanation: B) We know the following about the Hudson lease:
Principal = $36,990
Buyout = 0.40 × $36,990 = $14,796
Down Payment = $0
Term = 36 months
i = 9.5%
m = 12
i/m = 0.79167%
Input these values into the equation of value for a lease, and solve for the unknown payment (PMT):
Principal0 = Down Payment + PMT × PVIFADue + Buyout × PVIF
$36,990 = $0 + PMT × PVIFADue(0.79167%, 36) + $14,796 × PVIF(0.79167%, 36)
$36,990 = PMT × 32.620968 + $36,296 * 0.8135
PMT = $821.57
Diff: 3
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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5) You can lease a Lincoln LS Premium for $809.72 per month for 36 months, or you can purchase the car
for $55,000. The lease buyout is $27,907.20 and the lease rate is 1.9% APR. Is it more economical to lease or
buy the car? (Ignore taxes.)
A) Lease
B) Buy
C) Indifferent
Answer: A
Explanation: A) We know the following about the Lincoln LS Premium lease:
Principal = $55,000
Down Payment = $0
Buyout = $27,907.20
PMT = $809.72 at the beginning of each month
Term = 36 months
i = 1.9%
m = 12
i/m = 0.1583%
In order to determine if it is more economical to lease or buy we must first calculate the present value of
the monthly payments, discounted at the monthly lease rate (the APR divided by 12 months). Then we
can compare this value to the sticker price of $55,000.
PV Payments = PMT × PVIFADue(0.1583%,36) + Buyout × PVIF(0.1583%,36)
PV Payments =$1562.46 × 35.0217 + $27,907.20 × 0.944837
PV Payments = $54,720
Therefore it is cheaper to lease ($54,720 vs. $55,000 to buy).
Diff: 3
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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6) You want to lease a Nash Rambler which sells for $26,990. The lease has a term of 48 months at a rate of
3.9% APR. At the end of the term the lease buyout is $12,955.20. You can afford to make a $2,000 down
payment. What are the monthly lease payments?
A) $312.29
B) $335.36
C) $341.57
D) $357.21
E) $365.59
Answer: A
Explanation: A) We know the following about the Hudson lease:
Principal = $36,990
Buyout = $12,955.20
Down Payment = $2,000
Term = 48 months
i = 3.9%
m = 12
i/m = 0.325%
Input these values into the equation of value for a lease, and solve for the unknown payment (PMT):
Principal0 = Down Payment + PMT × PVIFADue + Buyout × PVIF
$26,990 = $2,000 + PMT × PVIFADue(0.325%, 48) + $12,955.20 × PVIF(0.325%, 48)
$26,990 = $2,000 + PMT × 44.5209 + $12,955.2 × 0.8557756
PMT = $312.29
Diff: 3
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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7) You want to lease a LaSalle Series 37 convertible which sells for $56,990. The lease has a term of 48
months at a rate of 4.9% APR. At the end of the term the lease buyout is $27,925.10. You can afford to
make a $4,000 down payment. What are the monthly lease payments?
A) $687.31
B) $735.36
C) $741.47
D) $757.57
E) $778.88
Answer: A
Explanation: A) We know the following about the Hudson lease:
Principal = $56,990
Buyout = $27,925.10
Down Payment = $4,000
Term = 48 months
i = 4.9%
m = 12
i/m = 0.40833%
Input these values into the equation of value for a lease, and solve for the unknown payment (PMT):
Principal0 = Down Payment + PMT × PVIFADue + Buyout × PVIF
$56,990 = $4,000 + PMT × PVIFADue(0.40833%, 48) + $27,925.10 × PVIF(0.40833%, 48)
$56,990 = $4,000 + PMT × 43.68615 + $27,925.10 × 0.82234
PMT = $687.31
Diff: 3
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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8) Whirlpool sells its 4.0 cubic foot, stainless steel front load washer and steam dryer set for $1,400. It also
offers a 48 month lease purchase financing arrangement with end-of-month payments of $30. Customers
have to make a final lump-sum payment called the "buy-out." After the buy-out customers own their
washer-dryer. Whirlpool advertises its financing rate of 7% APR. What buyout makes this a fair deal?
A) $182.83
B) $194.59
C) $198.62
D) $225.47
Answer: B
Explanation: B) We know the following about the lease:
Principal = $1400
Down Payment = $0
PMT = $30 at the end of each month
Term = 48 months
i = 7.0%
m = 12
i/m = 0.5833%
Unlike a car lease which requires payments at the beginning of the month, Whirlpool requires payments
be made at the end of the month. You must multiply the payment by the PVIFA in the equation of value
for a lease, and not the PVIFADue.
Principal0 = Down Payment + PMT × PVIFA + Buyout × PVIF
$1400 = $0 + $30 × PVIFA(0.5833%, 48) + Buyout × PVIF(0.5833%, 48)
$1400 = $30 × 41.7602 + Buyout × 0.75640
Buyout = $194.59
Diff: 4
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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9) As a graduation present, your father has given you $5000 to use as a down payment for a brand new
Audi A4. The price of the A4 is $60,000. You will get a 48-month lease at 7.9% APR. The buyout at the end
of the lease term is 40% of its purchase price. What are the (beginning of month) lease payments?
A) $750.41
B) $907.37
C) $913.35
D) $1035.18
Answer: B
Explanation: B) We know the following about the Audi lease:
Principal = $60,000
Buyout = 0.40 × $60,000 = $24,000
Down Payment = $5,000
Term = 48 months
i = 7.9%
m = 12
i/m = 0.6583%
Input these values into the equation of value for a lease, and solve for the unknown payment (PMT):
Principal0 = Down Payment + PMT × PVIFADue + Buyout × PVIF
$60,000 = $5,000 + PMT × PVIFADue(0.6583%, 48) + $24,000 × PVIF(0.6583%, 48)
$55,000 = PMT × 41.311 + $24,000 * 0.7298
PMT = $907.37
Diff: 4
Section: 4.3 Car Leases
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10) One year ago you signed a 4 year lease on a Mazda3 Sport. The sticker price on the car was $21,200,
you made no down payment, the lease rate was 3%, and the monthly payments (starting at the time of
signing) were $252.64. The buyout was $11,000 due at the end of the lease term. Now (two years after
signing the lease but just before the 25th lease payment) Mazda has just released the new Mazda3 with
better styling and fuel economy. You want to get out of your lease on the old Mazda3 Sport and lease one
of the new ones. Mazda is happy to take your old model from you and cancel the lease if you have
positive equity in the car. Equity is defined as the market value of the car (today) minus the principal
outstanding. The market value of your old car is $18,650. What is the value of your equity in the car?
A) -$2863.53
B) -$113.47
C) $1490.89
D) $2436.51
Answer: B
Explanation: B) Equity = resale value - principal owing
The principal owing prior to the 13th payment is the present value of the remaining payments discounted
at the lease rate. The remaining payments include 36 monthly payments and the buyout.
Principal owing = PV of lease payments
PV of Lease Payments = PMT × PVIFADue + Buyout × PVIF
PV of Lease Payments = $252.64 × PVIFADue(0.25%, 36) + $11,000 × PVIF(0.25%, 36)
PV of Lease Payments = $8709.09 + $10054.374
PV of Lease Payments = $18,763.47
Equity = $18,650 - $18,763.47 = -$113.47
As you can see, you do not have positive equity in the car.
Diff: 4
Section: 4.3 Car Leases
AACSB: Analytical Thinking
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11) One year ago you signed a 3 year lease on a Dodge Challenger SRT, which has 470 horsepower and a
HEMI V8 engine. The sticker price on the car was $47,245. You chose not to make a down payment, the
lease rate was 6%, and the monthly payments (starting at the time of signing) were $820.64. The buyout is
51% of the sticker price, due at the end of the lease term. Now (one year after signing the lease but just
before the 13th lease payment) gas prices have risen so sharply that you want to get out of your lease on
the Challenger and lease a more fuel-efficient car. How much do you still owe?
A) $16,301.77
B) $18,608.59
C) $21,376.69
D) $39,985.29
Answer: D
Explanation: D) We know the following about the Dodge Challenger SRT lease:
Principal = $47,245
Buyout = 0.51 × $47,245 = $24,094.95
Down Payment = $0
Monthly Payments = $820.64
Term = 36 months
i = 6%
m = 12
i/m = 0.50%
The principal owing prior to the 13th payment is the present value of the remaining payments discounted
at the lease rate. The remaining payments include 24 monthly payments and the buyout.
Principal owing = PV of lease payments
PV of Lease Payments = PMT × PVIFADue + Buyout × PVIF
PV of Lease Payments = $820.64 × PVIFADue(0.50%, 24) + $24,094.95 × PVIF(0.50%, 24)
PV of Lease Payments = $18,608.5931 + $21,376.6943
PV of Lease Payments = $39,985.2856
Diff: 4
Section: 4.3 Car Leases
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12) Two years ago you signed a 5 year lease on an Aston Martin DB9, one of the most timeless sports cars
ever produced. The sticker price on the car was $174,900, you made a $10,000 down payment, the lease
rate was 7%, and the monthly payments (starting at the time of signing) were $2,274.76. The buyout was
$69,960 due at the end of the lease term. Now (two years after signing the lease but just before the 25th
lease payment) Aston Martin has just released the new DB9 with even better styling and more luxurious
features. You want to get out of your lease on the old DB9 and lease one of the new ones. How much do
you still owe?
A) $56,743.08
B) $74,101.07
C) $120,844.15
D) $130,844.15
Answer: D
Explanation: D) We know the following about the Dodge Challenger SRT lease:
Principal = $174,900
Buyout = $69,960
Down Payment = $10,000
Monthly Payments = $2274.76
Term = 60 months
i = 7%
m = 12
i/m = 0.5833%
The principal owing prior to the 25th payment is the present value of the remaining payments discounted
at the lease rate. The remaining payments include 36 monthly payments and the buyout. Notice that we
do not include the down payment, as it was paid at the time the lease was signed.
Principal owing = PV of lease payments
PV of Lease Payments = PMT × PVIFADue + Buyout × PVIF
PV of Lease Payments = $2274.76 × PVIFADue(0.583%, 36) + $69960 × PVIF(0.583%, 36)
PV of Lease Payments = $74,101.07 + $56,743.08
PV of Lease Payments = $130,844.15
Diff: 4
Section: 4.3 Car Leases
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13) The BMW 650i Cabriolet has a MSRP of $105,500. The car has a 360hp engine. The lease rate is 7.9%.
On a 3 year lease the buyout at the end of the term is $58,025. Annual lease payments are $21,290.67. With
leases, all payments (down-payments, lease payments and the buyout) are taxed. The tax rate is 13%.
What is the present value of the taxes on the BMW lease? (Discount at the lease rate.)
A) $13,005
B) $14,710
C) $13,715
D) $14,189
Answer: C
Explanation: C) To find the present value of the taxes on the lease multiply the payments and buyout by
the tax rate, 13%. Then simply discount these cash flows back to time zero:
PV Taxes = 0.13 × 21,290.67 × PVIFADue(.079,3) + 0.13 × 58,025 × PVIF(.079,3)
PV Taxes = $13,715
Diff: 4
Section: 4.3 Car Leases
AACSB: Analytical Thinking
14) The BMW 650i Cabriolet has a MSRP of $105,500. The lease rate is 7.9%. On a 3 year lease the buyout
at the end of the term is $58,025. Annual lease payments are $21,290.67. BMW Financial Services will also
lend you the money to buy the 650i at an interest rate of 7.9% per annum. Loan payments are made at the
end of each year. With the loan you must borrow enough to buy the car plus sales tax. On the lease, you
pay tax on all payments (down-payments, lease payments and the buyout). The tax rate is 13%. Which
financing alternative generates a larger tax liability on a present value basis?
A) Leases generate the same tax liability as loans;
B) Leases generate a smaller tax liability than loans;
C) Leases generate a larger tax liability than loans;
Answer: A
Explanation: A) PV Taxes for Loan = 0.13 × 105, 500
PV Taxes for Loan= $13,715
PV Taxes for Lease = 0.13 × 21,290.67 × PVIFA Due(.079,3) + 0.13 × 58,025 × PVIF(.079,3)
PV Taxes for Lease = $13,715
Therefore leases and loans generate the same retail tax payments on a present value basis.
Diff: 4
Section: 4.3 Car Leases
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15) You have just purchased a $250,000 home, and the bank has quoted you an interest rate of 6.5% on a
25-year mortgage. You chose to make 26 payments per year. What periodic rate should you use to
calculate the mortgage payments?
A) 0.2463%
B) 0.2471%
C) 0.2475%
D) 0.2479%
Answer: A
Explanation: A) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.065/2)^(2/26) -1
j = 0.002463
Diff: 2
Section: 4.4 Mortgages
AACSB: Analytical Thinking
16) You bought a ski chalet at Whistler for $270,000. You borrow the full amount over a 30-year term. The
bank quotes you a rate of 3%. You select monthly payments. What periodic rate will you use to solve for
the mortgage payments?
A) 0.2455%
B) 0.2465%
C) 0.2475%
D) 0.2485%
Answer: D
Explanation: D) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
Where
i = the quoted rate
m = the number of payments
j = (1 + 0.03/2)^(2/12) -1
j = 0.0024845
Diff: 2
Section: 4.4 Mortgages
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17) You want to buy a house in Scarborough for $563,000. You plan to make a down payment of $73,190
and you intend to borrow the remainder with a mortgage. The bank quotes a rate of 5.95% for a 25 year
term. You elect to make semi-monthly payments (2 payments per month). What is the semi-monthly rate
(periodic rate) on the mortgage?
A) 0.2446%
B) 0.2479%
C) 0.2516%
D) 0.2525%
Answer: A
Explanation: A) Bank EAR = (1 + APR/2) 2 - 1
For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.0595/2)^(2/24) - 1
j = 0.002445991
j = 0.2446%
Diff: 2
Section: 4.4 Mortgages
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18) You have just purchased a $250,000 home, and the bank has quoted you an interest rate of 6.5% on a
25-year mortgage. You chose the make 26 payments per year. How much is each mortgage payment?
A) $768
B) $772
C) $776
D) $780
Answer: B
Explanation: B) Mortgage payments are just amortized loan payments and are solved using the
amortized loan equation of value:
Principal = PMT * PVIFAj,n*m
For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.065/2)^(2/26) -1
j = 0.00246326
n = 25
n * m = 25 * 26 = 650
PVIFA = (1 - (1 + 0.00246326)^(-26 * 25))/0.00246326
PVIFA = 323.9330147
PMT = Principal/ PVIFAj,n*m
PMT = 250,000/323.9330147
PMT = $771.76
Diff: 3
Section: 4.4 Mortgages
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19) Your mortgage loan has a principal of $700,000, an amortization period of 20 years and a quoted rate
of 5%. You elect to make 24 payments per year. What is the size of each mortgage loan payment?
A) $2,298
B) $2,302
C) $2,306
D) $2,310
Answer: A
Explanation: A) Mortgage payments are just amortized loan payments and are solved using the
amortized loan equation of value:
Principal = PMT * PVIFAj,n*m
For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.05/2)^(2/24) -1
j = 0.0020598
n = 20
n * m = 20 * 24 = 480
PVIFA = (1 - (1 + 0.0020598)^(-20 * 24))/ 0.0020598
PVIFA = 304.66954
PMT = Principal/ PVIFAj,n*m
PMT = 700,000/304.6695436
PMT = $2297.57
Diff: 3
Section: 4.4 Mortgages
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20) You bought a ski chalet at Whistler for $270,000. You borrow the full amount over a 30-year term. The
bank quotes you a rate of 6%. You select bi-weekly payments (26 payments per year). What are the biweekly mortgage payments?
A) $730
B) $735
C) $740
D) $745
Answer: C
Explanation: C) Mortgage payments are just amortized loan payments and are solved using the
amortized loan equation of value:
Principal = PMT * PVIFAj,n*m
For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.06/2)^(2/26) -1
j = 0.002276341
n = 30
n * m = 30 * 26 = 780
PVIFA = (1 - (1.002276341)^-780)/0.002276341
PVIFA = 364.7375
PMT = Principal/ PVIFAj,n*m
PMT = 270,000/364.7375
PMT = $740.26
Diff: 3
Section: 4.4 Mortgages
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21) You are planning to buy a ski chalet in Fernie for $300,000. You intend to make a down payment of
11% of the price and borrow 89%. Banks are quoting an annual rate of 5% (APR) on a five year term. You
choose a 30 year amortization with semi-monthly payments (two payments per month). What are your
semi-monthly mortgage payments?
A) $711.74
B) $716.34
C) $722.87
D) $775.64
Answer: A
Explanation: A) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.05/2)^(2/24) -1
j = 0.0020598
Principal = PMT * PVIFAj,n*m
n = 30
n * m = 30 * 24 = 720
PVIFA = (1 - (1 + 0.0020598)^(-720))/0.0020598
PVIFA = 375.13487
PMT = Principal/ PVIFAj,n*m
PMT = 267000/ 375.13487
PMT = $711.74
Diff: 3
Section: 4
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22) You have obtained a 20 year, $200,000 mortgage with a quoted rate of 5% for your brand new house
located in Forest Hill, Toronto. You choose to make bi-weekly payments (i.e. every other week). Your
payments are $605.90. What will the principal outstanding be after five years? Please round your answer
to two decimal places.
A) $163,119
B) $165,437
C) $166,755
D) $167,822
Answer: C
Explanation: C) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.05/2)^(2/26) - 1 = 0.0019012368
The principal outstanding is equal to the present value of the remaining payments:
Principal = PMT * PVIFAj,n * m
Where
n = 20 - 5 = 15
n * m = 15 × 26 = 390
Principal Outstanding = $605.90 × [(1 - (1.0019012368)^(-390))/0.0019012368]
Principal Outstanding = $166,755.45
Diff: 3
Section: 4.4 Mortgages
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23) Your mortgage loan has a principal of $250,000, an amortization period of 25 years and a quoted rate
of 3%. You elect to make semi-monthly payments of $591.19. How much principal do you pay in the first
year?
A) $6,763
B) $6,781
C) $6,792
D) $6,837
Answer: D
Explanation: D) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.03/2)^(2/24) - 1 = 0.001241488
The principal outstanding is equal to the present value of the remaining payments:
Principal = PMT × PVIFAj,n * m
Where
n = 25 - 1 = 24
n * m = 24 × 24 = 576
Principal Outstanding = $591.19 × PVIFAj,n * m
Principal Outstanding = $591.19 × 411.3116046
Principal Outstanding = $243,163.31
Principal Paid = $250,000 - $243,163.31 = $6,836.69
Diff: 3
Section: 4.4 Mortgages
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24) You bought a ski chalet at Whistler for $270,000. You borrow the full amount over a 30-year term. The
bank quotes you a rate of 6%. You select bi-weekly payments. After 3 years, how much principal is
outstanding on this mortgage?
A) $259,290
B) $259,375
C) $259,431
D) $259,576
Answer: A
Explanation: A) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.06/2)^(2/26) -1
j = 0.002276341
PMT = Principal/ PVIFAj,n ∗ m
n = 30
n * m = 30 * 26 = 780
PVIFA = (1 - (1.002276341)^-780)/0.002276341
PVIFA = 364.7375
PMT = Principal/ PVIFAj,n * m
PMT = 270,000/364.7375
PMT = $740.26
After three years the principal outstanding is the present value of the remaining payments. After three
years there are 780 - 3 * 26 = 702 payments remaining.
Principal = PMT * PVIFAj,n∗m
Where
n * m = 702
Principal Outstanding = $740.26 * [(1 - (1. 002276341)^(-702)) / 0. 002276341]
Principal Outstanding = $259,289.53
Diff: 4
Section: 4.4 Mortgages
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25) Your mortgage loan has a principal of $800,000, a term of 40 years and a quoted rate of 8.75%. You
elect to make semi-monthly payments. What is the amount of principal owing after five years of the 40
year term?
A) $759,290
B) $779,375
C) $782,431
D) $785,622
Answer: D
Explanation: D) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.0875/2)^(2/24) -1
j = 0.00357471
PMT = Principal/ PVIFAj,n * m
n = 40
n * m = 40 * 24 = 960
PVIFA = (1 - (1. 00357471)^-960)/0. 00357471
PVIFA = 270.643213
PMT = Principal/ PVIFAj,n * m
PMT = 800,000/270.6432
PMT = $2955.92
After five years the principal outstanding is the present value of the remaining payments. After five years
there are 960 - 5 * 24 = 840 payments remaining.
Principal = PMT * PVIFAj,n * m
Where
n * m = 840
Principal Outstanding = $2955.92 × [(1 - (1.00357471)^(-840)) / 0.00357471]
Principal Outstanding = $785,622.46
Diff: 4
Section: 4.4 Mortgages
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26) Your mortgage loan had a principal of $100,000 when you first borrowed the money five years ago.
The mortgage had an amortization period of 60 years and the quoted rate on the loan was 8%. You chose
to make semi-monthly payments (two payments per month). The payments are $330.36. How much
principal have you paid after 5 years of payments? (You just made your 120th payment yesterday.)
Express your answer as a percentage of the original principal ($100,000).
A) 0.38%
B) 0.40%
C) 0.42%
D) 0.44%
Answer: D
Explanation: D) STEP 1: Determine the semi-monthly rate j
j = (1 + 0.08/2)^(2/24) - 1 = 0.00327374
STEP 2: The Principal Outstanding is the PV of the remaining payments, with 1440 - 120 remaining
payments of
Principal = PMT * PVIFAj,n * m
n * m = 55 x 24 = 1,320
PVIFA = (1 - (1 + 0.00327374)^(-1,320))/ 0.00327374
PVIFA = 301.375145
Principal = PMT × PVIFAj,n * m
Principal = $330.36 × 301.375145
Principal = $99,562.29
Principal repaid during first five years = $100,000 - $99,562.29 = $437.71
As percentage of original principal = 100 × (437.71/100,000) = 0.4377%
Diff: 4
Section: 4.4 Mortgages
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27) You are considering buying a house and you need a mortgage. You need to borrow $250,000. Your
bank offers you a rate of 3% with a 25 year amortization period and monthly payments of $1,183.11. A
mortgage broker offers you a 35 year amortization at 3%. How much more interest do you pay over the
life of the 35 year mortgage compared to the standard 25 year mortgage?
A) $48,074
B) $49,264
C) $52,264
D) $53,300
Answer: A
Explanation: A) For Canadian mortgages the periodic rate is given by:
j=
2/m - 1
j = (1 + 0.03/2)^(2/12) - 1
j = 0.002484517
PMT = Principal/ PVIFAj,n * m
n = 40
n * m = 40 * 12 = 420
PVIFA = (1 - (1.002484517)^-420)/0. 002484517
PVIFA = 260.542854
PMT = Principal/ PVIFAj,n * m
PMT = 250,000/260.542854
PMT = $959.54
Difference in Interest = 420 × 959.54 - 300 × 1,183.11
Difference in Interest = 403,006.80 - 354,933
Difference in Interest = $48,073.80
Diff: 4
Section: 4.4 Mortgages
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 5 Introduction to Risk and Return
LO1: Explain the Risk-Return Relationship
1) Which of the following is a true statement?
A) It is easy to predict the probability and length of a foreign country's recession.
B) Although economists understand the relationship between risk and return, they have been unable to
develop a way to quantify it.
C) There is a direct relationship between risk and expected return.
D) Risk and the likelihood of realizing future cash flows from an investment are unrelated.
E) Riskless investments do not usually earn a positive return.
Answer: C
Explanation: C) We expect return to increase as risk increases.
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Diff: 1
Section: 1
AACSB: Analytical Thinking
2) Which of the following most closely defines the term risk in finance?
A) Knowing that you will lose money on an investment
B) A decision in which the potential outcomes are known with certainty
C) A measure of the variability of cash flows
D) A situation in which the required return on an asset equals its expected return
E) A measure of the magnitude of cash flows
Answer: C
Explanation: C) Risk is the variability in outcomes couples with the possibility of harm.
Diff: 1
Section: 1
AACSB: Analytical Thinking
3) The expected return on an asset is 13% and the required return is 12%. You should probably
A) wait and see what happens to actual returns before making a decision.
B) buy the asset now.
C) sell the asset now.
D) hold the asset.
E) None of the above.
Answer: B
Explanation: B) If the expected return exceeds the required return, you should buy.
Diff: 1
Section: 1
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4) Which of the following would be the most useful to an investor who is evaluating securities to add to
her portfolio?
A) The previous opportunity cost of holding the asset
B) The simple interest return
C) The historical return
D) The expected return
E) The Lynch risk-adjusted historical return
Answer: D
Explanation: D) Expected return is the return that is expected to be earned each period on a given asset
in the future.
Diff: 1
Section: 1
AACSB: Analytical Thinking
5) To earn a ________ return, you must incur ________ risk.
A) lower; higher
B) higher; higher
C) decent; very high
D) higher; lower
E) None of the above.
Answer: B
Explanation: B) We expect return to increase as risk increases.
Diff: 1
Section: 1
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LO2: Calculate the Expected Return on a Single Asset
1) Consider the following bet: heads I pay you a dollar, tails you pay me a dollar. What is the expected
payoff (return) of this bet? (Assume a fair coin.)
A) -$0.50
B) $1.00
C) $0
D) $0.50
E) -$1.00
Answer: C
Explanation: C) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = 0.5 × ($1.00) + 0.5 × (-$1.00) Expected return = $0
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
2) Given the following probability distributions, what are the expected returns for the Market and for
Security J? State 1 P1 = 0.2 Km = -10% Kj = 40% : State 2 P1 = 0.5 Km = 10% Kj = -20% : State 3 P1 = 0.3 Km =
30% Kj = 30%
A) 10.0%; 13.0%
B) 9.5%; 13.0%
C) 10.0%; 11.3%
D) 12.0%; 7.0%
E) 10.0%; 9.5%
Answer: D
Explanation: D) Expected return = E(k) = Pr 1k1 + Pr2k2 + ... + Prnkn
Market E(k) = (.20 × -.10) + (.50 × .10) + (.30 × .30) = .12 or 12%
Security J E(k) = (.20 × .40) + (.50 × -.20) + (.30 × .30) = .07 or 7%
Diff: 3
Section: 2.3
AACSB: Analytical Thinking
3) If the probability of a 20% return is 70% and the probability of a 4% loss is 30%, what is the expected
return to the nearest whole percentage?
A) 17%
B) 3%
C) 13%
D) 15%
E) 11%
Answer: C
Explanation: C) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
E(k) = (.70 × .20) + (.30 × -.04) = .128 or 13%
Diff: 2
Section: 2.3
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4) If the required return from an asset is 10%, and the asset has a 60% probability of yielding a 20% return
and a 40% probability of earning a 5% return, you should
A) not acquire the asset since the expected return of 32% exceeds the required return.
B) purchase the asset since the expected return of 14% exceeds the required return.
C) buy the asset because the expected return of 32% exceeds the required return.
D) forgo the investment opportunity since the expected return of 14% is too low.
E) buy the asset because the expected return of 12.5% exceeds the required return.
Answer: B
Explanation: B) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = (.60 × .20) + (.40 × .05) = .14 or 14%
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
5) If the probability of a 20% return is 70% and the probability of a 3% loss is 30%, what is the expected
return?
A) 13%
B) 10%
C) 12%
D) 17%
E) 15%
Answer: A
Explanation: A) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = (.70 × .20) + (.30 × -.03) = .13 or 13%
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
6) If General Motors expects profits of $50 million in a booming economy, what is the expected profit
during a recession if this is the only other possibility and the overall expected profit is $35 million? The
probability of a recession is 70%.
A) $35.00 million
B) $25.00 million
C) $23.45 million
D) $39.50 million
E) $28.57 million
Answer: E
Explanation: E) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
35 = (.30 ∗ 50) + (.70 ∗ X)
20 = .70X
X = $28.57 million
Diff: 2
Section: 2.3
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7) A home insurance company anticipates the following pattern of claims, based on historical data. What
is the expected claim on the next policy sold by the company?
Type of Claim
1
2
3
4
Size of Claim
$200,000
$50,000
$2,000
$0
Number of
Claims out of
10,000 Policy
Holders
1
10
200
9,789
Probability
0.0001
0.001
0.02
0.9789
A) $100
B) $110
C) $120
D) $130
E) $140
Answer: B
Explanation: B) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = 0.0001 × $200,000 + 0.001 × $50,000 + 0.02 × $2,000 + 0.9789 × $0 = $110Expected return =
$110
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
8) Which of the following is a false statement?
A) Expected returns are not always predicted accurately.
B) Expected returns may differ from actual returns because of an unforeseen recession.
C) Historical returns can be calculated with more confidence than expected returns.
D) Accurate predictions of expected returns depend on the analyst's ability to estimate probabilities.
E) Although expected returns may differ from actual returns, they seldom do.
Answer: E
Explanation: E) The expected return and actual return can differ, and they often do.
Diff: 1
Section: 2.3
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9) Suppose you paid $18.50 per share for Commerce Group Inc. common stock and sold it one year later
for $24 per share. What was your holding period return if the stock paid no dividends during the year?
A) 27%
B) 13%
C) 23%
D) 32%
E) 30%
Answer: E
Explanation: E) HPRi =
HPRi =
= .297 or 30%
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
10) A year ago, you purchased IBM stock for $94 a share. Today, IBM stock is selling for $93 a share.
Additionally, you just received a cheque for $1.20 per share. Your holding period return is
A) 0.21%.
B) 2.34%.
C) -2.34%.
D) 2.13%.
E) 1.06%.
Answer: A
Explanation: A) HPRi =
HPRi =
= .21%
Diff: 2
Section: 2.1
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11) You bought a stock for $80.00 and sold it after three years for $95.00. While you held the stock it paid
$3.00 in dividends. What is the annualized return?
A) 18.75%
B) 11.25%
C) 7.50%
D) 22.50%
E) 9.38%
Answer: C
Explanation: C) HPRi =
HPRi =
= 22.5%
Since this return is over three years, we must divide by 3 to get the annualized return.
= 7.5%
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
12) Compaq recently adjusted the probabilities for its expected cash flows in light of the Asian currency
crisis. It revised the probability of favourable conditions from 32% to 18% and the probability of poor
earnings from 7% to 17%. Which of the following is the most likely result from this revision?
A) It would raise expected returns.
B) It would lower expected returns.
C) The probabilities cannot be revised once they have been estimated.
D) It would lower its historical return.
E) It would have no effect on expected returns.
Answer: B
Explanation: B) As the expected return of a higher return decreases, the expected return decreases.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
13) Frank's Franks went public and opened at $15.00 per share. One year later the stock was selling for
$17.50 per share. What was the holding period return if during the year Frank sent out $1.25 per share in
dividends?
A) 17%
B) 21%
C) 25%
D) 14%
E) 23%
Answer: C
Explanation: C) HPRi =
HPRi =
= 25%
Diff: 2
Section: 2.1
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14) XYZ Corp expects to have $350,000 in sales in a poor economy, $500,000 in a moderate economy, and
$900,000 in a booming economy. If the chances of a booming economy and poor economy are 10% each,
what is the expected return?
A) 525,000
B) 512,500
C) 500,000
D) 805,000
E) 621,000
Answer: A
Explanation: A) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = 350,000 × 10% + 500,000 × 80% + 900,000 × 10% = 525,000
Diff: 3
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AACSB: Analytical Thinking
15) The stock for L-Corp expects a 12% return in a down economy, 15% in a normal economy, and 20% in
a booming economy. What is the expected return if there is a 20% chance for a down economy and a 65%
chance for a normal economy?
A) 13.05%
B) 15.00%
C) 15.15%
D) 15.55%
E) 14.25%
Answer: C
Explanation: C) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = .12 × .2 + .15 × .65 + .20 × .15 = 15.15%
Diff: 2
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16) The Table below presents returns across three states of nature for two assets: Risky and Safe. The
expected return on Safe is 8.4%. Which asset has a higher expected return?
State of Nature
Recession
Normal
Boom
Return to Risky
Investment
-5%
15%
25%
Probability
0.2
0.6
0.2
Return to Safe
Investment
14%
8%
4%
A) Risky
B) Safe
C) Both have the same expected return
Answer: A
Explanation: A) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return (risky) = 0.2(-5%) + 0.6(+15%) + 0.2(+25%) = 13%
The risky investment has the higher expected return.
Diff: 2
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AACSB: Analytical Thinking
17) You are watching the Inter Milan vs. Barcelona Champions League game with your best friend Joe.
You make a deal with Joe:
If Barcelona wins, you walk away with $110.
If Inter Milan wins, you walk away with $50.
If you paid $100, what is your expected return assuming that each team has an equal probability of
winning?
A) -0.21
B) -0.22
C) -0.20
D) -0.23
E) -0.24
Answer: C
Explanation: C) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return (Barcelona wins) =
Expected return (Milan wins) =
- 1 = 0.10
- 1 = -0.50
Expected return = (0.5 × 0.1) + (0.5 × -0.5)
Expected return = -0.2 or -20%
Diff: 2
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18) It costs $1,000 to enter the following game of chance, which is based on the outcome of a coin toss (fair
coin). If the coin comes up 'heads', you win and walk away with $2,000, which is a 100% rate of return.
However, if the coin comes up 'tails', you lose and walk away with nothing, which is a - 100% rate of
return. What is the expected return on this gamble?
A) 0%
B) 1,000%
C) 100%
D) 10%
E) -10%
Answer: A
Explanation: A) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = (0.5 × 1) + (0.5 × -1)
Expected return = 0.00 or 0%
Diff: 2
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LO3: Compute the Risk of Holding a Single Asset
1) Which of the following statements is true?
A) Calculus of variations (CV) adjusts standard deviations to compare the risk of securities with different
expected returns.
B) Risk-averse investors prefer securities with high standard deviations.
C) An increase in risk will result in an increase in the standard deviation.
D) Standard deviations can be computed for stock returns, but not for bond yields.
E) If the returns from a security are normally distributed, 86% of the observations fall within one
standard deviation of the expected value.
Answer: C
Explanation: C) Greater deviations from the mean result in a greater standard deviation.
Diff: 1
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2) Consider the following bet: heads I pay you a dollar, tails you pay me a dollar. What is the standard
deviations of the payoffs (returns) of this bet? (Assume a fair coin.)
A) -$1.00
B) $0
C) $0.50
D) $1.00
E) $10.00
Answer: D
Explanation: D) Step 1 - Compute the expected return.
Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = 0.5 × ($1.00) + 0.5 × (-$1.00) Expected return = $0
Step 2 - Use the expected return to calculate the standard deviation.
Standard deviation =
Standard deviation =
Standard deviation =
= 1 or $1
Diff: 3
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3) If an asset has a 35% probability of earning a 20% return and a 65% probability of earning a 5% return,
what is its standard deviation?
A) 1.2%
B) 18.0%
C) 7.2%
D) 11.0%
E) 12.2%
Answer: C
Explanation: C) Step 1 - Compute the expected return.
Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = (0.35 × 0.20) + (.65 × 0.05)Expected return = 0.1025
Step 2 - Use the expected return to calculate the standard deviation.
Standard deviation =
Standard deviation =
Standard deviation =
= 0.0715 or 7.2%
Diff: 3
Section: 3.2
AACSB: Analytical Thinking
4) A company has a 40% probability of earning 20%, a 40% probability of earning 10%, and a 20%
probability of earning 5%. The standard deviation is
A) 13.0%.
B) 36.0%.
C) 37.0%.
D) 6.0%.
E) 15.0%.
Answer: D
Explanation: D) Step 1 - Compute the expected return.
Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = (0.40 × 0.20) + (0.40 × 0.10) + (0.20 × 0.05)Expected return = 0.13
Step 2 - Use the expected return to calculate the standard deviation.
Standard deviation =
Standard deviation =
Standard deviation =
= 0.06 or 6%
Diff: 3
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5) XYZ Corp has a 30% chance to earn 12% returns, a 40% chance for 18% returns, and a 30% chance to
earn 15% returns. What is the standard deviation?
A) 2.49%
B) 15.3%
C) 4.24%
D) 15%
E) 5.62%
Answer: A
Explanation: A) Step 1 - Compute the expected return.
Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = .3 × 12% + .3 × 15% + .4 × 18%Expected return = 15.3%
Step 2 - Use the expected return to calculate the standard deviation.
Standard deviation =
Standard deviation =
Standard deviation = 2.49%
Diff: 3
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6) A company will earn 10% returns in a poor economy, 15% returns in a normal economy, and 25%
returns in a booming economy. What is the standard deviation if there is a 25% chance of a poor economy
and a 25% chance of a booming economy?
A) 10.83%
B) 5.45%
C) 6.12%
D) 11.18%
E) 4.91%
Answer: B
Explanation: B) Step 1 - Compute the expected return.
Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = .25 × 25% + .5 × 15% + .25 × 10%Expected return = 16.25%
Step 2 - Use the expected return to calculate the standard deviation:
Standard deviation =
Standard deviation =
Standard deviation = 5.45%
Diff: 3
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7) The Table below presents returns across three states of nature for two assets: Risky and Safe. The
standard deviation of Safe is 3.2%. What is the difference between the standard deviation of Risky and
Safe? (Risky - Safe)
State of Nature
Recession
Normal
Boom
Probability
0.2
0.6
0.2
Return to Risky
Investment
-5%
15%
25%
Return to Safe
Investment
14%
8%
4%
A) 3.6%
B) 4.6%
C) 5.6%
D) 6.6%
E) 7.6%
Answer: D
Explanation: D) Expected return = E(k) = Pr 1k1 + Pr2k2 + ... + Prnkn
Expected return (risky) = 0.2(-5%) + 0.6(+15%) + 0.2(+25%) = 13%
Next, use the expected return to calculate the standard deviation:
Standard deviation =
Standard deviation =
Standard deviation = 9.8%
Difference = 9.8% - 3.2% = 6.6%
Diff: 3
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8) You pay $1,000 to flip a two-sided, fair coin at the local fair. If you flip heads, you walk away with
$3,000, a return of 200%. However, if you flip tails,you walk away with $250, a return of -75%. What is the
standard deviation of the returns?
A) 0.1375%
B) 1.375%
C) 13.75%
D) 137.5%
E) 1,375%
Answer: D
Explanation: D) Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = (0.5 × 2) + (0.5 × - 0.75) = 0.625
Next, use the expected return to calculate the standard deviation:
Standard deviation =
Standard deviation =
Standard deviation =1.375 or 137.5%
Diff: 2
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AACSB: Analytical Thinking
9) It costs $1,000 to enter the following game of chance, which is based on the outcome of a coin toss (fair
coin). If the coin comes up 'heads' then you win and walk away with $1,100, which is a 10% rate of return.
If the coin comes up 'tails', then you lose and walk away with $900, which is a -10% rate of return. What is
the standard deviation of the returns?
A) 9%
B) 15%
C) 30%
D) 10%
E) 5%
Answer: D
Explanation: D) Expected return = E(k) = Pr 1k1 + Pr2k2 + ... + Prnkn
Expected return = (0.5 × 0.1) + (0.5 × -0.1)
Expected return = 0.00 or 0%
Next, use the expected return to calculate the standard deviation:
Standard deviation =
Standard deviation =
Standard deviation = 0.10 or 10%
Diff: 2
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10) It costs $1,000 to enter the following game of chance, which is based on the outcome of a coin toss (fair
coin). If the coin comes up 'heads' then you win and walk away with $1,100, which is a 10% rate of return.
If the coin comes up 'tails', then you lose and walk away with $900, which is a -10% rate of return. What is
the variance of the returns?
A) 0.05
B) 0.1
C) 0.09
D) 0.01
E) 0.5
Answer: D
Explanation: D) Expected return = E(k) = Pr 1k1 + Pr2k2 + ... + Prnkn
Expected return = (0.5 × 0.1) + (0.5 × -0.1)
Expected return = 0.00 or 0%
Next, use the expected return to calculate the variance:
0.50 × (0.10 - 0)2 + 0.50 × (-0.10 - 0)2 = 0.01
Diff: 2
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LO4: Determine the Expected Return for a Portfolio of Assets
1) If Microsoft stockholders expect either a 25% return or a 2% return, each with a 50% probability, and
Apple Computer shareholders expect a 10% return with certainty, what is the expected return from a
portfolio comprised of equal amounts of stock from both firms?
A) 37.00%
B) 23.50%
C) 11.75%
D) 10.75%
E) 12.33%
Answer: C
Explanation: C) Step 1 - Compute the expected returns of each stock in the portfolio.
Expected return = E(k) = Pr1k1 + Pr2k2 + ... + Prnkn
Expected return = (0.50 × 0.25) + (.50 × 0.02)Expected return = 0.135
Step 2 - Use the expected returns of each stock to compute the expected return on the portfolio.
E(kp) = w1E(k1) + w2E(k2) + ... + wnE(kn)
E(kp) = (.50 × .135) + (.50 × .10) = .1175 or 11.75%
Diff: 3
Section: 4.1
AACSB: Analytical Thinking
2) Suppose that you hold a two-asset portfolio consisting of 100 shares of Clooney Brothers at $33 per
share and 100 shares of Marx Brothers at $42 per share. Assume that you have computed the expected
return on Clooney Brothers and Marx Brothers to be 20% and 12%, respectively. What is the expected
return from the portfolio?
A) 20.0%
B) 16.0%
C) 15.5%
D) 12.0%
E) 13.5%
Answer: C
Explanation: C) Step 1 - We must first compute the weights of each asset in the portfolio.
wi =
Weight of Clooney =
Weight of Marx =
= 0.44
= 0.56
Step 2 - Use the weights to compute the expected return on the portfolio.
E(kp) = w1E(k1) + w2E(k2) + ... + wnE(kn)
E(kp) = (.44 × .20) + (.56 × .12) = .155 or 15.5%
Diff: 3
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3) An expected return from a portfolio
A) can be calculated more accurately than the expected return from any of the securities in the portfolio.
B) will lie somewhere between the highest and lowest expected returns from securities in the portfolio.
C) cannot be computed if there are fewer than three securities in the portfolio.
D) will exceed the highest expected return from any of the securities in the portfolio.
E) will be lower than the expected return from the security in the portfolio with the lowest yield because
portfolios have less risk than individual securities.
Answer: B
Explanation: B) The expected return of a portfolio is the weighted average of the expected returns for
each individual security.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
4) The table below shows market data for two shares on two days.The two shares are the components of a
value weighted index like the S&P/TDX 60. Calculate the percentage change in the index over the two
days.
Stock 1
Date
1
2
Price
$1
$1.50
Stock 2
Shares
Outstanding
100
100
Price
$2
$2.20
Shares
Outstanding
150
150
A) 10%
B) 20%
C) 30%
D) 40%
E) 50%
Answer: B
Explanation: B) Return =
-1
TV1 = Total Value of Index (Day 1) =$1 × 100 + $2 × 150
TV1 = $400
TV2 = Total Value of Index (Day 2) =$1.50 × 100 + $2.20 × 150
TV2 = $480
Return =
Return = 0.20 or 20%
Diff: 2
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5) You have a portfolio of two shares: you invested $12,000 in a small biotech company and $6,000 in a
fiber optic cable manufacturer. What is the portfolio weight on the biotech stock?
A) 0.25
B) 0.33
C) 0.50
D) 0.67
E) 0.75
Answer: D
Explanation: D) wi =
w=
= 0.67
Diff: 2
Section: 4.1
AACSB: Analytical Thinking
6) You bought 200 shares of Microsoft at $50 per share, 100 shares of IBM for $100 a share and 300 shares
of Amazon.com for $25 per share. What is the portfolio weight on the Amazon.com holding?
A) 0.25
B) 0.26
C) 0.27
D) 0.28
E) 0.29
Answer: C
Explanation: C) wi =
Amount invested in Amazon = 300 × $25 = $7,500
Amount invested in Microsoft = 200 × $50 = $10,000
Amount invested in IBM = 100 × $100 = $10,000
Total amount invested = $7,500 + $10,000 + $10,000 = $27,500
Weight of Amazon =
= 0.27
Diff: 2
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7) After taking a reading-week trip to the Dominican Republic, you are now hooked on Cuban cigars.
You decide to build a stock portfolio with two different cigar companies:
Altadis'Behike(Altadis)
Gurkha'sHis Majesty's Reserve (Gurkhas)
You purchase 1,000 Altadis' shares, each at a price of $45. You also purchase 1,200 Gurkha's shares, each
at a price of $65. Calculate Altadis' portfolio weight.
A) 0.316
B) 0.366
C) 0.386
D) 0.416
E) 0.426
Answer: B
Explanation: B) wi =
Amount invested in Altadis' Behike = 1,000 × $45 =$45,000
Amount invested in Gurkha's = 1,200 × $65 = $78,000
Total amount invested = $45,000 + $78,000 = $123,000
Weight of Altadis' =
= 0.366
Diff: 2
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LO5: Explain Diversification and Portfolio Risk
1) Bond prices rise when interest rates fall. These two variables (bond prices and interest rates) are
A) not correlated.
B) positively correlated.
C) negatively correlated.
D) positively skewed.
Answer: C
Explanation: C) Negatively correlated values move inversely with respect to one another. In other words,
when one is up the other is down.
Diff: 1
Section: 5.1
AACSB: Analytical Thinking
2) Correlation
A) is a measure similar to the standard deviation, but more precise.
B) may only be positive.
C) is usually negative for a portfolio with two securities.
D) measures the degree to which a change in the riskiness of one security causes the risk of another to
change.
E) ranges between −1 and +1.
Answer: E
Explanation: E) The degree of correlation between different securities can vary between -1.0 and +1.0.
Diff: 1
Section: 5.1
AACSB: Analytical Thinking
3) By incrementally adding securities to a portfolio
A) you can reduce portfolio risk only if the new security is uncorrelated with the others in the portfolio.
B) you raise portfolio risk since having more securities in a portfolio increases the likelihood that one of
them will become worthless.
C) you may reduce portfolio risk, even if new securities are not negatively correlated with others in the
portfolio.
D) you may eliminate all risk with about 15 different shares in a portfolio.
E) you reduce risk at an increasing rate.
Answer: C
Explanation: C) Two imperfectly correlated shares combine to produce a portfolio with less risk.
Diff: 1
Section: 5.2
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4) Assume you currently hold one type of security and decide to construct a portfolio. Which of the
following would provide the greatest degree of risk reduction?
A) Adding a security that has perfect negative correlation with the one you are holding
B) Doubling the quantity of the security you already hold
C) Adding a positively, but not perfectly, correlated security
D) Adding a security that is uncorrelated with your current one
E) Adding a security that has perfect positive correlation with the one you are holding
Answer: A
Explanation: A) Returns that are perfectly negatively correlated offset each other's returns, removing
risk.
Diff: 1
Section: 5.2
AACSB: Analytical Thinking
5) All of the following statements are true EXCEPT which one?
A) The standard deviation of a portfolio of assets is the weighted average of the standard deviations of
the assets in the portfolio.
B) The expected return on a portfolio of assets is the weighted average of the expected returns of the
assets in the portfolio.
C) The expected return on an asset held by itself is the weighted average of the possible outcomes, where
the weights reflect the probability of each outcome.
D) The risk of an asset held by itself can be measured by the standard deviation of the expected returns.
Answer: A
Explanation: A) Correlation between different assets in a portfolio make the weighted average method
not work.
Diff: 1
Section: 5
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 6 Portfolio Theory
LO1: Explain Diversification
1) Through diversification it is possible to eliminate all of the company-specific risk inherent in owning
shares. However, as a general rule it will not be possible to eliminate systematic (market) risk.
Answer: TRUE
Explanation: Diversification cannot eliminate market or systematic risk. This type of risk affects all risky
assets in the capital market, and thus is impossible to eliminate through diversification.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
2) Your broker tells you that it is important to diversify because doing so will increase your expected
returns, even if you diversify by randomly selecting shares (naive diversification).
Answer: FALSE
Explanation: Diversification will lower risk by eliminating company-specific (or unsystematic) risk, but it
may not necessarily increase your average returns.
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Diff: 1
Section: 1.2
AACSB: Analytical Thinking
3) If two shares have a correlation of +1, then the standard deviation of a portfolio between them is given
by: σp = wσ1 + (1 - w)σ2
Answer: TRUE
Explanation: From the text we know the equation for the standard deviation of a 2 asset portfolio is:
σp =
Substituting the correlation of +1 we have:
σp =
After rearranging and simplifying we have:
σp2 = (wσ1)2 + [(1 - w)σ2]2 + 2wσ1 (1 - w)σ2
σp2 = [wσ1 + (1 - w)σ2]2
σp = wσ1 + (1 - w)σ2
Diff: 4
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4) Answer the following two questions. Assume that the portfolio weights are positive:
1. Can the return on a portfolio ever be less than the smallest return on an individual security in the
portfolio?
2. Can the risk (variance) of a portfolio ever be less than the smallest risk (variance) of an individual
security in the portfolio?
A) No. Yes.
B) No. No.
C) Yes. No.
D) Yes. Yes.
Answer: A
Explanation: A) 1. The return on a portfolio is the weighted average of the returns of the individual
securities within the portfolio. If the weights are all positive, then the portfolio return will never be less
than that of the security with the smallest return - it's mathematically impossible.
2. The reason for diversification is to reduce the risk (variance). If the covariance is small (negative) then
some portfolios have less variance than any individual securities in the portfolio. Think of the bathing
suit and umbrellas company example in the Diversification video.
Diff: 3
Section: 1.1
AACSB: Analytical Thinking
5) ________ is the act of giving something variety.
A) Variance
B) Covariance
C) Deviation
D) Diversification
Answer: D
Explanation: D) Diversification is the act of giving something variety.
Diff: 1
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6) Stock A has an expected return of 10% and a standard deviation of 10%. Stock B has an expected return
of 15% and a standard deviation of 20%. The two shares are perfectly negatively correlated (ρ 1,2 = -1).
What set of weights yields a portfolio with a zero variance?
A) 2/3 in Stock A; 1/3 in Stock B
B) 2/3 in Stock B; 1/3 in Stock A
C) 2 in Stock A; -1 in Stock B
D) 2 in Stock B; -1 in Stock A
E) None of the above.
Answer: A
Explanation: A) From the text we know the equation for the standard deviation of a 2 asset portfolio is:
σp =
After substituting the correlation of -1, setting the variance to zero, and squaring both sides we have:
0 = w20.12 + (1 - w)20.22 + 2w(1 - w)(-1)(0.1)(0.2)
0 = w2[0.12 + 0.22 + 0.04] - w [2(0.2)2 + 0.04] + 0.22
0 = 0.09w2 - 0.12w + 0.04
After multiplying both sides of the equation by 100 we get:
0 = 9w2 - 12w + 4
By factoring the quadratic equation we get:
0 = (3w - 2)(3w - 2)
0 = 3w - 2
w = 2/3
Diff: 4
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7) You construct an equally weighted, two asset portfolio between ACME Corp., an American valve and
regulator manufacturer, and Wayne Enterprises, a Hong Kong property company. The standard
deviation of the returns on ACME's shares is 30% and 55% on Wayne Enterprises. Because of the
international diversification, the returns on the two companies have no covariance (correlation = zero).
What is the standard deviation of returns of the portfolio?
A) 9.81%
B) 17.60%
C) 22.50%
D) 31.32%
E) 42.50%
Answer: D
Explanation: D) Apply the equation for the standard deviation of a 2 asset portfolio:
σp =
Remember, the correlation is zero.
σp =
σp =
σp =
= 0.3132 or 31.32%
Diff: 3
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8) An investor is considering investing one-half of his wealth in Asset A and one-half in Asset B. He is not
sure how the two assets are correlated. The correlation might be r = +1 or it might be r = -1. If it is r = + 1,
then the portfolio standard deviation is 15%. Calculate the portfolio standard deviation if the correlation
is r = -1. What is the difference between the standard deviations of Scenario 1 and Scenario 2? (Scenario 1 Scenario 2)
ASSET A ASSET A
Expected Standard
Deviation
Scenario Return
1
10%
20%
2
10%
20%
ASSET B
Expected
Return
5%
5%
ASSET B Correlation
Standard Correlation
Deviation of A and B
10%
+1
10%
-1
A) 2.5%
B) 5.0%
C) 7.5%
D) 10.0%
E) 15.0%
Answer: D
Explanation: D) Apply the equation for the standard deviation of a 2 asset portfolio to each scenario, and
find the difference between the two standard deviations.
Scenario 1:
σp =
σp =
σp =
σp =
= 0.15 or 15%
Scenario 2:
σp =
σp =
σp =
= 0.05 or 5%
Difference = 0.15 - 0.05 = 0.10 or 10%
Diff: 3
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9) You have decided to create a portfolio with two assets: stock X and stock Y. You invest 20% of your
funds in X and 80% of your funds in stock Y. The standard deviation of X is 30% and the standard
deviation of Y is 40%. The two shares have a correlation coefficient of - 0.5. What is the portfolio's
standard deviation?
A) 30.00%
B) 29.46%
C) 33.24%
D) 36.92%
E) 40.00%
Answer: B
Explanation: B) Apply the equation for the standard deviation of a 2 asset portfolio:
σp =
σp =
σp =
σp =
= 0.2946 or 29.46%
Diff: 2
Section: 1.1
AACSB: Analytical Thinking
10) Shares A and B are perfectly negatively correlated (ρ1,2 = -1) and their standard deviations are 0.20
and 0.30 respectively. What is the standard deviation of a portfolio with 50% invested in Stock A and 50%
invested in Stock B?
A) 5%
B) 6%
C) 7%
D) 8%
E) 9%
Answer: A
Explanation: A) From the text we know the equation for the standard deviation of a 2 asset portfolio is:
σp =
Substituting the correlation of -1 we have:
σp =
σp =
σp =
σp = 0.05
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11) Consider the data provided in the table below for a portfolio of Assets A and B. The correlation of the
two assets is ρ = -0.9523. What is the standard deviation of the returns of the portfolio?
Portfolio
Weights
Standard
Deviation
Asset A
Asset B
0.33
0.67
0.5
0.6
A) 6.25%
B) 25%
C) 35%
D) 55%
E) 57.5%
Answer: B
Explanation: B) From the text we know the equation for the standard deviation of a 2 asset portfolio is:
σp =
After substituting the inputs from the problem we have:
σp =
σp =
σp =
σp = 0.24999 or 25%
Diff: 3
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12) Delilah Jones has a portfolio of shares A and B. See the table below for details. What is the correlation
between the two shares?
Weights
Expected
Return
Standard
Deviation
A
40%
B
60%
15%
20%
20%
22%
Portfolio
11.5169%
A) -1.0
B) -0.5
C) 0
D) 0.5
E) 1.0
Answer: B
Explanation: B) From the text we know the equation for the standard deviation of a 2 asset portfolio is:
σp =
(0.115169)2 = 0.420.22 + 0.620.222 + 2(0.4)(0.6)(0.2)(0.22)ρ1,2
0.013264 = 0.0064 + 0.0174 + 0.02112ρ1,2
-0.010536 = 0.02112ρ1,2
ρ1,2 = -0.4989 or -0.50
Diff: 3
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AACSB: Analytical Thinking
13) Consider a 2 asset portfolio with 60% in Google Inc. (GOOG) and 40% in John Deere (DE). Google has
a standard deviation of 60%, John Deere has a standard deviation of 45% and their correlation is 0.2.
What is the standard deviation of returns of the portfolio?
A) 38.33%
B) 43.35%
C) 45.25%
D) 50.00%
E) 52.50%
Answer: B
Explanation: B) From the text we know the equation for the standard deviation of a 2 asset portfolio is:
σp =
σp =
σp =
σp =
= 0.4335 or 43.35%
Diff: 2
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14) Which of the following statements is true?
A) A low risk portfolio is constructed by selecting low risk shares.
B) It is easy to find perfectly negatively correlated shares.
C) Low risk portfolios will only reflect unsystematic risk.
D) Negatively correlated shares help build a low risk portfolio.
E) Market risk reduces as more shares are added to a portfolio.
Answer: D
Explanation: D) To build a low-risk portfolio, we should collect shares that are negatively correlated.
Diff: 1
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15) ________ risk affects all shares to a greater or lesser extent and is due to large macroeconomic shocks.
This type of risk ________ be eliminated through diversification.
A) Systematic; can
B) Systematic; cannot
C) Unsystematic; can
D) Unsystematic; cannot
E) None of the above
Answer: B
Explanation: B) Systematic risk, also referred to as nondiversifiable risk in the text, includes events such
as wars, changes in government policy and oil price shocks. These events affect all risky assets in the
capital market, and thus systematic risk is impossible to eliminate through diversification (although it can
be reduced).
Diff: 2
Section: 1.2
AACSB: Analytical Thinking
16) How would you describe the risk of a company's CEO having a heart attack?
A) Not diversifiable or systematic
B) Not diversifiable or unsystematic
C) Diversifiable or unsystematic
D) Diversifiable or systematic
Answer: C
Explanation: C) The death of a CEO will affect the company and its supply chain. It will not affect the
broader market. Thus, it is a diversifiable or unsystematic risk.
Diff: 1
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17) ________ risk ________ be eliminated through greater diversification and is due to firm-specific or
industry-wide factors such as strikes or resource price changes.
A) Systematic; can
B) Systematic; cannot
C) Unsystematic; can
D) Unsystematic; cannot
E) None of the above
Answer: C
Explanation: C) Unsystematic risk, also referred to as diversifiable risk in the text, includes events such
as employee strikes, loss of major customers and technological obsolescence. It is important to note that
these events only affect one or a few firms and thus can be eliminated through diversification.
Diff: 2
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AACSB: Analytical Thinking
18) Which of the following is not a source of unsystematic risk?
A) A major economic downturn
B) A crippling labour strike
C) A competitor's successful advertising campaign
D) The departure of a firm's chief executive officer
E) The expiration of a patent
Answer: A
Explanation: A) Unsystematic risk is also called firm-specific risk and does not affect the entire market.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
19) Which of the following statements is false?
A) Adding more unrelated securities to a portfolio reduces unsystematic risk.
B) Changes in Federal Reserve policy have more effect on systematic risk than unsystematic risk.
C) Systematic risk will increase during a recession.
D) Market risk may be reduced through diversification.
E) Oil shocks affect market risk.
Answer: D
Explanation: D) Unsystematic risk is also called firm-specific risk and does not affect the entire market.
Diff: 1
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20) Which of the following statements is false?
A) Adding additional securities to a portfolio only reduces market risk.
B) The risk-return relationship relates only to market risk.
C) Reducing market risk usually implies sacrificing expected return.
D) The appropriate measure of risk should only consider the incremental risk a security adds to a welldiversified portfolio.
E) Investors are usually not fully compensated for bearing the total risk associated with a security.
Answer: A
Explanation: A) Market risk cannot be eliminated through diversification.
Diff: 1
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21) ________ risk cannot be eliminated by diversification.
A) Market
B) Unsystematic
C) Firm-specific
D) Systemic
Answer: A
Explanation: A) Market risk cannot be eliminated through diversification.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
22) An increase in nondiversifiable risk
A) would have no effect on the beta and would, therefore, cause no change in the required return.
B) would cause an increase in the beta and would increase the required return.
C) would cause an increase in the beta and would lower the required return.
D) would cause a decrease in the beta and would, therefore, lower the required rate of return.
Answer: B
Explanation: B) Nondiversifiable risk cannot be diversified out so it would increase the risk of the
portfolio, requiring higher returns.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
23) Risk that affects all firms is called
A) management risk.
B) nondiversifiable risk.
C) diversifiable risk.
D) total risk.
Answer: B
Explanation: B) Nondiversafiable risk affects all assets to some extent.
Diff: 1
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24) ________ risk can be eliminated by diversification.
A) Market
B) Unsystematic
C) Nondiversifiable
D) Systematic
Answer: B
Explanation: B) Diversifiable risk is also called unsystematic.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
25) Which of the following is a characteristic of unsystematic risk?
A) Affects one or a few firms
B) Includes events like oil price shocks
C) Cannot be reduced though diversification
D) Is the only risk that investors in the market portfolio worry about
Answer: A
Explanation: A) Unsystematic risk affects one or few firms.
Diff: 1
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26) Consider a value-weighted market index that includes the two companies shown in the table. What is
the percentage change in the index from Day 1 to Day 2?
Day
1
2
Company 1
Price
$7.00
$7.24
Company 1
# of Shares
400
400
Company 2
Price
$10.00
$10.53
Company 2
# of Shares
1,500
1,500
A) 4.00%
B) 4.25%
C) 4.50%
D) 4.75%
E) 5.00%
Answer: E
Explanation: E) Value of Company 1 on Day 1 = $7 × 400 = $2,800
Value of Company 2 on Day 1 = $10 × 1,500 = $15,000
Total Value on Day 1 = $2,800 + $15,000 = $17,800
Value of Company 1 on Day 2 = $7.24 × 400 = $2,896
Value of Company 2 on Day 2 = $10.53 × 1,500 = $15,795
Total Value on Day 2 = $2,896 + $15,795 = $18,691
The percentage change in the index =
= 0.0501 or about 5.00%
Diff: 2
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27) Consider a value-weighted market index that includes the two companies shown in the table. You
form a portfolio to mimic the index on Day 1. The mimic portfolio is designed to earn the same return as
the index. What is the portfolio weight for Company 1?
Day
1
2
Company 1
Price
$6.62
$7.24
Company 1
# of Shares
200
200
Company 2
Price
$10.00
$10.54
Company 2
# of Shares
750
750
A) 15%
B) 16%
C) 17%
D) 18%
E) 19%
Answer: A
Explanation: A) Value of Company 1 on Day 1 = $6.62 × 200 = $1,324
Value of Company 2 on Day 1 = $10 × 750 = $7,500
Total Value on Day 1 = $1,400 + $7,500 = $8,824
wi =
Weight of Company 1 =
= 0.150 or 15%
Diff: 2
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28) Consider a value-weighted market index that includes the following two companies. On Day 1 you
form a portfolio to mimic the index. (In other words, to earn the same return as the index.)
Day
1
2
Company 1
Price
$6.62
$7.24
Company 1
# of Shares
200
200
Company 2
Price
$10.00
$10.54
Company 2
# of Shares
750
750
What is the portfolio weight on Company 1, and what is the return on the portfolio from Day 1 to Day 2?
(Weight %, Return %)
A) 14%, 5%
B) 14%, 6%
C) 15%, 6%
D) 15%, 7%
E) 16%, 5%
Answer: C
Explanation: C) Value of Company 1 on Day 1 = $6.62 × 200 = $1,324
Value of Company 2 on Day 1 = $10 × 750 = $7,500
Total Value on Day 1 = $2,648 + $15,000 = $8,824
wi =
The weight of Company 1 =
= 0.15 or 15%
Next, calculate the return on the portfolio:
The weight of Company 2 = (1 - 0.15) = 0.85
The return on company 1 =
The return on company 2 =
=
= 0.054
The return on the portfolio from Day 1 to Day 2:
E(kp) = w1E(k1) + w2E(k2) + wnE(kn)
E(kp) = 0.15 × 0.0937 + 0.85 × 0.054 = 0.05995 or 6%
Diff: 3
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= 0.0937
29) A popular value-weighted index is constructed out of shares in the two companies shown in the table,
below. On Day 1 you construct a portfolio that mimics the index. In order for your portfolio to earn the
same return as the index from Day 2 to Day 3, what portfolio weight do you need for Company 1 on Day
2?
Company 1
Day
1
2
3
Price
6.62
7.53
8.82
Company 1
# of Shares
Outstanding
400
400
400
Company 2
Price
10.00
10.54
11.07
Company 2
# of Shares
Outstanding
1,500
1,500
1,500
A) 12%
B) 13%
C) 14%
D) 15%
E) 16%
Answer: E
Explanation: E) Value of Company 1 on Day 2 = $7.53 × 400 = $3,012
Value of Company 2 on Day 2 = $10.54 × 1,500 = $15,810
Total Value on Day 2 = $3,012 + $15,810 = $18,822
wi =
The weight of Company 1 =
= 0.16 or 16%
The weight of Company 2 =
= 0.84 or 84%
Diff: 3
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30) A popular value-weighted index is constructed out of shares in the two companies, shown in the table
below. On Day 1 you construct a portfolio that mimics the index with 15% invested in Company 1 and
85% invested in Company 2. On Day 2, what trades do you need to make in order to adjust your portfolio
weights so that your portfolio earns the same return as the index from Day 2 to Day 3?
Company 1
Day
1
2
3
Price
6.62
7.53
8.82
Company 1
# of Shares
Outstanding
400
400
400
Company 2
Price
10.00
10.54
11.07
Company 2
# of Shares
Outstanding
1,500
1,500
1,500
A) Buy more of Company 1 and buy more of Company 2
B) Buy more of Company 1 and sell some of Company 2
C) Sell some of Company 1 and sell some of Company 2
D) Sell some of Company 1 and buy more of Company 2
E) Make no trades
Answer: E
Explanation: E) No trades are necessary. The weights will change from Day 1 to Day 2 as the relative
prices of the two shares change. The weights will change automatically, and the portfolio will continue to
track the index in the second period without any adjustments.
Diff: 4
Section: 1.3
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31) In a well-diversified portfolio, the most relevant type of risk to a well-diversified investor is
A) interest rate risk.
B) unsystematic risk.
C) market risk.
D) exchange rate risk.
E) firm-specific risk.
Answer: C
Explanation: C) A large and well diversified portfolio has no unsystematic risk, thus investors only care
about systematic risk.
Diff: 1
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AACSB: Analytical Thinking
32) In a well-diversified portfolio, the most relevant type of risk to a well-diversified investor is
A) firm-specific risk.
B) interest rate risk.
C) exchange rate risk.
D) market risk.
E) unsystematic risk.
Answer: D
Explanation: D) Investors in a market portfolio only care about systematic risk.
Diff: 1
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33) ________ is what investors do when they invest equal amounts of money in a portfolio of randomly
selected shares.
A) Naive diversification
B) Efficient investing
C) Sharpe's Method
D) Effective portfolio creation
Answer: A
Explanation: A) Naive diversification is the strategy of investing equal amounts of money in a portfolio
of randomly selected shares.
Diff: 1
Section: 1.3
AACSB: Analytical Thinking
LO2: Explain Nondiversifiable Risk
1) If the stock market becomes more risky (e.g. there is greater uncertainty about the economy), the beta
of the market portfolio increases.
Answer: FALSE
Explanation: Beta itself is defined with respect to the market portfolio; therefore the market's beta is
always equal to 1.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
2) The slope of the characteristic line is beta.
Answer: TRUE
Explanation: The characteristic line relates the return on a security to the return on the market. The slope
of the characteristic line is beta.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
3) Beta is a more relevant measure of risk to an investor with a well-diversified portfolio than to an
investor who holds only one stock.
Answer: TRUE
Explanation: If your portfolio is not well diversified, then you are exposed to both unsystematic and
systematic risk (i.e. total risk). In that case, the standard deviation is more useful because it measures
total risk. Diversified investors are only exposed to systematic risk, and so find beta more useful as it
measures systematic risk.
Diff: 1
Section: 2.1
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4) CISCO System's stock has a correlation with the market of 0.65. CISCO's standard deviation of returns
is 45% and standard deviation of the market is 20%. What is CISCO System's beta?
A) 0.29
B) 0.85
C) 1.19
D) 1.46
E) 1.76
Answer: D
Explanation: D) Step 1 - Compute the covariance of the returns.
The correlation between the returns on C's stock and the market is:
ρC,M =
By rearranging the formula we know that the covariance is:
COV(kC,kM) = ρC,M × σCσM
COV(kC,kM) = 0.65 × 0.45 × 0.20 = 0.0585
Step 2 - Use the covariance to compute Cisco's beta.
βi =
β=
= 1.4625
Diff: 3
Section: 2.1
AACSB: Analytical Thinking
5) ________ shows that investors who hold the market portfolio do not care about unsystematic risk.
A) Beta
B) Capital Asset Pricing Model
C) Variance
D) Stock Market Index
Answer: B
Explanation: B) The CAPM holds that investors who hold the market portfolio do not care about the
unsystematic risk.
Diff: 1
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6)
Asset
A
B
C
Return
10%
12%
14%
Beta
0.74
1.00
1.25
Standard
Deviation
20%
40%
30%
Refer to the data in the table. Which asset possesses the greatest amount of systematic risk?
A) A
B) B
C) C
D) Both A and C
E) Impossible to tell, given the above information
Answer: C
Explanation: C) Asset C possesses the greatest amount of risk because it has the highest beta. A beta of
1.25, or any value greater than 1, means the asset has greater than average risk.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
7) Which of the following statements concerning beta is correct?
A) Its calculation is unnecessary and too complicated to be used efficiently.
B) The risk free asset is equal to 1.
C) The portfolio beta is the sum of the single asset betas.
D) It measures the amount of systematic risk possessed by an individual asset.
Answer: D
Explanation: D) Beta also measures the amount of market risk possessed by an individual asset.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
8) The change of risk in a portfolio from the addition of one more share of a particular asset to the
portfolio is called
A) CAPM.
B) marginal risk.
C) market risk.
D) diversifiable risk.
Answer: B
Explanation: B) Marginal risk is the increase in a portfolio's risk resulting from the addition of one more
unit of a particular asset to the portfolio.
Diff: 1
Section: 2.1
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9) A friend tells you about a mutual fund that can protect you on the downside. In other words, in bear
markets the return on the mutual fund does not fall as much as the market's return. The fund's Beta is
A) greater than one.
B) equal to one.
C) less than one.
Answer: C
Explanation: C) If the mutual fund's returns fall by less when the market falls, then the fund's
characteristic line is relatively flat and the Beta is less than one.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
10) The table below gives the historic return over the past five months for the market portfolio and two
assets: A and B. Which of the answers below best describes the historic beta for A and B?
Month
1
2
3
4
5
Market
3%
-5%
1%
-10%
6%
Asset A
5%
-6%
4%
-12%
10%
Asset B
4%
4%
4%
4%
4%
A) βA < 0; βB = 0
B) βA > 0; βB = +1
C) βA > 0; βB = 0
D) βA > +1; βB = 0
E) βA < -1; βB = +1
Answer: D
Explanation: D) Beta tells us that if the market's return changes by X%, then the asset's return changes by
β * X%.
From the table, for each change in the return of the market, the return of A changes by a greater amount
in the same direction implying that asset A's beta is greater than one.
The return on asset B does not change, implying that asset B's beta is 0.
Diff: 2
Section: 2.2
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11) The table below gives the historic return over the past five months for the market portfolio and two
assets: A and B. Which of the answers below best describes the historic beta for A and B?
Month
1
2
3
4
5
Market
4%
2%
4%
9%
3%
Asset A
3%
1%
2%
7%
1%
Asset B
10%
5%
8%
12%
7%
A) βA < 1; βB < 1
B) βA = 0; βB < 1
C) βA = 0; βB > 0
D) βA > 1; βB > 1
E) βA < 1; βB > 1
Answer: E
Explanation: E) Beta tells us that if the market's return changes by X%, then the asset's return changes by
β * X%.
For each change in the return of the market, the return of stock A changed in the same direction by a
smaller amount implying that stock A's beta is < 1.
For each change in the return of the market, the return of stock B changed in the same direction by a
greater amount implying that stock B's beta is > 1.
Diff: 1
Section: 2.2
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12) Last year the market's return was 7% and Hare Growth earned 9%. This year the market was up and
yielded 17%. If Hare Growth's Beta is 1.75, then what is Hare's return this year?
A) 12.25%
B) 15.75%
C) 17.50%
D) 24.50%
E) 26.50%
Answer: E
Explanation: E) Beta is the slope of the characteristic line. The slope is the rise over the run. In other
words, the change in the y-axis variable (the stock) over the change in the x-axis variable (the market).
Beta =
Δk = Beta × ΔkM
The market's return changed by +10% (from 7% to 17%) so:
Δk = 1.75 × 10% = 17.50%
Hare Growth's return this year is equal to its return last year plus the change in its return for this year:
k = 9% + 17.50% = 26.5%
Diff: 3
Section: 2.2
AACSB: Analytical Thinking
13) In the Capital Asset Pricing Model (CAPM), beta measures
A) the standard deviation of a single asset.
B) the price volatility of a single security not held in a portfolio.
C) the degree of correlation between two securities.
D) the historical relationship between the returns from an asset and the returns from the efficient
portfolio.
E) the firm-specific risk of an asset.
Answer: D
Explanation: D) The slope of the line that best fits the returns of the asset against the returns of the
market is beta.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
14) Fishing supply company, Outside Tackle, has its returns graphed against the market returns for a 5
year period. The line that has the best fit for the data has the formula y = .1254 + 1.265x. What information
can we derive from this?
A) The beta of Outside Tackle is .1254.
B) The systematic risk of Outside Tackle is less than average for the market.
C) The beta for Outside Tackle is 1.265.
D) Outside Tackle has posted better returns than the market for this time period.
Answer: C
Explanation: C) The slope of the characteristic line is the beta of the security.
Diff: 1
Section: 2.2
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15) The points that do not fall onto the characteristic line for a company don't do so because of
A) market risk.
B) nondiversifiable risk.
C) total risk.
D) firm-specific risk.
E) standard deviation of returns.
Answer: D
Explanation: D) Variations result from firm-specific risk factors.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
16) What is the Beta for a security whose returns do not vary across states of nature (a risk-free security)?
A) 0
B) Between 0 and 1
C) 1
D) > 1
E) < 0
Answer: A
Explanation: A) If the returns never change, then they are unrelated to the market and the slope of the
security's characteristic line would be zero. When the market rises and falls they stay unchanged, and so
the Beta of such a security is zero.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
17) Your friend tells you that the Prudent Mutual Fund gives you more downside protection than buying
an exchange traded fund (ETF) that mimics the market portfolio. What is he telling you about the fund's
Beta?
A) β < 1
B) β > 1
C) β = 1
D) β = 0
Answer: A
Explanation: A) If a fund gives you more "downside protection" than the market index, that means that
the fund's returns fall more slowly than the returns on the market in Bear markets. If that is true, then the
Beta of the fund is less than one.
Diff: 1
Section: 2.3
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18) A friend tells you about a fund that does just as well as the market in bull markets but cushions your
fall in bear markets. That is, its returns fall by less than the market's in bear markets. Your friend is telling
you that the fund's Beta is ________ in bull markets, but that the fund's Beta is ________ in bear markets.
A) less than one; less than one
B) less than one; equal to one
C) equal to one; less than one
D) equal to one; greater than one
E) greater than one; less than one
Answer: C
Explanation: C) Your friend is telling you that the fund's Beta is equal to one in bull markets (because it
goes up by the same amount as the market), but that the fund's Beta is less than one in bear markets
(because the fund's returns fall by less than the market's returns).
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
19) You own a stock portfolio invested 30% in a film company, 20% in a bank stock, 10% in a mining
company, and 40% in an oil company. The betas of these four shares are 1.4, 0.6, 1.5, and 1.8 respectively.
What is the portfolio beta?
A) 1.00
B) 1.20
C) 1.35
D) 1.41
E) 1.50
Answer: D
Explanation: D) Take the weighted average of the individual betas to find the portfolio beta.
βp = w1β1 + . . . + wnβn
βp = (0.30 × 1.4) + (0.20 × 0.6) + (0.10 × 1.5) + (0.40 × 1.8)
βp = 0.42 + 0.12 + 0.15 + 0.72 = 1.41
Diff: 2
Section: 2.3
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20) Your portfolio had a beta of 1.233. The portfolio included two shares. The first stock had a beta of 0.7
and the second had a beta of 1.1. What were the portfolio weights for each stock?
A) -0.333 in stock 1; 1.333 in stock 2
B) -0.333 in stock 2; 1.333 in stock 1
C) 0.333 in stock 1; 0.667 in stock 2
D) 0.333 in stock 2; 0.667 in stock 1
E) None of the above.
Answer: A
Explanation: A) Let w be the portfolio weight of the first stock and (1 - w) the weight on the second:
βp = w1β1 + . . . + wnβn
1.233 = w(0.7) + (1 - w)(1.1)
1.233 = 0.7w + 1.1 -1.1w
0.133 = -0.4w
w=
= -0.333
The weight of Stock 2 = (1 - (-0.333)) = 1.333
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21) You hold the following portfolio, consisting of Assets A, B and C. What is the portfolio beta?
Asset
A
B
C
Return
10%
12%
14%
Beta
0.75
1.00
1.25
Portfolio
Weight
0.20
0.40
0.40
A) 0.75
B) 1.00
C) 1.05
D) 1.15
E) 1.25
Answer: C
Explanation: C) Take the weighted average of the individual betas to find the portfolio beta.
βp = w1β1 + . . . + wnβn
βp = (0.20 × 0.75) + (0.40 × 1.0) + (0.40 × 1.25)
βp = 0.15 + 0.40 + 0.50 = 1.05
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22) You manage a portfolio in which you invest half of your money in T-Bills and the other half in a
mutual fund that is indexed to match the market portfolio. What is the beta of this portfolio?
A) 0
B) 0.25
C) 0.50
D) 0.75
E) 1.00
Answer: C
Explanation: C) Take the weighted average of the individual betas. Remember the market has a beta of
1.0 and the risk free asset a beta of 0.
βp = w1β1 + . . . + wnβn
βp = (0.50 × 1.0) + (0.50 × 0)
βp = 0.50 × 1.0 = 0.50
The beta for T-Bills (a risk-free asset) is 0, and the beta for the market (by definition) is 1. With half
invested in each, that makes the beta of the portfolio 0.5.
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23) You own two mutual funds. Fund A has an expected return of 12% and a beta of 0.8. Fund B has an
expected return of 18% and a beta of 1.4. If your portfolio beta is the same as the market portfolio, what
proportion of your portfolio is invested in fund A?
A) 1/4
B) 1/3
C) 1/2
D) 2/3
E) 3/4
Answer: D
Explanation: D) Let w be the weight of fund A:
βp = wβ1 + (1 - w)β2
1.0 = w(0.8) + (1 - w)(1.4)
1.0 = 0.8w + 1.4 - 1.4w
-0.4 = -0.6w
w = 2/3
Diff: 3
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24) You manage your own portfolio of about twenty shares. One of which is Honda Motors. The returns
on Honda tend to move up and down with the economy as a whole. You decide to sell Honda and
replace it with the common stock of Repo-Man Inc., an asset recovery company. Repo-Man's shares tend
to rise when the economy falls, and vice versa. Your portfolio's beta should
A) decrease.
B) increase.
C) remain unchanged.
D) either increase or decrease.
Answer: A
Explanation: A) If a stock's returns move up and down with the economy, then the Beta is positive.
Honda's Beta is positive.If a stock's returns move inversely with the economy, then the Beta is negative.
Repo-Man's Beta is negative.A portfolio's Beta is a weighted average of the betas of all the shares in the
portfolio. If you replace a positive beta with a negative beta, then the weighted average will fall.
Diff: 2
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25) Warren has a portfolio with three shares as shown in the table. What is the beta of Warren's portfolio?
Stock
Raymond's
Keller
Industries
Huron Power
Required
Return
6.75%
Portfolio
Weight
0.4
Beta
0.50
11.43%
9.27%
0.35
0.25
1.50
1.05
A) 0.775
B) 0.988
C) 1.017
D) 1.340
E) 1.505
Answer: B
Explanation: B) Take the weighted average of the individual betas to find the portfolio beta.
βp = w1β1 + . . . + wnβn
βp = (0.40 × 0.50) + (0.35 × 1.50) + (0.25 × 1.05)
βp = 0.20 + 0.525 + 0.2625 = 0.9875 or 0.988
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26) Peter Lynch has the following portfolio of investments:
Stock
A
B
C
D
Investment
$21 million
$42 million
$11 million
$32 million
Beta
0.945
1.47
2.10
1.26
What is the beta of Peter's portfolio?
A) 1.000
B) 1.126
C) 1.366
D) 1.534
E) 1.877
Answer: C
Explanation: C) First determine the weights of each stock in the portfolio:
Total Investment = $21 + $42 + $11 + $32
Total Investment = $106 million.
w1 =
= 0.20
w2 =
= 0.40
w3 =
= 0.10
w1 =
= 0.30
Next take the weighted average of the individual betas to find the portfolio beta.
βp = w1β1 + . . . + wnβn
βp = (0.20 × 0.945) + (0.40 × 1.47) + (0.10 × 2.10) + (0.30 × 1.26)
βp = 0.19 + 0.588 + 0.21 + 0.378 = 1.366
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27) You own a portfolio that is equally invested in three assets: 1) the risk-free asset; 2) Stock 1; and 3)
Stock 2. Stock 1 has a beta of 1.9 and the portfolio has the same risk as the market portfolio.
What is the beta of Stock 2 in the portfolio?
A) 1.0
B) 1.1
C) 1.2
D) 1.3
E) 1.4
Answer: B
Explanation: B) The market has a beta of 1, so we know the total portfolio also has a beta of 1.
The risk-free asset has a beta of 0.
βp = w1β1 + . . . + wnβn
1.0 = (0.33 × 1.9) + (0.33 × β2) + (0.33 × 0)
1.0 = 0.627 + (0.33 × β2)
0.373 = (0.33 × β2)
β2 = 1.1
Diff: 3
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28) If Acme Dynamite stock has a beta of .8 and a standard deviation of 15% and Splat Paintball stock has
a beta of 1.3 and a standard deviation of 9%, what is the beta of a portfolio comprised of equal weights of
both securities?
A) 24%
B) 12%
C) 18%
D) 1.05
E) 2.10
Answer: D
Explanation: D) βp = w1β1 + . . . + wnβn
βp = (0.50 × 0.80) + (0.50 × 1.3)
βp = 0.40 + 0.65 = 1.05
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29) Tom wishes to calculate the riskiness of his portfolio, which is comprised of equal amounts of two
shares. Which of the following measures would you recommend?
A) Weighted average betas of the two securities
B) A weighted average of the correlation between the two securities
C) Weighted average standard deviations
D) The slope of the security market line
E) A weighted average of the coefficients of variation
Answer: A
Explanation: A) The beta of a portfolio is the weighted average of the individual betas.
Diff: 1
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30) A beta coefficient of + 1 represents an asset that
A) is unaffected by market movement.
B) is less responsive than the market portfolio.
C) has the same response as the market portfolio.
D) is more responsive than the market portfolio.
Answer: C
Explanation: C) The Market's Beta is Equal to 1.
Diff: 1
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31) The beta of a portfolio
A) does not change over time.
B) is irrelevant, only the betas of the individual assets are important.
C) is the weighted average of the betas of the individual assets in the portfolio.
D) is the sum of the betas of all assets in the portfolio.
Answer: C
Explanation: C) The beta of a portfolio is the weighted average of the individual betas.
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32) The beta of the market
A) is 1.
B) is greater than 1.
C) cannot be determined.
D) is less than 1.
Answer: A
Explanation: A) The market's beta is equal to 1.
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33) An individual's portfolio consists of three separate assets. Asset 1 has a beta of 1.4, asset 2 has a beta of
.84 and asset 3 has a beta of 1.05. The investor has invested $240 in asset 1, $500 in asset 2, and $260 in
asset 3. Calculate the portfolio beta.
A) 1.03
B) 1.17
C) 1.09
D) 0.93
E) 0.85
Answer: A
Explanation: A) Step 1 - Calculate the portfolio weights.
Total portfolio value = $240 + $500 + $260 = $1,000
wi =
The weight of Asset 1 =
= 0.24
The weight of Asset 2 =
= 0.50
The weight of Asset 3 =
= 0.26
Step 2 - Use the weights to compute the portfolio beta.
βp = w1β1 + . . . + wnβn
βp = (0.24 × 1.4) + (0.50 × 0.84) + (0.26 × 1.05)
βp = 0.336 + 0.42 + 0.273 = 1.03
Diff: 3
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LO3: Explain the Relationship between Nondiversifiable Risk and Return
1) Beta is the slope of the security market line.
Answer: FALSE
Explanation: The SML is the graph of the CAPM equation, E(ki) = kF + βi[E(kM) - kF].
Remember that the graph of a straight line is y = b + mx, where m is the slope of the line. Therefore, the
slope of the SML is the market risk premium: E(kM) - kF.
Diff: 1
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2) You want to buy $20,000 worth of shares in Tootsie Roll Industries Inc. on margin, but you only have
$10,000 of your own money to invest. The remaining $10,000 is borrowed by issuing T-Bills; assume the
cost of borrowing is the risk-free rate. What is the portfolio weight for Tootsie Roll?
A) 0.25
B) 0.50
C) 1.00
D) 1.50
E) 2.00
Answer: E
Explanation: E) wi =
wi =
= 2.0
Diff: 2
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3) A friend tips you off on a hot stock: Sure Thing Mines Ltd. You only have $10,000 to invest but you
want to invest more. Assume that you can borrow an additional $5,000 by short-selling the risk free asset
(issuing T-Bills). You purchase $15,000 worth of shares in Sure Thing Mines Ltd.
The expected returns and standard deviations of the two assets are outlined in the table below:
Asset
T-Bills
Sure Thing
Mines
Expected
Return
5.5%
Beta
0
15%
1.70
What is the beta of the portfolio?
A) 1.50
B) 1.70
C) 2.50
D) 2.55
E) 2.70
Answer: D
Explanation: D) Step 1 - Compute the weights of each asset in the portfolio.
You issued $5,000 of T-Bills, so you are short T-Bills. Short positions are represented by negative portfolio
weights.
wi =
wt-bills =
wSure Thing =
= -0.50
= 1.50
Step 2 - Use the weights to compute the beta for the portfolio.
βp = w1β1 + . . . + wnβn
Recall that the beta of the risk free asset is 0
βp = -0.50 × 0 + 1.50 × 1.70 = 2.55
Diff: 3
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4) Your video-game addicted nephew tells you that the Nintendo Wii is much better than the Microsoft
X-Box. To take advantage of this information, you decide to build a two asset portfolio by buying shares
in Nintendo and selling shares short in Microsoft. For your long position you buy 1700 shares of
Nintendo at a price of $40 per share. For the short position, you sell 1000 shares in Microsoft at a price of
$35 per share. What is the portfolio weight for your short position in Microsoft?
A) -1.06
B) -0.94
C) 0
D) 0.34
E) 0.50
Answer: A
Explanation: A) The short position generates a positive cash flow, so your equity investment in the
portfolio is the cost of buying Nintendo less the proceeds from selling Microsoft. Investment = Cost of
buying Nintendo - Proceeds from selling MicrosoftInvestment = $68,000 - $35,000Investment = $33,000
wi =
The weight of Nintendo in the portfolio =
= 2.06
The portfolio weight on the Microsoft position =
= -1.06
The weight on Microsoft is negative because it is a short position. Just to verify the weights:
2.06 + (-1.06) = 1.
Diff: 4
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5) You are looking over your brother's portfolio. In his portfolio, he is holding one long position and one
short position. Jimmy, your brother, bought 1,600 shares of Sunny Inc. each for $55. He sold 1,000 shares
of Rainy Ltd. for $50 a share. Calculate the portfolio weight on the Rainy Ltd. position.
A) -1.32
B) -0.76
C) -0.50
D) 0.24
E) 0.30
Answer: A
Explanation: A) The short position generates a positive cash flow, so your equity investment in the
portfolio is the cost of buying Sunny less the proceeds from selling Rainy. Investment = Cost of buying
Sunny - Proceeds from selling RainyInvestment = $88,000 - $50,000Investment = $38,000
wi =
The portfolio weight on the Sunny position is =
= 2.32
The portfolio weight on the Rainy position is =
= -1.32
The weight on Rainy is negative because it is a short position. Just to verify the weights:
2.32 + (-1.32) = 1.
Diff: 4
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6) Your friend, Dobson, manages the Formula Growth mutual fund. Dobson expects to earn 11% on his
portfolio with a beta of 1.2. You only invest in shares of General Electric and T-Bills. You like GE because
it was started in 1890 by Thomas Edison, the great American inventor, and it has a diversified portfolio of
products including jet engines and MRI diagnostic imaging machines. The expected return of GE is 13%
and its beta is 1.40. The expected return on T-Bills is 2%. If you construct your portfolio so that its risk is
equal to the risk of Formula Growth, then what portfolio weight do you need on the shares of GE?
A) 0.85
B) 0.86
C) 0.87
D) 0.88
E) 0.89
Answer: B
Explanation: B) Since we want the portfolio to have a beta of 1.2, we equate this beta to the weighted
average of the betas of our two securities, GE shares and T-Bills. Let w be the weight of GE.
βp = w1β1 + . . . + wnβn
1.2 = w(1.4) + (1 - w)0
1.2 = 1.4w
w=
= 0.857 or 0.86
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7) A friend brags that she expects to earn a return of 10.25% on her portfolio with a beta of 0.825. Can you
match her performance with Stock X (12% return and a beta of 1.1) and the risk free asset that earns a 5%
return? With what portfolio weights?
A) Yes, 0.75 Stock X and 0.25 Risk Free Asset
B) Yes, 0.25 Stock X and 0.75 Risk Free Asset
C) Yes, 0.5 Stock X and 0.5 Risk Free Asset
D) No
Answer: A
Explanation: A) Let w be the weight of Stock X.
βp = w1β1 + . . . + wnβn
0.825 = w(1.1) + (1 - w)0
0.825 = 1.1w
w=
= 0.75
Thus, the weight of the risk-free asset is 0.25.
These weights yield the following portfolio expected return:
E(kp) = w1E(k1) + w2E(k2) + wnE(kn)
E(kp) = (0.75 × 0.12) + (0.25 × 0.05) = 0.1025 or 10.25%
Yes, you can match her risk and return by investing 75% in asset X and the rest in the risk free asset.
Diff: 3
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8) You want to buy $20,000 worth of shares in Tootsie Roll Industries Inc. on margin, but you only have
$10,000 of your own money to invest. The remaining $10,000 is borrowed by issuing T-Bills; assume the
cost of borrowing is the risk-free rate. What is the portfolio weight for the risk free asset (T-Bills)?
A) -1.00
B) -0.50
C) 1.00
D) 0.50
E) 2.00
Answer: A
Explanation: A) wi =
You issued $10,000 of T-Bills, so you are short T-Bills. Short positions are represented by negative
portfolio weights.
wi =
= -1.0
Diff: 2
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9) You want to buy $20,000 worth of shares in Tootsie Roll Industries Inc. on margin, but you only have
$10,000 of your own money to invest. The remaining $10,000 is borrowed by issuing T-Bills; assume the
cost of borrowing is the risk-free rate. The weight of Tootsie Roll Industries in your portfolio is 2.0. The
weight of T-Bills in your portfolio is -1.0. Assume that the expected return on Tootsie Roll is 12% and the
expected return on the risk free asset (T-Bills) is 5%. What is the return on your portfolio?
A) 17%
B) 18%
C) 19%
D) 20%
E) 21%
Answer: C
Explanation: C) E(kp) = w1E(k1) + w2E(k2) + wnE(kn)
E(kp) = 2.0(.12) + -1.0(.05) = .19
Diff: 2
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10) You want to buy $20,000 worth of shares in Tootsie Roll Industries Inc. on margin, but you only have
$10,000 of your own money to invest. The remaining $10,000 is borrowed by issuing T-Bills; assume the
cost of borrowing is the risk-free rate. The weight of Tootsie Roll Industries in your portfolio is 2.0. The
weight of T-Bills in your portfolio is -1.0. Assume that Tootsie Roll has a beta of 0.75. What is the beta of
the portfolio?
A) 0.75
B) 1.25
C) 1.50
D) 1.75
E) 2.00
Answer: C
Explanation: C) βp = w1β1 + . . . + wnβn
Recall that the beta of the risk free asset is 0
βp = 2.0 × 0.75 = 1.50
Diff: 2
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11) Consider the two assets outlined in the table below. What is the beta of the two asset portfolio given
that 40% is invested in X?
Asset
X
Risk Free
Expected
Return
12%
5%
Beta
0.40
0
A) 0.026
B) 0.085
C) 0.160
D) 0.190
E) 0.220
Answer: C
Explanation: C) βp = w1β1 + . . . + wnβn
Recall that the beta of the risk free asset is 0.
βp = 0.40 × 0.40 + 0.60 × 0 = 0.16
Diff: 2
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12) You live in an Eichler-built house in Cupertino California. You admire Apple so much that it is the
only stock that you want in your portfolio. You have $100,000 of your own money to invest and you
intend to buy more Apple on margin by borrowing an additional $40,000. Your broker will lend to you at
the risk free rate, 5%, and has guaranteed the lending rate for the duration of your investment. Apple's
expected return is 12% and the expected return on the market is 8%. Apple's beta is 1.25. What beta do
you expect from your portfolio?
A) 1.25
B) 1.45
C) 1.55
D) 1.65
E) 1.75
Answer: E
Explanation: E) Your investment is $100,000.
The portfolio weight on the Apple position is:
wi =
=
= 1,4
The margin loan is risk free (guaranteed by the broker) so it is equivalent to a short position in the risk
free asset. Thus, its beta is zero.
βp = w1β1 + . . . + wnβn
βp = (w)1.25 + (1 - w)0
βp = 1.4 × 1.25 = 1.75
Diff: 3
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13) The ________ shows the possible risk/return combinations for a portfolio.
A) Portfolio Possibility Line
B) Portfolio Beta
C) Modern Portfolio Theory
D) Momentum Effect
Answer: A
Explanation: A) The portfolio possibility line is the graph of the possible risk/return combinations for a
portfolio.
Diff: 1
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14) When buying on margin, the amount of money provided by the investor is called
A) collateral.
B) margin.
C) capital.
D) order.
E) cash.
Answer: B
Explanation: B) The amount of money provided by the investor is called margin.
Diff: 1
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15) George wants to pick a stock for his Diversified Hedge Fund. The fund has holdings in every country
with a stock market. George is trying to decide which asset he should add to his portfolio: Stock A or
Stock B. Expected return, Standard deviation and beta values for the two shares are outlined in the table
below. Which stock is best for George's portfolio and why?
Expected
Return
Standard
Deviation
Beta
Stock A
Stock B
Risk-Free Asset
8%
12%
5%
12%
1
22%
2
A) Stock A because it has a lower Beta.
B) Stock A because it has more return per unit of standard deviation.
C) Stock B because it has a higher return.
D) Stock B because it has a higher Treynor Index with respect to standard deviation.
E) Stock B because it has a higher Treynor Index with respect to Beta.
Answer: E
Explanation: E) Since George's portfolio is diversified, he is only concerned with systematic
(nondiversifiable) risk. Recall that Beta measures the amount of systematic risk possessed by an asset.
Beta is the relevant measure of risk for George, and he should choose the stock with the highest return
premium per unit of beta risk (Treynor index).
Recall that the Treynor Index measures the excess of an asset's return over the risk-free return per unit of
systematic risk. George should choose the stock with the highest Treynor index.
Treynor Index =
Treynor Index for Stock A =
= 0.03
Treynor Index for Stock B =
= 0.035
Since Stock B has a greater Treynor index, it offers a higher reward per unit of risk. George should choose
Stock B.
Diff: 3
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16) You have been scouring The Wall Street Journal looking for shares to add to your (large) portfolio. The
table presents data that you have collected on four shares that look promising. You have calculated the
return that you anticipate earning from each stock along with its beta. Which of the four securities should
you add to your portfolio? (Assume you must choose just one.) Assume the risk-free rate is 7.00% and the
market risk premium is 2.00%.
Stock
A
B
C
D
Anticipated
Return
9.01%
7.06%
8.74%
11.50%
Beta
1.70
0.00
0.87
2.50
A) Stock A
B) Stock B
C) Stock C
D) Stock D
Answer: B
Explanation: B) Calculate the Treynor Index (TI) of each stock, and compare each to the market's Treynor
Index (slope of Security Market Line):
Treynor Index =
Treynor Index for the market =
= 0.02
Treynor Index for Stock A =
= 0.01182
Treynor Index for Stock C =
= 0.02
Treynor Index for Stock D =
= 0.018
We can see that Stock C plots on the SML, while Stocks A and D plot below it. Without calculating the
Treynor Index of Stock B, we know that it plots above the SML. This is because it has a Beta equal to zero
(i.e. risk free) and it has a rate of return (7.06%) higher than the risk free rate (7%).
Diff: 3
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17) The table below shows selected financial data for the Turtle Income fund, the Hare Growth fund, the
market portfolio and the risk free asset. What is the market's Treynor Index?
Expected
Return
Std Dev.
Beta
Turtle
Hare
Market
Risk Free
10%
8.5%
0.7143
13%
17.9%
1.4
12%
11.9%
1
5%
0%
0
A) 5.00%
B) 5.71%
C) 6.21%
D) 7.00%
E) 12.20%
Answer: D
Explanation: D) The market's Treynor index (slope of the SML) can be measured using rise-over-run.
Treynor Index =
Treynor Index for the market =
= 0.07 or 7%
Diff: 2
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18) Which of the following funds is the best choice for a well-diversified investor?
Expected
Return
Standard
Dev.
Beta
Balanced
Fund
Growth
Fund
Hedge
Fund
Market
Portfolio
Risk-Free
Asset
9.3%
11.0%
11.5%
9.0%
3.0%
26.0%
1.18
32.0%
1.45
35.0%
1.52
22.0%
1.00
0%
A) Balanced
B) Hedge
C) Growth
Answer: B
Explanation: B) Each fund offers a different expected return, as well as a different level of risk. We can
differentiate between them by comparing the Treynor Indexes for each fund:
Treynor Index =
Treynor Index for Balanced =
= 0.05339 or 5.339%
Treynor Index for Growth =
= 0.05517 or 5.517%
Treynor Index for Hedge =
= 0.05592 or 5.592%
The Hedge fund has the highest Treynor Index, and therefore generates the most return per unit of risk,
making it the best investment.
Diff: 2
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19) The table below presents performance data for the Socially Responsible mutual fund over the last five
years. The table also includes information on the returns of the market index and T-Bills over the same
period. What is the Treynor Index for Socially Responsible?
Average
Return
Socially
Responsible
Market
T-Bills
13%
6%
1.5%
Standard
Deviation
Beta
37.5%
15%
N/A
3
1
N/A
A) 2.3%
B) 3.8%
C) 7.0%
D) 9.5%
E) 11.5%
Answer: B
Explanation: B) Treynor Index =
Treynor Index for Socially Responsible =
= 3.8%
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20) Refer to the performance data for three mutual funds and the market portfolio in the following table.
Which is the best investment based on its excess return per unit of systematic risk?
5 year
return
Beta
Treynor
Index
AGF
AIM
Alta
Market
Risk-free
0.1348
1.35
0.0784
1.02
0.0574
0.78
0.1361
1
0.02
0
?
0.0573
0.0479
0.1161
A) AGF
B) AIM
C) Alta
D) Market
E) Risk-Free
Answer: D
Explanation: D) The Treynor index measures the excess return per unit of systematic risk.
Treynor Index =
Treynor Index for AGF =
= 0.085 or 8.5%
The market has the highest Treynor index, so it is the best investment.
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21) The table below shows selected financial data for the Turtle Income fund, the Hare Growth fund, the
market portfolio and the risk free asset. Calculate the Treynor Index for each of the funds. How do the
Treynor Index measures for the two funds compare to the Market's Treynor Index value?
Expected
Return
Std Dev.
Beta
Turtle
Hare
Market
Risk Free
10%
8.5%
0.7143
13%
17.9%
1.4
12%
11.9%
1
5%
0%
0
A) Turtle < Hare < Market
B) Turtle < Hare = Market
C) Hare < Turtle < Market
D) Hare < Turtle = Market
E) Market < Hare < Turtle
Answer: D
Explanation: D) Treynor Index =
Treynor Index for the market =
Treynor Index for Hare =
= 0.07
= 0.057
Treynor Index for Turtle =
= 0.07
Turtle's Treynor Index is equal to the market's. However, Hare's is less than the market's.
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22)
Asset
Stock A
Stock B
Risk-Free Asset
Expected
Return
9%
11%
5%
Beta
0.9
1.4
Consider the assets outlined in the table above. Which asset offers the best risk-return trade-off?
A) Stock A
B) Stock B
C) The risk-free asset
D) Either Stock A or Stock B as both have the same risk-return trade-off
Answer: A
Explanation: A) The Treynor Index measures the excess of an asset's return over the risk-free return per
unit of systematic risk, essentially the risk-return trade off.
Treynor Index =
Treynor Index for Stock A =
= 0.0444
Treynor Index for Stock B =
= 0.0428
Stock A has the higher Treynor Index, and therefore the better risk-return trade-off.
Diff: 2
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23) Fred's Frankfurters has an expected return of 18.9%. The market has an expected return of 13.5%. If
the risk free rate is 5%, calculate the Treynor Index. (Round to two decimal places)
A) 13.90%
B) 5.40%
C) 5.18%
D) 8.48%
E) 7.50%
Answer: D
Explanation: D) Step 1 - Calculate the beta for Fred's Frankfurters.
E(ki) = kF + βi[E(kM) - kF]
βi =
βi =
=
= 1.64
Step 2 - Use the beta to compute the Treynor Index.
Treynor Index =
Treynor Index =
= 0.0848
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24) You are considering investing in Stock ABC. This stock has an expected return of 14%, the risk free
rate is 5%, and the market risk premium (or Treynor Index) is 8%. What is the beta of Stock ABC?
A) 0.950
B) 1.125
C) 1.250
D) 1.400
E) 1.500
Answer: B
Explanation: B) Treynor Index =
In equilibrium, all assets have the same Treynor index as the market, which is the market risk premium
or 8%.
0.08 =
0.08βABC= 0.09
βABC =
βABC = 1.125
Diff: 2
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25) Your friend tells you that ABC Mutual Fund can beat the market return and has less risk than the
market. Is this possible?
A) In the short-run, yes. In the long-run, no.
B) In the short-run, yes. In the long-run, yes.
C) In the short-run, no. In the long-run, no.
D) In the short-run, no. In the long-run, yes.
Answer: A
Explanation: A) Your friend is suggesting that fund plots above the SML. The SML indicates the long-run
"expected" return. So, in the long-run all assets (and funds) plot on the SML. However, in the short-run a
fund's (or asset's) return will vary around the average (expected value) and so the fund could outperform the SML for brief periods of time.
Diff: 1
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26) The table below shows selected financial data for the Turtle Income fund, the Hare Growth fund, the
market portfolio and the risk free asset. If you wanted to build a portfolio out of T-Bills and the market
portfolio to mimic the performance of the Turtle Income Fund, what proportion would you invest in the
market portfolio?
Expected
Return
Std Dev.
Beta
Turtle
Hare
Market
Risk Free
10%
8.5%
0.7143
13%
17.9%
1.4
12%
11.9%
1
5%
0%
0
A) 37.1%
B) 50.0%
C) 71.4%
D) 105.7%
E) 140.0%
Answer: C
Explanation: C) The quickest way to find the replicating portfolio for Turtle is to look at Turtle's Beta
Turtle's Beta is 0.7143. If we had invested 71.4% of our wealth in the market portfolio and the remainder
in T-Bills we would have earned the same return and Beta as Turtle.
To double check:
The return of the portfolio is the weighted average of the returns of each asset
E(kp) = (0.7143 × 0.12) + (0.2857 × 0.05)
E(kp) = 0.085716 + 0.014285 = 0.10
The beta of the portfolio:
βp = w1β1 + . . . + wnβn
βp = (0.7143 × 1.0) + (0.286 × 0) = 0.7143
Diff: 3
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27) The expected return on the market is 10%, the risk free rate is 5% and Midnight Rider Trucking Inc.
has a beta of 1.2. What is the expected return for Midnight Rider Trucking Inc.?
A) 4%
B) 7%
C) 11%
D) 13%
E) 16%
Answer: C
Explanation: C) E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.05 + 1.20 (0.10 - 0.05)
E(ki) = 0.05 + 0.06 = 0.11 or 11%
Diff: 2
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28) The equilibrium expected return on an asset is 14%, the risk-free rate is 4% and the return on the
market portfolio is 12%. What is the beta of the asset?
A) 1.10
B) 1.15
C) 1.20
D) 1.25
E) 1.30
Answer: D
Explanation: D) E(ki) = kF + βi[E(kM) - kF]
βi =
βi =
=
= 1.25
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29) The required return on a security is 10%, the risk-free rate is 5%, and the return on the market is 14%.
What is the beta of the firm?
A) 0.14
B) 0.55
C) 0.83
D) 1.00
E) 1.40
Answer: B
Explanation: B) Rearrange the CAPM equation to solve for beta.
E(ki) = kF + βi[E(kM) - kF]
βi =
βi =
=
= 0.55
Diff: 2
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30) The risk-free rate is 7 percent, the expected return on the market is 10 percent, and the expected return
on Security J is 13 percent. What is the beta of Security J?
A) 0.5
B) 1.0
C) 1.5
D) 2.0
E) 2.5
Answer: D
Explanation: D) Rearrange the CAPM equation to solve for beta.
E(ki) = kF + βi[E(kM) - kF]
βi =
βi =
=
=2
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31) When the conclusion of the capital asset pricing model is graphed, the resulting line is called the
A) Beta.
B) Capital Market Line.
C) Characteristic Line.
D) Efficient Set.
E) Security Market Line.
Answer: E
Explanation: E) The graph of the CAPM equation is called the security market line or SML.
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32) A stock has a beta of 1.8. The expected market return is 10.5%. The equilibrium return for the stock is
17.30%. What is the risk-free rate according to the CAPM?
A) 1%
B) 2%
C) 3%
D) 4%
E) 5%
Answer: B
Explanation: B) E(ki) = kF + βi[E(kM) - kF]
kF =
kF =
kF = 0.02 or 2%
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33) Which of the following is true about the Security Market Line (SML)? The SML
A) expresses a relationship between expected returns and systematic (nondiversifiable) risk.
B) expresses the equilibrium relationship between expected returns and risk for all shares.
C) expresses the long-run average return.
D) is a function of beta.
E) All of the above are true.
Answer: E
Explanation: E) All of these statements are true regarding the SML.
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34) The risk-free rate is 5%, the beta of Stock A is 1.2, the beta of Stock B is 0.8, and the expected return on
Stock A is 12.2%. What is the expected return on the market portfolio?
A) 8.4%
B) 9.2%
C) 9.8%
D) 11.0%
E) 12.2%
Answer: D
Explanation: D) Based on stock A:
E(ki) = kF + βi[E(kM) - kF]
0.0122 = 0.05 + 1.2[E(kM) - 0.05]
0.072 = 1.2[E(kM) - 0.05]
0.06 = E(kM) - 0.05
E(kM) = 0.11 or 11%
Diff: 2
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35) The risk-free rate is 5%, the beta of Stock A is 1.2, the beta of Stock B is 0.8, and the expected return on
Stock A is 12.2%. What is the expected return on Stock B?
A) 8.4%
B) 9.2%
C) 9.8%
D) 11.0%
E) 12.2%
Answer: C
Explanation: C) Step 1 - Find the return on the market portfolio from data for Stock A:
E(ki) = kF + βi[E(kM) - kF]
0.0122 = 0.05 + 1.2[E(kM) - 0.05]
0.072 = 1.2[E(kM) - 0.05]
0.06 = E(kM) - 0.05
E(kM) = 0.11 or 11%
Step 2 - Solve for expected return of Stock B:
E(ki) = 0.05 + 0.8 [0.11 - 0.05]
E(ki) = 0.05 + 0.088 - 0.04
E(ki) = 0.05 + 0.048 = 0.098 or 9.8%
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36) The expected return on the market is 10%, the risk free rate is 5% and Black Magic Cosmetics Inc. has
a beta of -1. What is the expected return for Black Magic Cosmetics Inc.?
A) -10%
B) -5%
C) 0%
D) 5%
E) 7.5%
Answer: C
Explanation: C) E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.05 - 1.0 (0.10 - 0.05)
E(ki) = 0.05 - 0.05 = 0%
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37) Assume that the financial markets are in equilibrium. Information on three particular shares is
provided in the table below. Find the risk free rate and the expected return on the market portfolio.
Asset
A
B
C
Expected
Return
7.6%
12.4%
15.6%
Beta
0.2
0.8
1.2
A) 5%, 14%
B) 5%, 18%
C) 6%, 14%
D) 6%, 18%
E) 7%, 16%
Answer: C
Explanation: C) Use the Treynor Index. Recall that capital market equilibrium occurs when all securities
lie on the SML - when the Treynor Indexes of all assets are equal.
This means that all three assets will have the same Treynor Index, which is the slope of the SML.
First use the Treynor Index to find the risk-free rate:
Treynor Index =
Treynor Index for A =
Treynor Index for B =
We know that these two Treynor Indexes are equal, so we can set them equal to each other and solve for
kF:
(0.076 - kF) / 0.2 = (0.124 - kF) / 0.8
0.8 (0.076 - kF) = 0.2 (0.124 - kF)
0.0608 - 0.8kF = 0.0248 - 0.2kF
0.0608 = 0.0248 + 0.6kF
0.036 = 0.6kF
kF = 0.6 or 6%
Now solve for the market return using the CAPM Equation and stock A:
E(ki) = kF + βi[E(kM) - kF]
0.076 = 0.06 + 0.2[E(kM) - 0.06]
0.016 = 0.2[E(kM) - 0.06]
0.08 = E(kM) - 0.06
E(kM) = 0.14 or 14%
Diff: 4
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38) Assume that the capital market is in equilibrium, the risk free rate is 2%, and the return on the market
is 12%. You want to construct a portfolio on the SML with an expected return of 16%. What are the
portfolio weights?
A) -0.4, 1.4
B) -0.1, 1.1
C) 0.2, 0.8
D) 0.4, 0.6
E) 0.4, -1.4
Answer: A
Explanation: A) Let w be the weight of the risk-free asset:
E(kp) = wkF + (1 - w)kM
0.16 = 0.02w + (1 - w)0.12
0.16 = 0.02w + 0.12 - 0.12w
0.04 = 0.02w - 0.12w
0.04 = -0.10w
w = -0.4
The weight of the market = 1 - w:
1 - (-0.4) = 1.4
A negative weight on the risk free asset and a weight greater than one on the market portfolio imply
buying the market on margin, or borrowing at the risk free rate to buy more of the market portfolio.
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39) The expected return on the market is 8% and the risk free rate is 3%. A stock has an expected return of
6.75% and a beta of 0.75. Where does the stock plot relative to the SML?
A) Below the SML
B) On the SML
C) Above the SML
Answer: B
Explanation: B) Treynor Index =
Treynor Index for the market =
Treynor Index for the stock =
= 0.05 or 5%
= 0.05 or 5%
Since Treynor indexes are equal, stock plots on the SML.
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40) The expected return on the market is 9% and the risk free rate is 4%. A stock has an expected return of
8% and a beta of 0.8. What is the slope of the SML?
A) 1.00%
B) 4.00%
C) 5.00%
D) 8.00%
E) 9.00%
Answer: C
Explanation: C) The SML is the graph of the CAPM equation, E(ki) = kF + βi[E(kM) - kF]. We know the
graph of a straight line is given by the equation y = b + mx, where m is the slope of the line. Using this
concept we can see that the slope of the SML is given by the market risk premium E(k M) - kF.
E(kM) - kF = 0.09 - 0.04 = 0.05 or 5%
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41) Assume that the risk-free rate is 5.5% and the market risk premium is 6%. A portfolio manager has
$10 million invested in a two-asset portfolio that has an (equilibrium) expected return of 12%. The
manager plans to sell $3 million of Stock A with a beta of 1.6. She plans to reinvest this $3 million into
Stock B that has a weight of 0.70. What is the (equilibrium) expected return of her new portfolio?
A) 8.28%
B) 10.38%
C) 10.52%
D) 10.90%
E) 11.31%
Answer: B
Explanation: B) Step 1 - Find the beta for the old portfolio from the CAPM given the expected return:
E(ki) = kF + βi[E(kM) - kF]
0.12 = 0.055 + βi(0.06)
0.065 = βi(0.06)
βi = 1.0833
Step 2 - We know the old portfolio had a beta of 1.0833, and contained only two assets, so we can
calculate the beta for the other asset in the portfolio:
βp = w1β1 + . . . + wnβn
1.0833 = (0.3 × 1.6) + (0.7 × β2)
1.0833 = 0.48 + (0.7 × β2)
β2 =
= 0.8619
Step 3 - Calculate the beta of the new portfolio:
βp = (0.3 × 0.7) + (0.7 × 0.8619)
βp = 0.21 + 0.60333 = 0.8133
Step 4 - Find the new expected return:
E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.055 + 0.8133 × 0.06
E(ki) = 0.055 + 0.048798 = 0.1038 or 10.38%
Diff: 4
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42) J.R. has a three stock portfolio. Details of the portfolio are provided in the table. If the T-bill rate is 5%
and the market risk premium is 5.5%. According to the CAPM, what is the expected return of J.R.'s
portfolio?
Stock
Motherlode
Mines
Lewd Lemons
Bonanza Beef
Investment
Beta
$30,000
$40,000
$30,000
1.6
1.0
0.8
A) 5.50%
B) 6.16%
C) 10.00%
D) 10.50%
E) 11.16%
Answer: E
Explanation: E) In order to find the return on the portfolio as a whole, we must first find the portfolio
beta. Take the weighted average of the individual betas to find the portfolio beta.
βp = w1β1 + . . . + wnβn
βp = (0.3 × 1.6) + (0.4 × 1.0) + (0.3 × 0.8)
βp = 0.48 + 0.4 + 0.24 = 1.12
Use the beta to compute the return on the portfolio.
E(kp) = kF + βp[E(kM) - kF]
E(kp) = 0.05 + 1.12 × 0.055
E(kp) = 0.05 + 0.0616 = 0.1116 or 11.16%
Diff: 3
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43) The Horizons Bull Plus Fund seeks daily investment results that correspond to two times (200%) the
daily performance of the S&P/TDX 60 Index. If you wanted to build a portfolio out of T-Bills and the S&P
Index to mimic the performance of the Bull Plus Fund, then what are the portfolio weights? Assume that
the expected return on the S&P index is 10%, the risk free rate is 4%.
A) wS&P = 1.5 and wT-Bill = -0.5
B) wS&P = 1.67 and wT-Bill = -0.67
C) wS&P = 2 and wT-Bill = -1
D) wS&P = 2.33 and wT-Bill = -1.33
E) wS&P = 2.67 and wT-Bill = -1.67
Answer: E
Explanation: E) The expected return on the Horizons Bull Plus Fund is equal to twice the expected return
on the market portfolio:
E(k) = 2 × E(kM)
E(k) = 2 × 0.10 = 0.20 or 20%
We know that the expected return on the portfolio, which we found must be 20%, is the sum of each
individual security's expected return multiplied by its portfolio weight:
Let w be the weight of the T-Bills
E(k) = w(kF) + (1 - w)(E(kM))
0.20 = w(0.04) + 0.10 - 0.10w
0.10 = 0.04w - 0.10w
0.10 = -0.06w
w = -1.67
The weight of the S&P Index = 1 - w or 1 - (-1.67) = 2.67
Diff: 4
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44) The Explosive Bull Plus Fund seeks daily investment results that correspond to two times (200%) the
daily performance of the S&P/TDX 60 Index. The expected return on the S&P index is 6%, and the
expected return on T-Bills (the risk-free rate) is 2%. If you wanted to build a portfolio out of T-Bills and
the S&P index to mimic the performance of the Fund, then what are the portfolio weights of each asset?
A) wS&P = 1 and wT-Bill = 0
B) wS&P = 1.5 and wT-Bill = -0.5
C) wS&P = 1.8 and wT-Bill = -0.8
D) wS&P = 2.5 and wT-Bill = -1.5
E) wS&P = 2.67 and wT-Bill = -1.67
Answer: D
Explanation: D) The expected return on the Explosive Bull Plus Fund is equal to twice the expected
return on the market portfolio. Let E(k) be the expected return on the Explosive Bull Plus Fund:
E(k) = 2 × E(kM)
E(k) = 2 × 0.06 = 0.12 or 12%
We know that the expected return on the portfolio, which we found must be 12%, is the sum of each
individual security's expected return multiplied by its portfolio weight.
Let w be the weight of the T-Bill:
E(k) = w(kF) + (1 - w)(E(kM))
0.12 = (w × 0.02) + (1 - w)(0.06)
0.12 = 0.02w + 0.06 - 0.06w
0.06 = -0.04w
w = -1.5
The weight of the market = 1 - (-1.5) = 2.5
Diff: 4
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45) The Horizons Bear Plus Fund seeks daily expected returns that are two times (200%) the inverse
(opposite) of the performance of the S&P/TDX 60 Index. If k F = 5% and E(kM) =10%, what is the Beta
coefficient for the Bear Plus Fund?
A) -0.5
B) -2.0
C) -4.0
D) -5.0
E) +1.0
Answer: D
Explanation: D) If the Bear Plus fund wants to have an expected return which is -2 times the return on
the market, then we know:
E(kp) = -2 × E(kM)
From the CAPM we know that E(kp) can be expressed as:
E(kp) = kF + βp[E(kM) - kF]
Substituting the first expression for E(kp) into the second we get:
-2 × E(kM) = kF + βp[E(kM) - kF]
Now we solve for βp:
[-2 × E(kM)] - kF = βp[E(kM) - kF]
βp =
βp =
βp =
=
= -5
Diff: 4
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46) You have been asked to analyze two shares, Stock A and Stock B. The beta of stock A is 1.2, and the
beta of stock B is 0.8. The expected return on stock A is 13.5%, the expected return on stock B is 11.0% and
the risk-free rate is 7%. We also know that stock A is fairly priced. Which of the following regarding Stock
B must be true?
A) The expected return on stock A is too high.
B) Stock B is also fairly priced.
C) The price of stock B is too high.
D) The expected return on stock B is too high.
Answer: C
Explanation: C) Since we know that Stock A is correctly priced, the CAPM should hold:
E(ki) = kF + βi[E(kM) - kF]
0.135 = 0.07 + 1.2[E(kM) - kF]
We can now solve for the market risk premium, [E(kM) - kF].
0.065 = 1.2[E(kM) - kF]
[E(kM) - kF] = 0.0541667
Using the Market Risk Premium, we can now calculate the fair expected return of Stock B:
E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.07 + 0.8(0.0541667)
E(ki) = 0.07 + 0.0433333 = 0.1133 or 11.33%
Since 11.33% > 11.0%, the fair expected return of Stock B, as implied by the CAPM, is greater than the
actual return of stock B. Therefore, Stock B is priced too high (it is overvalued).
Diff: 4
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47) Union Pacific Corporation (ticker: UNP on TSX) owns transportation companies. Its principal
operating company, Union Pacific Railroad Company, links 23 states across the country. After studying
UNP's financials, you predict the future return on investment to be 8%. The risk free rate is 4.5%, the
expected market return is 10% and UNP's beta is 0.6. Which of the following statements is true about
UNP?
A) Equilibrium return < anticipated return, stock is undervalued
B) Equilibrium return > anticipated return, stock is overvalued
C) Equilibrium return > anticipated return, stock is undervalued
D) Equilibrium return < anticipated return, stock is overvalued
E) Equilibrium return = anticipated return, stock properly valued
Answer: A
Explanation: A) The equation for the expected return on any security in capital market equilibrium is:
E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.045 + 0.6(0.10 - 0.045)
E(ki) = 0.045 + 0.6(0.055)
E(ki) = 0.045 + 0.033 = 0.078 or 7.8%
Since the anticipated return on the stock is higher than the equilibrium return, shareholders will be
getting a higher return than the market believes they should receive. Therefore, its price is too low and it
is undervalued.
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
48) The company that prints unemployment insurance cheques is named Countercyclical Printing, Inc.
Countercyclical Printing's beta is -0.75, the risk free rate is 8%, and the risk premium on the market is 7%.
What is the equilibrium expected rate of return on Countercyclical Printing's stock?
A) -8.75%
B) -3.25%
C) 2.75%
D) 4.50%
E) 5.25%
Answer: C
Explanation: C) E(ki) = kF + βi[E(kM) - kF]
Remember that the market risk premium is equal to:
E(kM) - kF = 7%
E(ki) = 0.08 - 0.75(0.07)
E(ki) = 0.08 - 0.0525 = 0.0275 or 2.75%
Diff: 3
Section: 3.3
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49) Altria Group Inc. (ticker: MO on TSX) is an American manufacturer of tobacco products. Selected
Financial information for Altria is provided in the table below. What is the expected return on shares of
Altria using the SML?
Asset
Altria
Risk Free Asset
Market
Portfolio
Expected
Return
5%
Beta
0.5
0
10%
1
A) 5.0%
B) 7.5%
C) 10.0%
D) 12.5%
E) 15%
Answer: B
Explanation: B) From the text we know that the equation for the Security Market Line, and the expected
return on any security in capital market equilibrium, is:
E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.05 + 0.5(0.10 - 0.05)
E(ki) = 0.05 + 0.5(0.05)
E(ki) = 0.05 + 0.025 = 0.075 or 7.5%
Diff: 2
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50) Consider the data on expected returns and betas for a variety of assets in the table below. What is the
expected return on shares of Bank of America using the SML?
Asset
Bank of
America
Risk Free Asset
Market
Portfolio
Expected
Return
Beta
4%
0.9
0
10%
1
A) 5.4%
B) 6.0%
C) 8.2%
D) 9.4%
E) 11.2%
Answer: D
Explanation: D) From the text we know that the equation for the Security Market Line, and the expected
return on any security in capital market equilibrium, is:
E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.04 + 0.9(0.10 - 0.04)
E(ki) = 0.04 + 0.9(0.06)
E(ki) = 0.04 + 0.054 = 0.094 or 9.4%
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
51) The S&P/TDX 60 Bear Plus ETF seeks daily investment results such that its Beta is equal -2. The risk
free rate is 3.5% and the market risk premium is 6%. What is the equilibrium expected rate of return on
the ETF?
A) -19%
B) -8.5%
C) -2.5%
D) 0%
E) 3.5%
Answer: B
Explanation: B) Remember that the market risk premium is equal to the expected return on the market
less the return on the risk-free asset, or E(kM) - kF, and is 6%.
E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.035 - 2(0.06)
E(ki) = 0.035 - 0.12
E(ki) = -0.085 or -8.5%
Diff: 2
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52) A friend tells you about a mutual fund called the Global Asset Fund. The fund's expected return and
beta for next year are shown in the table below. The expected return and beta of the risk free asset and the
market portfolio are also shown in the table. Consider an alternative investment strategy of investing in a
portfolio on the Security Market Line with the same beta as the Global Asset Fund. What return should
you expect to earn from that portfolio?
Asset
Risk-Free
Market
Portfolio
Global Asset
Fund
Expected
Return
5.5%
Beta
0
11.5%
1
16%
1.59
A) 12%
B) 13%
C) 14%
D) 15%
E) 16%
Answer: D
Explanation: D) Any portfolio on the SML will earn a return given by the CAPM:
E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.055 + 1.59 [0.115 - 0.055]
E(ki) = 0.15 or 15%
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
53) If Geek Computer has a beta of 1.1, the return from Treasury bills is 3% and the return from the
market portfolio is 20%, what is the required return from Geek stock?
A) 20.0%
B) 22.8%
C) 15.7%
D) 18.7%
E) 21.7%
Answer: E
Explanation: E) E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.03 + 1.10 [0.20 - 0.03]
E(ki) = 0.217 or 21.7%
Diff: 2
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54) Analysts state that the required return from Plummet Soft Drinks stock is 25%, and the returns from
Treasury bills and the market portfolio are 4% and 20%, respectively. What is Plummet's beta?
A) 0.79
B) 1.00
C) 0.05
D) 1.31
E) 1.13
Answer: D
Explanation: D) Rearrange the CAPM equation to solve for beta.
E(ki) = kF + βi[E(kM) - kF]
βi =
βi =
=
= 1.31
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
55) The graph of the Capital Asset Pricing Model (CAPM) that relates the beta of a stock to its required
return is called the
A) characteristic line.
B) risk/return profile.
C) line of least resistance.
D) capital market line.
E) security market line.
Answer: E
Explanation: E) The SML is the linear relationship between expected return and beta.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
56) The security market line
A) is negatively sloped.
B) shifts in response to changing inflationary expectations.
C) does not respond to changes in investors' willingness to bear risk.
D) does not respond to investor expectations about political stability.
E) always has a slope of one.
Answer: B
Explanation: B) The intercept of the SML is the risk free rate and the slope is the market risk premium.
Diff: 1
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57) If Left Bank stock has a beta of 1.25, the return from the market portfolio is 15%, and the Treasury bill
return is 5%, what is the required return from the stock?
A) 17.5%
B) 12.5%
C) 16.0%
D) 7.5%
E) 15.0%
Answer: A
Explanation: A) E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.05 + 1.25 [0.15 - 0.05]
E(ki) = 0.175 or 17.5%
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
58) Asset p has a beta of 1.1. The risk-free rate of return is 4 percent, while the return on the market
portfolio of assets is 12 percent. The asset's required rate of return is
A) 6%.
B) 12.8%.
C) 5.4%.
D) 10%.
E) 9.5%.
Answer: B
Explanation: B) E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.04 + 1.10 [0.12 - 0.04]
E(ki) = 0.128 or 12.8%
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
59) Which of the following is not a widely-recognized problem with CAPM?
A) The model is complex and poorly understood by many finance professionals.
B) The model does not accurately explain stock returns over time.
C) Other factors besides market risk may influence security returns.
D) Beta values for any stock often change over time.
E) The model is difficult to test.
Answer: A
Explanation: A) The CAPM provides a simple measure of systematic risk and is widely used.
Diff: 1
Section: 3.4
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60) Asset y has a beta of 1.2. The risk-free rate of return is 4 percent, while the return on the market
portfolio of assets is 10 percent. What is the market risk premium?
A) 6%
B) 10%
C) 11.2%
D) 13.2%
E) 8%
Answer: A
Explanation: A) The market risk premium = [E(kM) - kF] = 0.10 - 0.04 = 0.06 or 6%
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
61) Calculate the required rate of return for Mercury Inc., assuming that the real risk-free rate is equal to
4% and the market risk premium (note that is not the same as the market return) is 6%. Mercury has a
beta of 1.5, and its realized rate of return has averaged 15% over the last 5 years.
A) 6%
B) 16%
C) 18%
D) 13%
E) 17%
Answer: D
Explanation: D) E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.04 + 1.50 [0.06]
E(ki) = 0.13 or 13%
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
62) Given the following information, determine which beta coefficient for Stock A is consistent with
equilibrium: E(ki) = 8.5%; kF = 4%; E(kM) = 12%.
A) 0.80
B) 1.26
C) 0.56
D) 1.10
E) 1.00
Answer: C
Explanation: C) Rearrange the CAPM equation to solve for beta.
E(ki) = kF + βi[E(kM) - kF]
βi =
βi =
=
= 0.56
Diff: 3
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63) If Geek Computer has a beta of .8, the return from Treasury bills is 3% and the return from the market
portfolio is 20%, what is the required return from Geek stock?
A) 16.6%
B) 15.7%
C) 22.8%
D) 20.0%
E) 17.5%
Answer: A
Explanation: A) E(ki) = kF + βi[E(kM) - kF]
E(ki) = 0.03 + 0.80 [0.20 - 0.03]
E(ki) = 0.166 or 16.6%
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
64) In the capital asset pricing model, an increase in inflationary expectations will be reflected by
A) a parallel shift downward in the security market line.
B) a decrease in the slope of the security market line.
C) an increase in the slope of the security market line.
D) a parallel shift upward in the security market line.
Answer: D
Explanation: D) An increase in inflationary expectations will cause an increase in the risk-free rate, which
will push the line up without affecting the slope.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
65) L9 Corp. has a beta of 1.34 and an expected return of 21%. If the market return is 17%, what is the
return you would expect to get from a T-Bill?
A) 5.24%
B) 8.64%
C) 3.41%
D) 2.16%
E) 4.50%
Answer: A
Explanation: A) E(ki) = kF + βi[E(kM) - kF]
kF =
kF =
kF = 0.0524 or 5.24%
Diff: 3
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66) The CAPM equation includes all of the following EXCEPT
A) Market Risk Premium.
B) Risk Free Rate.
C) Standard Deviation.
D) Beta.
E) The Return on the Market.
Answer: C
Explanation: C) The CAPM equation does not include the standard deviation.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
67) XYZ Corp has an expected return of 16%. If the risk free rate is 4.5% and the return for the market is
20%, calculate the Beta for XYZ.
A) 1.35
B) 0.86
C) 0.74
D) 1.12
E) 0.95
Answer: C
Explanation: C) Rearrange the CAPM equation to solve for beta.
E(ki) = kF + βi[E(kM) - kF]
βi =
βi =
=
= 0.74
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 7 Bonds
LO1: Explain Zero Coupon Bond Features and Markets
1) There are no questions in this section.
AACSB: Analytical Thinking
LO2: Explain Zero Coupon Bond Yields and Pricing
1) The table, below, shows market prices for four zero coupon bonds with four different terms: one, two,
three and four years. The bonds all have a face value of $1,000. The yield curve derived from the bond
prices in the table below is best described as
Term
(years)
Price
($)
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1
2
3
4
970.8738
933.5107
888.9964
822.7025
A) upward sloping with a 2% spread between short and long term yields.
B) flat.
C) upward Sloping with a 1% spread between short and long term yields.
D) downward sloping with a 2% spread between short and long term yields.
E) downward Sloping with a 1% spread between short and long term yields.
Answer: A
Explanation: A)
Term
(years)
1
2
3
4
Price
($)
970.8738
933.5107
888.9964
822.7025
Yield
($1,000/970.8738)^(1/1)-1
($1,000/933.5107)^(1/2)-1
($1,000/888.9964)^(1/3)-1
($1,000/822.7025)^(1/4)-1
0.03
0.035
0.04
0.05
The yield curve is upward sloping with a 2% spread between long and short yields.
Diff: 2
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2) Based on the table of bond prices, below, what is the shape of the yield curve? ($100 face value)
maturity
1
2
3
4
price
95.24
90.70
86.38
82.27
A) Flat
B) Upward sloping
C) Downward sloping
D) Not enough information
Answer: A
Explanation: A)
Term
Price
(years)
($)
1
95.24
2
90.70
3
86.38
4
82.27
Yield
($100/95.24)^(1/1)-1
($100/90.70)^(1/2)-1
($100/86.38)^(1/3)-1
($100/82.27)^(1/4)-1
0.05
0.05
0.05
0.05
The yield curve is flat at 5%.
Diff: 2
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3) Use the term structure of interest rates shown below to calculate the expected (one-year) spot rate from
year 1 to year 2.
Term
1-year
2-years
Spot Rate
6.5%
8%
A) 7.5%
B) 8.0%
C) 8.5%
D) 9.5%
E) 10.0%
Answer: D
Explanation: D) The best estimate of the expected future spot rate is the forward rate. To solve for the
forward rate, equate the future value of $1 invested in the roll-over and the lock-in:
(1 + k2)^2 = (1 + k1) * (1 + f)
Solve for f
f = (1 + k2)^2/(1 + k1) - 1
f = (1.08)^2/(1.065) - 1
f = 0.0952 or 9.5%
Diff: 2
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4) The term structure of interest rates is given below. What is the expected future spot rate next year?
Maturity
(Years)
1
2
Yield
4%
5%
A) 4%
B) 5%
C) 5.5%
D) 6%
E) 6.5%
Answer: D
Explanation: D) The best estimate of the expected future spot rate is the forward rate. To solve for the
forward rate, equate the future value of $1 invested in the roll-over and the lock-in:
(1 + k2)^2 = (1 + k1) * (1 + f)
Solve for f
f = (1 + k2)^2/(1 + k1) - 1
f = (1.05)^2/(1.04) - 1
f = 0.06 or 6%
Diff: 2
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5) The current yields for zero-coupon bonds with varying maturities are outlined in the table below. Find
the forward rate from the end of year 2 to the end of Year 3.
Maturity
(Years)
1
2
3
4
5
Yield
2.75%
3.25%
3.65%
4.00%
4.15%
A) 0.0445
B) 0.0454
C) 0.0475
D) 0.0506
E) 0.0722
Answer: A
Explanation: A) Equate the future value of $1 invested in the roll-over and the lock-in:
(1 + k3)^3 = (1 + k2)^2 * (1 + f3)
Solve for f3
f3 = (1 + k3)^3 / (1 + k2)^2 - 1
f3 = (1.0365)^3 / (1.0325)^2 - 1
f3 = 0.0445 or 4.45%
Diff: 3
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6) The current spot rate on bonds with maturity of 4 years is 1%. If bonds with a maturity of 5 years have
a spot rate of 1.5% then what is the implied one-year forward rate that starts in 4 years?
A) 3.5%
B) 3.7%
C) 2.2%
D) 3.2%
E) 2.7%
Answer: A
Explanation: A) Equate the future value of $1 invested in the roll-over and the lock-in:
(1 + k5)^5 = (1+ k4)^4 * (1 + f)
Solve for f
f = (1 + k5)^5 / (1 + k4)^4 - 1
f = (1.015)^5 / (1.01)^4 - 1
f = 0.0352 or 3.5%
Diff: 3
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7) Your boss wants you to forecast the interest rate (per annum) that will prevail for two years starting
one year from now. The spot interest rates starting today (time 0) are given in the table.
Maturity
(years from today)
1
2
3
4
5
6
Spot Yield
3.0%
3.2%
3.4%
3.6%
3.9%
4.1%
A) 3.6%
B) 3.4%
C) 3.8%
D) 3.3%
E) 3.5%
Answer: A
Explanation: A) Equate the future value of $1 invested in the roll-over and the lock-in:
(1 + k3)^3 = (1 + k1) * (1 + f13)^2
Solve for f13
f13 = [(1 + k3)^3 / (1 + k1)]^0.5 - 1
f13 = (1.034)^3 / 1.03]^0.5 - 1
f13 = 0.036 or 3.6%
Diff: 3
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8)
Refer to the data in the table. What is the average forward rate for the three year period starting two years
from today?
A) 1.16%
B) 5.11%
C) 5.51%
D) 6.18%
E) 6.74%
Answer: B
Explanation: B) Equate the future value of $1 invested in the roll-over and the lock-in:
(1 + k5)^5 = (1 + k2)^2 * (1 + f25)^3
Solve for f25
f25 = [(1 + k5)^5 / (1 + k2)^2]^0.3333 - 1
f25 = (1.043)^5 / (1.031)^2]^0.3333 - 1
f25 = 0.05107 or 5.11%
Diff: 4
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9) Safe Corp. has zero coupon bond with 10 years to maturity and a yield of 5%. Risky Company also has
a zero coupon bond with 10 years to maturity, but the yield on the bond is 5.25%. The higher yield on the
Risky bond reflects Risky's higher probability of default. Historically, the difference between the yields of
the two bonds has been 1%. This difference is called the "yield spread." Today the yield spread is only
0.25%. You expect that the yield spread will widen back to its historic value over the next few days.
Assume that both yields will change equally to bring the spread back to its historic position and assume
that the mid-point of the spread will stay where it is. What positions do you take in the two bonds to
profit from the expected changes?
A) Long the Risky bond; Long the Safe bond
B) Short the Risky bond; Short the Safe bond
C) Short the Risky bond; Long the Safe bond
D) Long the Risky bond; Short the Safe bond
Answer: C
Explanation: C) The yield of Risky Bonds will rise to 5.625% and the price will fall. The yield on Safe
bonds will fall to 4.625% and the Safe bond price will rise. Thus, buy Safe and sell Risky.
Diff: 4
Section: 2 Zero Coupon Bond Yields and Pricing
AACSB: Analytical Thinking
10) Consider a Sears 9% bond and a Government of Canada 9.25% bond both maturing in ten years. The
current yield to maturity on the Sears bond is 5.3% compared to the Gov't bond yield of 4.5%. The higher
yield on the Sears bond reflects Sear's higher probability of default. Historically, the difference between
the yields of the two bonds has been 1.2%. This difference is called the "yield spread." Today the yield
spread is only 0.8%. You expect that the yield spread will widen back to its historic value over the next
few days. Assume that both yields will change equally to bring the spread back to its historic position
and assume that the mid-point of the spread will stay where it is. What positions do you take in the two
bonds to profit from the expected changes?
A) Buy Sears, Sell Canada
B) Buy Sears, Buy Canada
C) Sell Sears, Buy Canada
D) Sell Sears, Sell Canada
Answer: C
Explanation: C) The yield of the Sears bonds will rise to 5.5% and the price will fall. The yield on the
Gov't bonds will fall to 4.3% and the Gov't bond price will rise. Thus, sell Sears and buy the Government
bonds.
Diff: 4
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11) Consider a Sears 9% bond and a Government of Canada 9.25% bond both maturing in ten years. The
current yield to maturity on the Sears bond is 5.3% compared to the Gov't bond yield of 4.5%. The higher
yield on the Sears bond reflects Sear's higher probability of default. Historically, the difference between
the yields of the two bonds has been 1.2%. This difference is called the "yield spread." Today the yield
spread is only 0.8%. You expect that the yield spread will widen back to its historic value over the next
few days. Assume that both yields will change equally to bring the spread back to its historic position
and assume that the mid-point of the spread will stay where it is. What is the anticipated price change for
the Sears bond and for the Government of Canada bond? Assume that both bonds have a face value of
$1,000 and that the price value of a basis point (PVBP) is $1.24 for both bonds. (The PVBP is the dollar
amount the price will change for each 1 basis point change in the yield.)
A) Sears -$49.60, Canada +$49.60
B) Sears -$24.80, Canada +$24.80
C) Sears +$49.60, Canada -$49.60
D) Sears +$24.80, Canada -$24.80
Answer: B
Explanation: B) The spread will widen from 80 to 120 bps. Since the yield on each bond changes by the
same amount to restore the spread, each will move 20 bps (120 - 80 = 40; 40/2 = 20).
Since the PVBP is $1.24 for each bond, the shift of 20 bps equates to 20 * $1.24 = $24.80.
The yield goes up for Sears and down for the Government bonds, therefore the price goes DOWN for
Sears and UP for Canada (both by $24.80).
Diff: 4
Section: 2 Zero Coupon Bond Yields and Pricing
AACSB: Analytical Thinking
12) Consider a Sears zero coupon bond and a Government of Canada zero coupon bond both maturing in
ten years. The current yield to maturity on the Sears bond is 5.3% compared to the Gov't bond yield of
4.5%. The higher yield on the Sears bond reflects Sear's higher probability of default. Historically, the
difference between the yields of the two bonds has been 1.2%. This difference is called the "yield spread."
Today the yield spread is only 0.8%. You expect that the yield spread will widen back to its historic value
over the next few days. Assume that both yields will change equally to bring the spread back to its
historic position and assume that the mid-point of the spread will stay where it is. What are the
anticipated price changes for the two bonds?
A) Sears - $11.21, Canada + $12.45
B) Sears + $11.21, Canada - $12.45
C) Sears + $11.21, Canada + $12.45
D) Sears - $11.21, Canada - $12.45
Answer: A
Explanation: A) The spread will widen from 80 to 120 bps. Since the yield on each bond changes by the
same amount to restore the spread, each will move 20 bps (120 - 80 = 40; 40/2 = 20).
The yield on the Sears bond will rise to 5.5% and the yield on the Government bond will fall to 4.3%.
Thus, the Sears price will fall and the Government bond price will rise.
Diff: 4
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13) The legal document specifying all the provisions attached to a bond issue is called a(n)
A) indenture.
B) trust deed.
C) loan contract.
D) covenant.
Answer: A
Explanation: A) Indenture.
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AACSB: Analytical Thinking
14) When bond rating agencies rate a company's bonds, they are most concerned with ________ risk.
A) interest rate
B) reinvestment rate
C) counter-party
D) default
Answer: D
Explanation: D) Ratings agencies are most concerned with default risk. The probability that the issuer
will fail to pay interest and/or coupons.
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15) Goopple Inc., the internet technology firm, has a 10-year coupon bond with a coupon rate of 5% that
yields 4.5%. The expected inflation rate is 1.5%, so the real yield on the bond is
A) 1.96%.
B) 3.00%.
C) 4.50%.
D) 2.96%.
Answer: D
Explanation: D) (1 + kn) = (1 + kr) × (1 + π)
kr = (1 + kn) / (1 + π) -1 = (1.045)/(1.015) - 1 = 0.029557 or 3%
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16) The nominal rate of interest is 6% and the real rate of interest is 3%. What is the expected inflation
rate?
A) 2.51%
B) 2.91%
C) 3.00%
D) 4.04%
E) 4.91%
Answer: B
Explanation: B) (1 + kn) = (1 + kr) × (1 + π)
π = (1 + kn) / (1 + kr) -1 = (1.06)/(1.03) - 1 = 0.0291 or 2.91%
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Section: 2 Zero Coupon Bond Yields and Pricing
AACSB: Analytical Thinking
17) The yield on a 1-year zero coupon bond selling today is 2%. The market expects that similar bonds
sold in one year's time will yield 3%. According to the expectations theory, a 2-year zero coupon bond for
sale today should have a yield of
A) 2.0%.
B) 2.5%.
C) 2.75%.
D) 3.0%.
E) 5.0%.
Answer: B
1/2
Explanation: B) (1 + k2) = [(1 + k1) × (1 + E(k1))]
k2 = [(1.02) * (1.03)]
0.5
- 1 = 0.024988 or 2.5%
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18) If a secured bond issuer defaults, then the bondholders will receive the
A) default premium.
B) collateral.
C) face value.
D) nothing. Bondholders receive nothing in default.
Answer: B
Explanation: B) Collateral is assets that are pledged as security for the loan. If the borrower defaults, then
the collateral is sold and the proceeds are used to satisfy any remaining obligations of the borrower.
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19) When a bond issuer (borrower) does not pay interest or principal it is called
A) default.
B) delinquency.
C) noncompliance.
D) non-service.
Answer: A
Explanation: A) Default means the failure to fulfill an obligation. In the context of loans and bonds,
default can occur in a number of ways, such as failure of the borrower to make interest or principal
payments or to follow the terms of the loan.
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20) The provisions in a bond indenture that limit a company's ability to borrow more money or
meaningfully increase its risk of default are called the
A) warrants.
B) guarantees.
C) covenants.
D) pledges.
Answer: C
Explanation: C) Covenants are conditions that the borrower must meet. They are designed to increase the
probability that the lender will receive interest and principal repayment. A guarantee is a promise by a
third party to assume the debt if the borrower defaults. A pledge is an offer of an asset as collateral for a
loan. Warrants are a type of derivative security.
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21) Which of the following is NOT an example of a corporate bond covenant?
A) The debt-to-equity ratio must stay below 2.
B) The company may not borrow additional funds.
C) The company may not pay a dividend to its shareholders.
D) The times-interest-earned ratio must not rise above 5.
Answer: D
Explanation: D) Covenants are conditions that the borrower must meet. They are designed to increase
the probability that the lender will receive interest and principal repayment. A strong times-interestearned (TIE) ratio indicates an improved likelihood that a company can pays its interest. A lender would
not make a covenant that limited how high the TIE ratio could go. Instead, the lender would set a floor
for the TIE ratio.
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22) Which of the following is a secured bond?
A) A T-Bond issued by the U.S. Treasury
B) A debenture
C) A mortgage bond
D) Commercial paper
Answer: C
Explanation: C) Government bonds are not secured. A debenture is the name for an unsecured corporate
bond. A mortgage bond is secured by a claim against land or property. Commercial paper is a short-term,
unsecured debt instrument issued by corporations. A mortgage bond is typically used to finance accounts
receivable,inventories and meet short-term liabilities.
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23) Investment grade bonds have a rating of A or better.
Answer: FALSE
Explanation: False. The term investment grade is used to refer to bonds from issuers with a rating of BBB
(Baa) or higher.
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24) The rate of return earned by an investor who holds a bond to until the date that the face value
becomes due and payable is called the
A) coupon yield.
B) coupon rate.
C) capital gain yield.
D) yield to maturity.
Answer: D
Explanation: D) The yield to maturity is (approximately) equal to the return an investor will earn if they
hold the bond to maturity.
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25) Which of the following is a correct statement about changes in the default risk premium (DRP) over
time?
A) The DRP is steady at about 200 basis points.
B) The DRP varies with the business cycle: rising in recessions and falling in expansions.
C) The DRP varies with the business cycle: falling in recessions and rising in expansions.
D) The DRP moves with changes in monetary policy
Answer: B
Explanation: B) The DRP is the compensation for the risk of default. It rises in recessions when the risk of
default rises.
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26) Which of the following is NOT true about treasury spot rates?
A) The bond must have no default risk
B) The bond must be for immediate settlement
C) The bond must be a zero coupon
D) The bond's maturity must be less than or equal to one year
Answer: D
Explanation: D) Spot rates are yields on government zero coupon bonds for immediate settlement. They
can have any maturity.
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27) Assume that the expectations theory holds. The yield on a 1-year bond is 6% and the expected future
spot rate (next year) is 8%. What is the yield on the 2-year bond?
A) 6.5%
B) 7.0%
C) 7.25%
D) 7.5%
Answer: B
1/2
1/2
Explanation: B) k2 = [(1 + k1) × (1 + E(k1))]
- 1 = [1.06 × 1.08]
- 1 = 0.07
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28) Assume that the expectations theory holds. The yield on a 1-year bond is 6% and the yield on a 2-year
bond is 5.5%. What is the expected future spot rate (next year)?
A) 5%
B) 5.25%
C) 5.5%
D) 5.75%
Answer: A
2
2
Explanation: A) E(k1) = (1 + k2) /(1 + k1) - 1 = (1.055) /(1.06) - 1 = 0.05
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29) If the yield on a 1-year bond is 6% and the yield on a 2-year bond is 7%, then what is the shape of the
yield curve?
A) Upward-sloping
B) Down-ward sloping
C) Flat
Answer: A
Explanation: A) The yield curve is a graph of the yields on bonds with different maturities. Maturity is
the x-axis variable.
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30) Assume that the expectations theory holds. If the yield curve is upward sloping, then future spot rates
are expected to be ________ current spot rates.
A) Greater Than
B) Lower Than
C) The same as
Answer: A
1/2
Explanation: A) k2 = [(1 + k1) × (1 + E(k1))]
-1
If k2 > k1 (upward sloping yield curve), then E(k1) > k1
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31) Assume that the expectations theory holds. If the yield curve is downward sloping, then future spot
rates are expected to be ________ current spot rates.
A) Greater Than
B) Lower Than
C) The same as
Answer: B
1/2
Explanation: B) k2 = [(1 + k1) × (1 + E(k1))]
-1
If k2 < k1 (downward sloping yield curve), then E(k1) < k1
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32) Assume that the maturity preference theory holds. The forward rate is ________ the expected future
spot rate.
A) Greater Than
B) Lower Than
C) The same as
Answer: A
Explanation: A) If the MPT is true, then the forward rate is a little larger than the expected future spot
rate, because of the premium built into long-term rates.
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33) Assume that the maturity preference theory holds. The yield curve is ________ than predicted by the
Expectations Theory.
A) Steeper Than
B) Flatter Than
C) The same as
Answer: A
Explanation: A) If the MPT is true, then the yield curve will be a little steeper than the expectations
hypothesis predicts.
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34) Which of the following is the best expression for the yield on a government T-Bill?
A) YTM = kr
B) YTM = kr + INF
C) YTM = kr + INF + MRP
D) YTM = kr + INF + MRP + LRP
E) YTM = kr + INF + MRP + LRP + DRP
Answer: B
Explanation: B) Government T-bills are short maturity and so have no maturity premium. They are
actively traded on the money market and so have no liquidity premium. They are issued by the
government and so have no default risk premium.
Diff: 2
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35) Which of the following is NOT a correct statement about STRIP bonds?
I. A STRIP is a zero coupon bond
II. A STRIP never trades at a premium to face value
III. The yield to maturity on a STRIP is equal to its capital gain yield
A) I
B) II
C) III
D) All three are correct statements about STRIPS
Answer: D
Explanation: D) STRIPS have no coupons, therefore they are zero coupon bonds, they must be priced at a
discount to generate a positive return and, since there are no coupons, their yield is entirely determined
by the changes in price–the capital gain yield.
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LO3: Explain Coupon Bond Features and Markets
1) In the secondary market, the most actively traded bonds (by volume) are bonds issued by
A) The Federal Government
B) Municipalities
C) Companies with a BBB or better rating
D) Companies with less than a BBB rating
Answer: A
Explanation: A) Federal government bonds are the most actively traded.
Diff: 1
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AACSB: Analytical Thinking
2) A convertible bond gives the holder the option of converting the bond to a longer maturity.
Answer: FALSE
Explanation: False. A convertible bond gives the holder the option to convert the face value of the bond
to (typically) a given number of shares in the company.
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AACSB: Analytical Thinking
3) A recent coupon bond issued by Ucantaffordit Financing Inc. has a face value of $1,000, matures in five
years and pays semi-annual coupons at LIBOR plus 100 basis points. This is an example of a ________
bond.
A) Adjustable
B) Floating rate
C) Flexible
D) Interest-only
Answer: B
Explanation: B) A floating rate bond has a variable coupon. In this case, rather than having a fixed
coupon rate, the coupon rate fluctuates with some benchmark rate, such as the London InterBank Offer
Rate (LIBOR).
Diff: 1
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4) A callable bond gives the bondholder the option of calling for the payment of the face value in
exchange for returning the bond to the issuer.
Answer: FALSE
Explanation: False. A callable bond gives the issuer the option to call for the return of the bond in
exchange for paying the holder the face value (plus, in most cases, a call premium).
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5) The feature of a bond whereby the issuer may redeem the bond from the holder in exchange for the
face amount plus, in most cases, a premium.
A) Sinking Fund
B) Purchase Fund
C) Repurchase (Repo)
D) Call
Answer: D
Explanation: D) A callable bond gives the issuer the option to call for the return of the bond in exchange
for paying the holder the face value (plus, in most cases, a call premium).
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AACSB: Analytical Thinking
6) A recent coupon bond issued by Supergrowth Inc. has a face value of $1,000, matures in ten years and
pays annual coupons of 4%. The bond has a feature that allows the bondholder to exchange the face value
for 50 common shares in Supergrowth. This is an example of a ________ bond.
A) Callable
B) Convertible
C) Flexible
D) Redeemable
Answer: B
Explanation: B) A convertible bond allows the holder of the bond to convert the face amount into a fixed
number of common shares at any time before the maturity of the bond if they so choose.
Diff: 1
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AACSB: Analytical Thinking
7) Which of the following are correct? Bonds are traded on the ________ market.
I. Auction
II. Dealer
III. Over-the-counter
A) I
B) II
C) III
D) I and II
E) II and III
Answer: E
Explanation: E) Bonds are traded in a dealer market, which is also known as an over-the-counter market.
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8) The coupon rate is
A) The annual coupon divided by the price of the bond
B) Equal to the yield to maturity
C) The annual coupon divided by the face value of the bond
D) The annual coupon divided by the issue price of the bond
Answer: C
Explanation: C) The coupon rate is equal to the annual dollar amount of coupons divided by the face
value of the bond.
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AACSB: Analytical Thinking
9) A coupon bond with 10 years to maturity and a coupon rate of 3.5% is priced at 98-27 1/2. How much
will it cost you to buy a $1,000 face value bond?
A) $988.275
B) $988.594
C) $998.275
D) $998.594
Answer: B
Explanation: B) Two part price quote. Handle and "32nds". First divide the 32nds by 32: 27.5/32 =
0.859375. Add this to handle: 98.859375. This is a percentage of face value. If face value is $1,000, then
price = $988.594.
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LO4: Explain Coupon Bond Yields and Pricing
1) The Government 2-year coupon bond has a face value of $1,000 and pays annual coupons of $33. The
next coupon is due in one year. Currently, the one and two-year spot rates on Government zero coupon
bonds are 4% and 4.5%. What is the correct price for the coupon bond at time zero (immediately)?
A) $977.68
B) $1,023.49
C) $1,025.00
D) $976.17
E) $1,000.00
Answer: A
Explanation: A) P =
+
P = $33/(1 + 0.04) + ($1,000 + $33)/(1 + 0.045)
P = $977.68
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AACSB: Analytical Thinking
2) A Government 2-year coupon bond has a face value of $1,000 and pays annual coupons of $30. The
next coupon is due in one year. Currently, the one and two-year spot rates on Government zero coupon
bonds are 5% and 5.5%. What is the correct price for the coupon bond at time zero (immediately)?
A) $925.46
B) $952.41
C) $953.98
D) $971.68
E) $1009.54
Answer: C
Explanation: C) P =
+
P = $30/(1 + 0.05) + ($1,000 + $30)/(1 + 0.055)
P = $953.98
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3) Consider a two year coupon bond issued today with a face value of $1,000 and a 6% coupon rate.
Suppose that yields on zero coupon bonds with terms one and two are 6% and 7% respectively. What is
your best estimate of the price of the bond next year after the first coupon?
A) $981.40
B) $982.45
C) $985.25
D) $992.50
E) $962.25
Answer: A
Explanation: A) The expected spot rate in the second year is the forward rate:
f=
-1
2
f = (1.07) / (1.06) - 1 = 0.080094
If the expectations are realized, then the price of the coupon bond after the first coupon will be:
P=
Where E(k1) is the expected spot rate in year 2.
P = ($1,000 + $60)/(1 + 0.080094)
P = $981.395
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4) The Government just issued a 2-year coupon bond with a face value of $1,000 and annual coupons of
$75. What is the expected price for the bond at year one (after the first coupon is paid)? Use the term
structure of interest rates shown below to answer the question.
A) $982
B) $992
C) $998
D) $1,000
E) $1,010
Answer: A
Explanation: A) The expected spot rate in the second year is the forward rate:
f=
-1
2
f = (1.08) / (1.065) - 1 = 0.09521
If the expectations are realized, then the price of the coupon bond after the first coupon will be:
P=
Where E(k1) is the expected spot rate in year 2.
P = ($1,000 + $75)/(1 + 0.09521)
P = $981.395
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5)
Bond
Zero1
Zero2
Coupon2
Maturity
1
2
2
FV
100
100
100
Coupon
0
0
4%
Yield
1%
2%
n.a.
Price
$99.0099
$96.1169
$101
Given the bond prices in the table, you should
A) Buy the two zeros and sell the coupon bond
B) Buy the coupon bond and sell the two zeros
C) Nothing. The prices are consistent. There is no arbitrage opportunity.
D) Buy the underpriced asset and sell the equivalent fairly priced asset.
Answer: D
Explanation: D) The Zero coupon bond prices are correct. The theoretical fair price for the coupon bond
is Pbond = 0.04 × $99.0099 + 1.04 × $96.1169 = $103.9219. Thus, the coupon bond is underpriced. To profit
from this, one should buy the underpriced asset and sell the equivalent fairly priced asset. In other
words, buy the coupon, strip it and sell the pieces.
Diff: 4
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6) If you can re-invest your coupons at the yield-to-maturity rate, then your actual return on a bond will
be equal to the yield-to-maturity. (Assuming that you hold to maturity.)
Answer: TRUE
Explanation: True.
Diff: 2
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AACSB: Analytical Thinking
7) Which of the following is NOT true about calculating a semi-annual coupon bond price?
A) Use half the annual coupon
B) Use half the annual yield
C) Use twice the number of coupon payments
D) Use half of the face value
Answer: D
Explanation: D) To price a semi-annual coupon bond, you use the total face value.
Diff: 2
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AACSB: Analytical Thinking
8) When you price a semi-annual coupon bond you can discount the face value in either of two equivalent
ways: 1) using 2n periods at the semi-annual rate of kd/2; or 2) using the number of years to maturity, n,
and the annual yield, kd.
Answer: FALSE
Explanation: False. The face must also be discounted for 2n periods at a semi-annual rate of kd/2. The
second procedure above mixes two different effective interest rates: one for the coupons and another for
the face. That is inconsistent.
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LO5: Explain Coupon Bond Price Properties
1) If the yield to maturity is equal to the coupon rate, then a bond's price will equal its face value.
Answer: TRUE
Explanation: True.
Diff: 2
Section: 5 Coupon Bond Price Properties
AACSB: Analytical Thinking
2) You own a 10-year coupon bond. Interest rate risk is not a concern to you because you intend to hold
the bond to maturity.
Answer: TRUE
Explanation: True. Interest rate risk refers to the risk that bond prices will fall if interest rates rise. If you
hold to maturity and have no intention of selling the bond, then this is not a risk to you.
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3) At issuance, a coupon bond's price is always equal to its face value.
Answer: FALSE
Explanation: False. The price at issuance depends on the relationship between the coupon rate and the
yield to maturity. If the coupon rate equals the yield, then the bond will sell a price equal to its face value.
If the two are not equal then the price will be above or below the face value.
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AACSB: Analytical Thinking
4) If the yield to maturity is greater than the coupon rate, then the bond trades at
A) A discount
B) A premium
C) Par
D) Depends on the time to maturity
Answer: A
Explanation: A) When the coupon rate is less than the yield, the bond must generate additional return for
the investor in the form of capital gains. To do so, it must trade at a discount to its face value.
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5) If the coupon rate is greater than the yield to maturity, then the bond trades at
A) A discount
B) A premium
C) Par
D) Depends on the time to maturity
Answer: B
Explanation: B) When the coupon rate is larger than the yield, the coupon is too generous and the bond
must lose value over time. To do so, it must trade at a premium to its face value.
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6) Consider holding a coupon bond for one year. If interest rates don't change, then the sum of the
coupon yield and the capital gain yield is equal to the yield to maturity.
Answer: FALSE
Explanation: True. $C/P0 + (P1 - P0)/P0 = yield to maturity.
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7) If a medium maturity coupon bond is issued at a premium, then, over its first year, its price will
________ . Assume that interest rates and the company's default risk premium don't change.
A) Rise
B) Fall
C) Remain Unchanged
Answer: B
Explanation: B) Fall. Bonds trade at a premium when the coupon rate is greater than the yield. If the
yield doesn't change, then the capital gain yield on such a bond is negative.
Diff: 2
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AACSB: Analytical Thinking
8) If a medium maturity coupon bond is issued at a discount, then, over its first year, its price will
________. Assume that interest rates and the company's default risk premium don't change.
A) Rise
B) Fall
C) Remain Unchanged
Answer: A
Explanation: A) Rise. Bonds trade at a discount when the coupon rate is smaller than the yield. If the
yield doesn't change, then the capital gain yield on such a bond is positive.
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9) What is the slope of the relationship between bond prices and yields?
A) Downward sloping (negative)
B) Upward sloping (positive)
C) Depends on the maturity of the bond
Answer: A
Explanation: A) Bond prices and yields are inversely related.
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10) You overhear the Governor of the Bank of Canada reveal that the Bank of Canada is going to lower
interest rates. This will come as a complete surprise to the market. If you wanted to profit from this
knowledge, then which investment strategy would you adopt?
A) Buy Short maturity bonds
B) Buy long maturity bonds
C) Short sell short maturity bonds
D) Short sell long maturity bonds
Answer: B
Explanation: B) If rates fall then prices rise and you should take a long position in bonds. Long maturity
bonds have more interest risk, which means that their price will rise by more than the price of short
maturity bonds.
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AACSB: Analytical Thinking
11) You overhear the Governor of the Bank of Canada reveal that the Bank of Canada is going to raise
interest rates. This will come as a complete surprise to the market. If you wanted to profit from this
knowledge, then which investment strategy would you adopt?
A) Buy Short maturity bonds
B) Buy long maturity bonds
C) Short sell short maturity bonds
D) Short sell long maturity bonds
Answer: D
Explanation: D) If rates rise then prices fall and you should take a short position in bonds. Long maturity
bonds have more interest risk, which means that their price will fall by more than the price of short
maturity bonds.
Diff: 2
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AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 8 Stocks
LO1: Explain the Primary Features of Shares and the Stock Market
1) There are no questions in this section.
AACSB: Analytical Thinking
LO2: Find the Value of a Preferred Share
1) There are no questions in this section.
AACSB: Analytical Thinking
LO3: Find the Value of a Common Share
1) Which of the following statements regarding the P/E ratio is FALSE?
A) Firms with higher payout ratios have higher P/E ratios
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B) Firms with higher dividend growth rates have higher P/E ratios
C) Firms with a higher cost of equity have higher P/E ratios
D) Firms with low risk have higher P/E ratios
Answer: C
Explanation: C)
=
The equation for the P/E ratio, shown above, can help us understand the relationship between the payout
ratio p, required return k, and the dividend growth rate g.
A larger payout ratio in the numerator will cause the P/E constant to increase, holding all else constant. A
larger growth rate will also cause the P/E ratio to increase, as the denominator will become smaller.
Therefore A) and B) are both true.
The required return of shareholders is mainly a function of risk. Shareholders of low risk firms will
require a lower return, k. We can see that decreasing k will cause the denominator to decrease, leading to
a higher P/E ratio. Therefore D) is also true.
Using the same logic a higher cost of equity would increase the denominator, leading to a lower P/E ratio.
Answer C) is false.
Diff: 1
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2) Industry professionals rarely build a company's P/E constant using the firm's payout ratio, growth and
required return because
A) the ratio of earnings paid out as dividends is unknown and cannot be estimated.
B) the return required by a firm's shareholders is unknown and cannot be estimated.
C) the equation for the P/E constant derives from the constant growth model, and the assumption of
constant growth is often not realistic.
Answer: C
Explanation: C) Both a firm's payout ratio and the return required by its equity investors can be
calculated.
The real reason investment professionals do not use this method is because the formula for the P/E ratio
is derived from the constant growth dividend discount model. This model assumes dividends will grow
at a constant rate, g. This assumption is often unrealistic, and an inappropriate assumption when trying
to value a firm. There are many factors that could cause a firm's future dividends to grow at a higher or
lower rate.
Diff: 1
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3) The method most commonly used by investment professionals to calculate a firm's P/E constant (its
benchmark P/E level) is to average the P/E ratios of comparable firms.
A) True
B) False
Answer: A
Explanation: A) This is true. Investment professionals do not usually use the formula for the P/E ratio
developed in Chapter 8, as it is based on the assumption of constant growth. This assumption is often
unrealistic.
The most common approach is to average the P/E ratios of comparable firms. This is where the formula
for the P/E ratio is valuable, as it can help us determine the best comparable firms. Appropriate
comparables will be in the same industry with a similar payout ratio, growth rate, and risk.
Diff: 1
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4)
Company
Big Kahuna Burger
Krusty Burger
McBurgertown
Paunch Burger
Fatso Burger
P/E
10.0
12.5
29.0
11.0
9.5
Growth
Payout
Rate (%) Risk (Beta) Rate (%)
4
0.27
30
6
0.29
27
7
0.40
58
4
0.28
29
5
0.29
31
You are a junior analyst valuing Big Kahuna Burger Inc. (a fast food chain) using the P/E approach. Your
manager gives you data on a variety of companies, provided in the table above. Which companies are
good comparables for Big Kahuna?
A) Fatso Burger only
B) Krusty Burger, McBurgertown
C) Krusty Burger, Paunch Burger, Fatso Burger
D) All of the companies are good comparables.
Answer: C
Explanation: C) All four companies provided by your manager are fast food chains specializing in
hamburgers, so all four are in the same business. McBurgertown's payout ratio and risk are both
considerably higher than the others, so it is not a good comparable. Its P/E ratio is also the highest which
is due to its high payout ratio. The other three companies (Krusty, Paunch and Fatso) are similar to Big
Kahuna Burger in respect to their payout rates, growth and risk. Thus, they are the best comparables.
Diff: 2
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5)
Company
Mega Lo Mart
Try-N-Save
Buy n Large
Superstore
P/E
?
16.9
15.3
17.0
Growth
Payout
Rate (%) Risk (Beta) Rate (%)
5
0.51
33
7
0.49
32
6
0.46
29
5
0.41
35
You are a junior analyst valuing Mega Lo Mart Inc. (the discount department store retailer) using the P/E
approach. Your manager informs you that Mega Lo Mart's EPS is currently $5.45. She also gives you data
on the firm's main competitors, provided in the table above. All three of these companies are good
comparables for Mega Lo Mart. What is Mega Lo Mart's fair value using the P/E approach?
A) $83.39
B) $89.38
C) $92.65
D) $100.00
Answer: B
Explanation: B) Estimate Mega Lo Mart's P/E constant by taking the average of the comparable firms' P/E
ratios:
P/E = Average of comparable firms P/E ratios
P/E = (16.9 + 15.3 + 17.0)/3
P/E = 16.4
Next, use your estimate of Mega Lo Mart's P/E constant and its EPS to calculate the firm's fair value:
P0 = P/E Constant * EPS1
P0 = 16.4 * $5.45
P0 = $89.38
Diff: 2
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6) Silicone Systems Inc. shares are trading for $500. Analysts expect Silicone to generate net income of
$41.7 billion. Silicone has 900 million shares outstanding. The average P/E ratio of Silicone's competitors
is 18. What is the fair price for a share of Silicone Systems?
A) $463
B) $500
C) $751
D) $834
Answer: D
Explanation: D) P0 = P/E Constant * EPS1
P0 = 18 * EPS1
EPS1 = Forecasted Net Income/ Shares Outstanding
EPS1 = $41,700 million/ 900 million shares
EPS1 = $46.33
P0 = 18 * $46.33
P0 = $834
Diff: 2
Section: 3.2 Price Earnings Valuation Method
AACSB: Analytical Thinking
7) Bluth's Original Frozen Banana Inc. operates a chain of frozen banana stands in California, and is set to
expand across the country. Bluth's is famous for its chocolate dipped frozen banana treats. The company
has just reported EPS of $1.77 and expects to maintain a 42% payout ratio. Shareholders require a return
of 12% and dividends are forecast to grow at 10%. What is the P/E Constant for Bluth's?
A) 14.75
B) 17.70
C) 21.00
D) 42.00
Answer: C
Explanation: C)
=
=
= 21
Diff: 2
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8)
Company
Oceanic Airlines
Trans American Airlines
South Pacific Air
Atlantic Airways
Payout
Required
Rate (%) Return (%)
21
8.0
18
9.0
13
4.0
16
7.0
Growth
Rate (%)
7.0
7.5
3.5
3.0
You are an analyst covering the airline industry. Your manager gives you data on a variety of companies,
provided in the table above. Which company has the largest P/E constant, and what is its value?
A) Trans American Airlines; 12
B) Oceanic Airlines; 21
C) Atlantic Airways; 24
D) South Pacific Air; 26
Answer: C
Explanation: C) Oceanic Airlines:
=
=
= 21
Trans American Airlines:
=
= 12
South Pacific Air:
=
= 26
Atlantic Airways:
=
= 4.0
Diff: 2
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9) Yesterday, McDonald's Corp paid out $1.7308B in dividends and repurchased $4.3983B worth of
shares. McDonald's has 1.12B shares outstanding. Analysts expect total payouts to grow at an annual
perpetual rate of 2% and investors require a 10% rate of return on McDonald's shares. What is the Total
Payout model estimate of the stock price today assuming that all payouts occur annually? (The next
payout will occur in one year.)
A) $50
B) $55
C) $60
D) $65
E) $70
Answer: E
Explanation: E) P = E/N
Where
E = Value of Equity = PV of payouts
E = $TP0 * (1 + g)/(k - g)
E = 6.1291 * 1.02/(0.10 - 0.02))
E = $78.146
P = Equity/Shares
P = $78.146/1.12B
P = $69.77
Diff: 2
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10) Yesterday, Wernham Hogg paid out $1.94B in dividends and repurchased $4.24B worth of shares.
Wernham Hogg has 1.18B shares outstanding. Analysts expect total payouts to grow at an annual
perpetual rate of 1% and investors require a 7.5% rate of return on Wernham Hogg shares. What is the
Total Payout model estimate of the stock price today assuming that all payouts occur annually? (The next
payout will occur in one year.)
A) $60.81
B) $69.83
C) $77.73
D) $80.57
E) $81.38
Answer: E
Explanation: E) P = E/N
Where
E = Value of Equity = PV of payouts
PV of payouts = [$TP0 * (1 + g)]/(k - g)
E = PV of payouts = $6.18 * (1 + 0.01)/(0.075 - 0.01)
E = $96.027692B
P = E/N
P = $96.027692B/1.18B
P = $81.38
Diff: 3
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11) Yesterday, Initech paid out $0.86B in dividends and repurchased $4.475B worth of shares. Initech has
1.22B shares outstanding and pays all of its dividends and makes its repurchases at the end of each year.
Because of the slow-down in the economy, analysts expect that next year Initech will hold dividend
payments constant at yesterday's level and cancel its stock repurchase program. Two years from now,
analysts forecast that total payouts will return to the level of yesterday. After that date analysts expect
that total payouts will grow at an annual rate of 2.5% in perpetuity. Assume that investors require a 9.5%
rate of return on Initech shares. What is the Total Payout model estimate of the stock price today?
A) $57.69
B) $63.18
C) $69.60
D) $70.39
E) $77.07
Answer: A
Explanation: A) P = E/N
Where
E = Value of Equity = PV of payouts
Year
1
2
Payouts
$0.86
$5.335
E = $0.86B/(1 + k) + [$TP2/(k - g) * (1/(1 + k))
E = $0.86B/(1.095) + (0.86 + 4.475)/(0.095-0.025) * (1/(1.095) )
E = $0.86/(1.095) + $76.2143 * (1/(1.095) )
E = $70.3875B
P = E/N
P = $70.3875B/1.22B
P = $57.69
Diff: 4
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12) Yesterday, Macallan Corp paid out $1.7308B in dividends and repurchased $4.3983B worth of shares.
Macallan has 1.12B shares outstanding and pays all of its dividends and makes its repurchases at the end
of each year. Because of the slow-down in the economy, analysts expect that next year Macallan will hold
dividend payments constant at yesterday's level and cancel its stock repurchase program. Two years
from now, analysts forecast that total payouts will return to the level of yesterday. After that date
analysts expect that total payouts will grow at an annual rate of 2% in perpetuity. Assume that investors
require a 10% rate of return on Macallan's shares. Which of the following is closest to the Total Payout
Model estimate of the stock price today?
A) $58
B) $60
C) $62
D) $64
E) $66
Answer: D
Explanation: D) P = E/N
Where
E = Value of Equity = PV of payouts
Year
1
2
Payouts
$1.7308
$6.1291
E = $1.7308/(1 + k) + [$TP2/(k - g) * (1/(1 + k))
E = $1.7308/(1.10) + (6.1291/(0.10 - 0.02)) * (1/(1.10))
E = $71.2223
P = Equity/Shares
P = $71.2223/1.12B
P = $63.59
Diff: 4
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13) Yesterday, Hewlett-Packard Co. paid out $0.806B in dividends and repurchased $7.703B worth of
shares. HP has 2.45B shares outstanding and pays all of its dividends and makes its repurchases on the
last day of each year. Because of the slow-down in the economy, analysts expect that next year HP will
payout nothing in order to conserve cash. Two years from now, analysts expect only dividends (no
repurchases) in an amount equal to the value of dividends paid out yesterday. Three years from now,
analysts expect HP to resume repurchases and pay dividends at yesterday's level. Analysts expect total
payouts to grow in subsequent years at a perpetual annual rate of 2.5%. Assume that investors require an
11% rate of return on HP's shares. What is the Total Payout model estimate of the stock price today?
A) $30.53
B) $32.68
C) $33.43
D) $37.11
E) $44.69
Answer: C
Explanation: C) P = E/N
Where
E = Value of Equity = PV of payouts
Year
1
2
3
Payouts
$0
$0.806B
$8.509
2
3
3
E = $0/(1 + k) + $0.806/(1 + k) + $8.509/(1 + k) + [$TP3(1 + g)/(k - g) * (1/(1 + k) )
E = $0/(1.11) + $0.806/[(1.11)^2] + $8.509/[(1.11)^3] + [$8.509 * (1.025)/(0.11-0.025)] * (1/(1.11^3))
E = $81.90235B
P = Equity/Shares
P = $81.90235B /2.45B
P = $33.43
Diff: 4
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14) Analysts expect Virtucon to make payouts of $8.7643B at the end of this year. Assume that all payouts
occur annually at the end of the year and that we are at the beginning of the year. Analysts forecast that
Virtucon's payouts will grow at 3% in perpetuity. Virtucon stockholders require a return of 11%.
Virtucon has 2.45B shares outstanding. Which of the following is the closest to the fair price for Virtucon's
shares today?
A) $45
B) $46
C) $47
D) $48
E) $49
Answer: A
Explanation: A) TP1 = 8.7643B
g = 3%
k = 11%
PV of total payouts = 8.7643B/(0.11 - 0.03)
PV of total payouts = 109.55375B
E = PV of total payouts
P = E/N
P = (109.55375B)/2.45B
P = $44.72
Diff: 3
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15) At the end of this year, analysts expect Tyrell Corp. to payout $1.03B in dividends and repurchase
$2.64B worth of shares. Assume that all payouts occur annually at the end of the year and that it is
currently the beginning of the year. Analysts expect payouts to grow at a constant rate in perpetuity. The
shares are currently trading for $40.78. Tyrell has 1.2B shares outstanding and its shareholders require a
10% rate of return. What growth rate is the market pricing into the stock?
A) 3.2%
B) 3.3%
C) 3.4%
D) 3.5%
E) 3.6%
Answer: A
Explanation: A) E0 = PV of payouts = $TP1 /(k - g)
$TP1 = $1.03 + $2.64 = $3.67
E0 = $3.67B/(0.1 - g)
P = E0 /N = E0/1.2B
P = $44.78
E0 = 1.2B x $44.78
$3.67B/(0.1 - g) = 1.2B × $44.78
(0.1 - g) = $3.67B/(1.2B × $44.78)
g = 0.1 - $3.67B/(1.2B × $44.78)
g = 0.0317
Diff: 3
Section: 3.2 Stock Repurchases and the Total Payout Model
AACSB: Analytical Thinking
16) In the market-to-book ratio, the market value (in the numerator) refers to the liquidation value of a
share of stock, i.e., the amount of money each shareholder would receive if the company were shut down,
its assets sold and liabilities paid off.
Answer: FALSE
Explanation: This statement is false. Book value refers to the liquidation value of a share of stock. Market
value refers to the stock's price on the open market. The stock price is equal to the present value of the
expected future cash flows received by the shareholder.
Diff: 1
Section: 3.4 Market-to-Book Valuation Method
AACSB: Analytical Thinking
17) Book value per share is equal to total assets divided by the number of shares outstanding.
Answer: FALSE
Explanation: This is false. Book value per share is equal to total assets minus all liabilities, divided by the
number of shares outstanding.
Diff: 1
Section: 3.4 Market-to-Book Valuation Method
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18) M/B ratios are typically
A) less than one and the same across industries.
B) less than one and vary across different industries.
C) greater than one and the same across industries.
D) greater than one and vary across different industries.
Answer: D
Explanation: D) An M/B ratio of less than one would indicate that the market value of the company is
less than its book value, and present a potential arbitrage opportunity.
There is no common M/B constant. Different industries have different average M/B ratios. The averages
fluctuate depending on industry specific factors and the current phase of the business cycle.
Diff: 1
Section: 3.4 Market-to-Book Valuation Method
AACSB: Analytical Thinking
19) Google Inc. is a technology company specializing in Internet-related products and services, including
its famous web search engine. Whirlpool Corp. manufactures home appliances including laundry
appliances, refrigerators, and dishwashers. Google has a market-to-book ratio of 3.8. Based on your
knowledge of the industries in which these two companies compete, and the determinants of the M/B
ratio, would you estimate that Whirlpool's market-to-book ratio is
A) less than Google's M/B ratio of 3.8
B) approximately equal to Google's M/B ratio of 3.8
C) greater than Google's M/B ratio of 3.8
Answer: A
Explanation: A) Industries with fewer tangible assets will tend to have higher M/B ratios because most of
the company's assets are off-balance sheet and so total assets (and owner's equity) is small. The most
common off-balance sheet asset is human capital. Technology companies, like Google, are good examples
of companies whose assets are their employees.
Manufacturing industries tend to have lower M/B ratios as their core asset is their manufacturing
facilities and equipment. These assets appear on their balance sheet and increase the book value of their
shares. Whirlpool is a large international manufacturing company with many manufacturing facilities.
Between all of these facilities, manufacturing equipment, and inventory, Whirlpool will likely have a high
book value per share.
Therefore, we can estimate that Whirlpool's market-to-book ratio will be less than Google's.
Diff: 2
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20)
Price
Debt
Equity
Total Assets
EBITDA
Shares Outstanding
$45.70
$31,450,000
$49,360,000
$120,223,000
$17,292,000
4,230,000
Play Now Inc. manufactures and distributes children's playground equipment. Select financial
information on the company is provided in the table, above. Shares of Play Now are currently trading for
$45.70. What is the market-to-book ratio for Play Now Inc.?
A) 1.60
B) 2.43
C) 3.91
D) 6.95
Answer: C
Explanation: C) M/B = Market price per share / Book value per share
M/B = Market price per share / (Equity/Shares outstanding)
M/B = $45.70 / ($49,396,000/4,230,000)
M/B = 3.91
Diff: 1
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21)
Price
Debt
Equity
Cash
EBITDA
Shares Outstanding
$65
$545M
$9,087M
$3,630M
$2,770M
487M
The industry average market-to-book ratio for the airline industry is 3. Estimate the fair value of Oceanic
Airlines' shares based on the industry average multiple and the data supplied in the table, above.
A) $17.06
B) $22.36
C) $55.98
D) $65.00
Answer: C
Explanation: C) First, calculate the book value per share for Oceanic Airlines:
BVPS = Equity/Shares Outstanding
BVPS = $9,087/487
BVPS = $18.66
Next, solve for the fair value of Oceanic's shares:
P = M/B × BVPS
P = 3 × $18.66
P = $55.98
Diff: 2
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22)
Wernhamm Hogg Paper Co.
Michael Scott Paper Company
Catalyst Paper
Prince Family Paper
M/B
1.9
1.0
1.7
2.0
You are a portfolio manager and are considering investing in Dunder Mifflin Paper Inc. Shares of Dunder
Mifflin are currently trading for $17.14, and its book value per share is $9.00. One of your analysts has
collected information on its main competitors, provided in the table above. What is Dunder Mifflin's fair
value?
A) $9.00
B) $14.85
C) $15.14
D) $24.98
Answer: B
Explanation: B) All four companies are in the paper business, so all four are appropriate comparables for
Dunder Mifflin.
Industry average M/B ratio = (1.9 + 1.0 + 1.7 + 2.0)/4 = 1.65
This is a good estimate of Dunder Mifflin's M/B ratio. Now use the market-to-book pricing model to
estimate its price:
P = M/B × BVPS
P = 1.65 × $9.00
P = $14.85
Diff: 2
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23)
Try-N-Save
Buy n Large
Sprawl-Mart
Superstore
M/B
3.1
2.8
3.7
4.2
You are a portfolio manager and are considering investing in Mega Lo Mart Inc. Shares of Mega Lo Mart
are currently trading for $71.40, and its book value per share is $26.00. One of your analysts has collected
information on its main competitors, provided in the table above. What is Mega Lo Mart's fair value and
should you buy its shares?
A) $45.40; Sell Shares
B) $71.40; Hold shares
C) $89.70; Buy shares
D) $97.40; Buy shares
Answer: C
Explanation: C) Industry average M/B ratio = (3.1 + 2.8 + 3.7 + 4.2)/4 = 3.45
This is a good estimate of Mega Lo Mart's M/B ratio. Now use the market-to-book pricing model to
estimate its price:
P = M/B × BVPS
P = 3.45 × $26.00
P = $89.70
Mega Lo Mart is trading for $71.40, which is much lower than its fair value of $89.70. This analysis
suggests that Mega Lo Mart shares are under-valued and you would expect the price to rise to the fair
value. You should buy shares in Mega Lo Mart.
Diff: 2
Section: 3.4 Market-to-Book Valuation Method
AACSB: Analytical Thinking
LO4: Explain the Efficient Markets Hypothesis
1) There are no questions in this section.
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 9 Capital Budgeting: Introduction and Techniques
LO1: Explain the Purpose of Capital Budgeting
1) There are no questions in this section.
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LO2: Define the Steps in the Capital Budgeting Process
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1) Most errors committed in capital budgeting analysis occur during what stage?
A) Adjusting for the time value of money
B) Calculating net present value
C) Estimating relevant cash flows
D) Finding the payback period
E) Interpreting the results of the analysis
Answer: C
Explanation: C) Estimating relevant cash flows is the toughest part for any firm, making errors almost
inevitable.
Diff: 1
Section: 2
AACSB: Analytical Thinking
2) All of the following are steps in the capital budgeting process EXCEPT
A) identifying opportunities.
B) the pre-audit.
C) evaluating opportunities.
D) the post audit.
E) implementing the project.
Answer: B
Explanation: B) The capital budgeting process does not include a pre-audit.
Diff: 1
Section: 2
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3) ________ is the process of deciding which long-term investments or projects a firm will acquire using
the long-term funds a firm has available.
A) Investment analysis
B) Capital budgeting
C) Capital marketing
D) Liability management
E) Corporate governance
Answer: B
Explanation: B) Capital budgeting is the process of deciding which projects a firm will acquire using its
long-term funds.
Diff: 1
Section: 2
AACSB: Analytical Thinking
4) The ultimate goal of capital budgeting analysis is to select projects that
A) maximize shareholder wealth.
B) cost the most funds.
C) lower operating expenses.
D) increase sales and market share.
E) enable managers to keep their jobs.
Answer: A
Explanation: A) The ultimate goal of capital budgeting is to maximize shareholder wealth.
Diff: 1
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Section: 2
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LO3: Analyse a Project Using a Variety of Techniques
1) Which of the following statements is FALSE?
A) The NPV will be positive if the IRR is less than the cost of capital.
B) If the multiple IRR problem does not exist, any independent project acceptable by NPV method will
also be acceptable by the IRR method.
C) When IRR = k (the cost of capital), NPV = 0.
D) The IRR can be positive even if the NPV is negative.
E) The NPV method is not affected by the multiple IRR problem.
Answer: A
Explanation: A) The NPV will be negative if the IRR is less than the cost of capital.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
2) The most widely used capital budgeting technique is
A) the payback period.
B) net present value.
C) internal rate of return.
D) the profitability index.
E) modified internal rate of return.
Answer: B
Explanation: B) Net Present Value is the most popular capital budgeting technique.
Diff: 1
Section: 3.2
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3) The primary problem with the NPV technique of capital budgeting is
A) that many people without a background in financial theory may not understand it.
B) that there is no adjustments for risk.
C) an unclear decision rule.
D) the fact that it ignores the time value of money.
E) that it uses unorthodox time value of money techniques.
Answer: A
Explanation: A) The primary problem with NPV is that it is hard for someone without a finance
background to understand it.
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4) An advantage of the net present value (NPV) method is that it
A) does not employ time value of money techniques.
B) is easy to use when available capital or resources are limited.
C) does not rely on the cost of capital.
D) provides its users with a clear decision criterion.
E) provides a "bang for the buck" analysis for each project.
Answer: D
Explanation: D) The NPV method provides a clear decision criterion.
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5) An NPV profile
A) graphs the NPV at a variety of discount rates.
B) graphs the NPV at a variety of internal rates of return.
C) graphs the NPV at a variety of modified internal rates of return.
D) graphs the payback period at a variety of discount rates.
E) compares the NPV and the IRR to determine which mutually exclusive projects should be accepted.
Answer: A
Explanation: A) An NPV profile graphs the NPV at a variety of different discount rates.
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6) An NPV profile is most helpful in dealing with what type of problem?
A) Difficulty in forecasting cash flows
B) The technical sophistication required to interpret NPV results
C) The fact that some projects may have multiple NPVs
D) Problems in estimating a firm's cost of capital
E) Making a decision about a project when recommendations from the payback and NPV calculations
conflict
Answer: D
Explanation: D) An NPV profile is helpful when it is difficult to determine a firm's cost of capital.
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7) If only one capital budgeting technique could be used to evaluate a project, which of the following
would be the most preferred?
A) Payback
B) IRR
C) MIRR
D) Profitability index
E) NPV
Answer: E
Explanation: E) The NPV is the most preferred capital budgeting technique.
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8) Analysts at Tabby Fur Storage predict that the net present value of a proposed new $10 million
warehouse is $1 million. How should these findings be interpreted?
A) Although NPV is positive, its value is too low for such a large expenditure and as a result, the project
should be rejected.
B) The project should be rejected because the NPV is less than the cost of the warehouse.
C) The project should be accepted because it will add value to the firm.
D) More information such as the payback period should be evaluated since the reliance on only one
capital budgeting technique should be discouraged.
E) The project does not meet the acceptance criteria of the NPV method and should be rejected.
Answer: C
Explanation: C) If a project will add value to a firm, it should be accepted.
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9) According to the net present value technique, a project is considered acceptable if
A) the sum of all cash inflows and outflows is positive.
B) the difference between all discounted cash inflows and outflows exceeds zero.
C) it lowers costs below an acceptable hurdle rate.
D) its rate of return is greater than the firm's cost of capital.
E) it returns the initial investment faster than competing projects.
Answer: B
Explanation: B) NPV projects are acceptable if they have a positive NPV value.
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10) On a purely theoretical basis, the NPV is the better approach to capital budgeting due to all the
following reasons EXCEPT
A) that it measures the benefits relative to the amount invested.
B) for the reasonableness of the reinvestment rate assumption.
C) that there may be multiple solutions for an IRR computation.
D) that it maximizes shareholder wealth.
Answer: A
Explanation: A) NPV does not measure the benefits relative to the amount invested.
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11) The NPV method assumes that cash inflows are reinvested at the
A) internal rate of return.
B) firm's cost of capital.
C) average yield on corporate bonds.
D) average yield from an equity index fund.
E) risk-adjusted hurdle rate.
Answer: B
Explanation: B) The NPV method assumes that cash inflows are reinvested at the firm's cost of capital.
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12) Pear Computer Corp. plans to introduce a new model called the Bartlett, whose sales are expected to
grow rapidly until the computer becomes obsolete in five years. Net cash inflows to be realized at the end
of the first year are $1 million, and they are expected to increase $1 million per year for each of the
remaining 4 years. Cash outflows for production expenses are $3.5 million today and an additional $1.5
million at the end of the second year to increase capacity. If Pear's cost of capital is 10%, what is the
project's NPV? Round to nearest whole dollar amount.
A) $9,412,700
B) $5,912,919
C) $6,173,452
D) $5,123,936
E) $8,998,418
Answer: B
Explanation: B) NPV =
NPV =
+
- Initial Investment
+
+
+
- 3,500,000 = $5,912,918.89
Using a financial calculator: CF0 = -3,500,000, C01 = 1,000,000, F01 = 1, C02 = 500,000, F02 = 1, C03 =
3,000,000, F03 = 1,
C04 = 4,000,000, F04 =1, C05 = 5,000,000, F05 = 1, NPV I = 10, CPT NPV = $5,912,918.89
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13) Costner Inc. would like to introduce its new haircutting machine, the "terminator." The machine will
cost $15,000 today. As a result of purchasing the machine, Costner expects to give 5,000 more haircuts for
$8 each. In the first year, Costner will give 2,000 more haircuts, and in the second year Costner will give
3,000 more haircuts. What is the net present value (NPV) associated with purchasing the terminator if
Costner's cost of capital is 9%? Round answer to the nearest whole dollar amount.
A) -$10,640
B) $19,879
C) $20,485
D) $19,380
E) -$19,879
Answer: B
Explanation: B) NPV =
NPV =
+
- Initial Investment
- 15,000 = $19,879.22
Using a financial calculator: CF0 = -15,000, C01 = 16,000, F01 = 1, C02 = 24,000, F02 = 1, NPV I = 9,
CPT NPV = $19,879.22
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14) The Seattle Corporation has been presented with an investment opportunity which will yield end of
year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and
$40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10%.
What is the NPV for this investment?
A) $135,984
B) $18,023
C) $219,045
D) $51,138
E) $92,146
Answer: D
Explanation: D) NPV =
NPV =
+
- Initial Investment
+
+
+
+
+
+
+
+
-
150,000 = $51,138
Using a financial calculator: CF0 = -150,000, C01 = 30,000, F01 = 4, C02 = 35,000, F02 = 5, C03 = 40,000, F03 =
1, NPV I = 10, CPT NPV = $51,138
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15) You are considering the purchase of an investment that would pay you $5,000 per year for Years 1-5,
$3,000 per year for Years 6-8, and $2,000 per year for Years 9 and 10. If you require a 14% rate of return,
and the cash flows occur at the end of each year, then how much should you be willing to pay for this
investment?
A) $15,819.27
B) $21,937.26
C) $32,415.85
D) $38,000.00
E) $52,815.71
Answer: B
Explanation: B) NPV =
NPV =
+
- Initial Investment
+
+
+
+
+
+
+
+
-0=
$21,937.26
Using a financial calculator: CF0 = 0, C01 = 5,000, F01 = 5 C02 = 3,000, F02 = 3, C03 = 2,000, F03 = 2, NPV I =
14
CPT NPV = $21,937.26
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16) Two projects each require a current cash expenditure of $10,000. Project A will generate cash inflows
of $2,000 per year for the next twelve years. Project B is expected to return $6,000 in 1 year, $4,000 at the
end of year 2, and $3,000 in 3 years. Which project should be selected if funds are unavailable to finance
both and capital costs are 6%?
A) Project B because it has a shorter payback period
B) Project B because it has a higher IRR
C) Project A because it has a higher IRR
D) Project A because it has a higher NPV
E) Project B because it has a higher NPV
Answer: D
Explanation: D) Step 1 - Calculate the NPV for Project A.
Project A can be solved like an annuity, so:
NPV = PMT
- Initial Investment
NPV = 2,000
- 10,000 = $6,767.69
Step 2 - Calculate the NPV for Project B.
NPV =
NPV =
- Initial Investment
+
+
- 10,000 = $1,739.22
Accept Project A because it has a higher NPV
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17) What is the NPV of the Boeing 787 Dreamliner project? The Boeing 787-8 can carry 230 passengers up
to 8,200 nautical miles at a cruising speed of mach 0.85. The Dreamliner is more comfortable for
passengers because of higher cabin humidity. Boeing completed construction on its final assembly plant
at time t = 0 for a total cost of $7B. Boeing has secured orders for 865 aircraft over the next five years (t = 1
to t = 5) for total proceeds of $138.4B ($160M per aircraft). The cost of building each plane is $140M.
Assume that cash flows (sales and costs) occur at the end of each year starting one year after the assembly
plant was completed. The project cash flows are shown in the table, below. What is the NPV of the project
if Boeing's cost of capital is 10%? Calculate the NPV as of time t = 0. (Round answer to the nearest
million).
Year
t=0
t=1
t=2
t=3
t=4
t=5
Capital
Investment
$7,000M
Annual
Sales
Annual
Revenues
Annual
Costs
173
173
173
173
173
27,680
27,680
27,680
27,680
27,680
24,220
24,220
24,220
24,220
24,220
Cash Flows
-7,000
3,460
3,460
3,460
3,460
3,460
A) $6,116M
B) $8,069M
C) $8,780M
D) $8,967M
E) $13,116M
Answer: A
Explanation: A) This project can be solved like an annuity, so:
NPV = PMT
NPV = 3,460M
- Initial Investment
- 7,000M = $6,116M
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18) What is the NPV of the Airbus A380 project? The Airbus A380 is the largest civilian aircraft ever built.
It can carry 555 passengers on two decks. Initial project investments were $13B. Assume that the initial
investment was paid on Dec 31, 2008. Assume that Airbus will produce 60 aircraft per year for five years.
Each aircraft will be sold for $230M and total operating costs are 75% of revenues. Assume that revenues
and costs occur at year-end with the first revenues (and costs) occurring on Dec 31, 2009. What is the NPV
of the project if Airbus' cost of capital is 11%? Calculate the NPV as of Dec 31, 2008. Ignore taxes and
assume that there are no terminal year cash flows.
A) -$2.799B
B) -$0.249B
C) $0.078B
D) $2.751B
E) $25.253B
Answer: B
Explanation: B) Step 1 - Calculate the amount of each cash flow.
$230,000,000 × 60 × 0.25 = $3,450,000,000
Step 2 - Use the cash flow amount and solve like an annuity.
NPV = PMT
NPV = 3,450,000,000
- Initial Investment
- 13,000,000,000 = -$249,155,289
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19) Two projects being considered are mutually exclusive and have the following projected cash flows:
Year
0
1
2
3
4
5
Project A
-$50,000
$15,625
$15,625
$15,625
$15,625
$15,625
Project B
-$50,000
0
0
0
0
$99,500
If the required rate of return on these projects is 10%, which would be chosen and why?
A) B, because of higher NPV.
B) B, because of higher IRR.
C) A, because of higher NPV.
D) A, because of higher IRR.
E) Neither, because both have IRRs less than the cost of capital.
Answer: A
Explanation: A) Project A can be solved like an annuity, so:
NPV = PMT
- Initial Investment
NPV = 15,625
- 50,000 = $9,231.04
Project B:
NPV =
NPV =
- Initial Investment
- 50,000 = $11,781.67
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20) Marlin Liquidators is considering the purchase of a new $175,000 crane. If Marlin expects the cash
inflows to be $45,000 after the first year, $76,000 after the second year, and $80,000 after the third year,
what is the NPV if the cost of capital is 15%? Round answer to the nearest whole dollar amount.
A) +$149,196
B) +$26,000
C) +$18,800
D) -$25,801
E) -$18,800
Answer: D
Explanation: D) NPV =
NPV =
+
- Initial Investment
+
- 175,000 = -$25,801.35
Using a financial calculator: CF0 = -175,000, C01 = 45,000, F01 = 1, C02 = 76,000, F02 = 1, C03 = 80,000, F03 =
1, NPV I = 15, CPT NPV = $25,801.35
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21) Going Postal Service Inc. is considering an upgrade of its sorting machines. The cost of the project is
$10,000 per machine and the improvement is expected to save $5,000 each year, beginning one year after
the adoption of the project and continuing for a total of 5 years. If Going's cost of capital is 10%, is the
project acceptable? Round answer to the nearest whole dollar.
A) Yes, the NPV = $15,000
B) Yes, the NPV = 15%
C) No, the NPV = -$8,954
D) Yes, the NPV = +$8,954
E) No, the NPV = 8%
Answer: D
Explanation: D) This project can be solved like an annuity, so:
NPV = PMT
NPV = 5,000
- Initial Investment
- 10,000 = $8,953.93
Using a financial calculator: CF0 = -10,000, C01 = 5,000, F01 = 5, NPV I = 10, CPT NPV = $8,953.93
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22) A firm is evaluating an investment proposal which has an initial investment of $5,000 and cash flows
presently valued at $4,000. The net present value of the investment is
A) -$1,000.
B) $0.
C) $1,000.
D) $1.25.
Answer: A
Explanation: A) NPV = PV(Cash Inflows) - PV(Cash Outflows)NPV = 4,000 - 5,000 = -$1,000
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23) In 1967, Lockheed planned to build a wide-bodied passenger aircraft called the L-1011 Tri Star airbus.
The pre-production phase of the Tri Star project was planned to end in 1971 and total $1B. Lockheed
planned to sell 35 aircraft per year for six years between 1972 and 1977 with an operating profit of $2M
per aircraft. This sales forecast was aggressive as it represented a market share of 45% of the world
market for wide-bodied aircraft (which was forecast to be about 80 aircraft per year).
By 1971 the company was in financial distress and had to seek a government bailout.
At the end of 1967, Lockheed had 11.3 million shares outstanding which traded at $70 per share. If the
market had known the NPV of the L-1011 project at that time, then what would the stock price have
been?
A) Larger than $70; hard to tell without more information
B) Much less than $70, as the project clearly had a large, negative NPV
C) About $70; the NPV of the project was close to zero
D) $70; the NPV of a project does not affect the stock price
Answer: B
Explanation: B) The undiscounted free cash flows from sales of aircraft are only 6 × 35 × $2M = $420M.
This is far less than the pre-production costs of $1B, so the NPV is clearly negative.
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24) What is the NPV of the F-22 Raptor project? The Lockheed Martin/Boeing F-22 Raptor is a stealth
fighter aircraft. It was designed primarily as an air superiority fighter, but it is also capable of ground
attack and other roles. Lockheed Martin Aeronautics is the prime contractor and is responsible for the
majority of the airframe, weapon systems and final assembly. Lockheed Martin invested over $10B on
design and manufacturing for the aircraft. Assume that those investments were paid for on Jan 1, 2003.
Each aircraft will be sold for $350M and the variable cost of building each airplane is $300M. Assume that
70 aircraft will be sold each year for 5 years. Assume that revenues and costs occur at year-end. (So 2003
revenues and costs are incurred on Dec 31, 2003. See the table of cash flows, below.) What is the NPV of
the project if Lockheed-Martin's cost of capital is 10%? (Assume that there are no taxes.)
Date
Jan. 1, 2003
Dec. 31, 2003
Dec. 31, 2004
Dec. 31, 2005
Dec. 31, 2006
Dec. 31, 2007
Investments
$10B
Revenues
Costs
$24.5B
$24.5B
$24.5B
$24.5B
$24.5B
$21B
$21B
$21B
$21B
$21B
A) $3,500,000
B) $3,267,754
C) $5,243,412
D) $13,267,75
E) $82,874,276
Answer: B
Explanation: B) This project can be solved like an annuity, so:
NPV = PMT
NPV = 3,500M
- Initial Investment
- 10,000M = $3,267.75M
Using a financial calculator: CF0 = -10,000, C01 = 3,500, F01 = 5, NPV I = 10, CPT NPV = $3,267.75M
Diff: 2
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25) Fritz Walther, the CEO of Carl Walther Sportwaffen GmbH, is choosing between two mutually
exclusive projects: 1) the Walther PBJ; and 2) the Walther PPK. Both projects involve an investment of
$100,000. The operating cash flows for each project are shown in the table. The opportunity cost of capital
is 10%. The PBJ project has an IRR of 11.65% and the PPK project has an IRR of 12.27%. Which project
should Fritz choose (and why)?
Year
0
1
2
PBJ
-100,000
40,000
80,000
PPK
-100,000
90,000
25,000
A) Choose the PPK project because its IRR is greater.
B) Choose the PPK because its NPV is higher.
C) Choose the PBJ because its NPV is higher.
D) Choose the PPK because it generates more operating cash flows.
E) Choose either because they both have the same NPV.
Answer: E
Explanation: E) NPV =
=
+
- Initial Investment
- 100,000 = $2,479.34
Using a financial calculator: CF0 = -100,000, C01 = 40,000, F01 = 1, C02 = 80,000, F02 = 1, NPV I = 10, CPT
NPV = $2,479.34
=
+
- 100,000 = $2,479.34
Using a financial calculator: CF0 = -100,000, C01 = 90,000, F01 = 1, C02 = 25,000, F02 = 1, NPV I = 10, CPT
NPV = $2,479.34
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26) Bernhard Stroh is the Master Brewer at the Lion's Head Brewery. Bernhard has the approval to brew a
new beer, but can't decide which: 1) a wheat beer; or 2) a pale ale. Both beers require an initial investment
of $1,000,000. The operating cash flows for each project are shown in the table. Lion's Head shareholders
required a rate of return of 10%. The Wheat project has an IRR of 15.36% and the Ale project has an IRR of
15.89%. Which project should Bernhard choose (and why)?
Year
0
1
2
Wheat
-1,000,000
200,000
1,100,000
Ale
-1,000,000
900,000
300,000
A) Choose the Ale project because its IRR is greater.
B) Choose the Ale because its NPV is higher.
C) Choose the Wheat because its NPV is higher.
D) Choose the Wheat because it generates more operating cash flows.
E) Choose either because they both have the same NPV.
Answer: C
Explanation: C) NPV =
NPVWheat =
+
- Initial Investment
- 1,000,000 = $90,909.09
Using a financial calculator: CF0 = -1,000,000, C01 = 200,000, F01 = 1, C02 = 1,100,000, F02 = 1, NPV I = 10,
CPT NPV = $90,909.09
NPVAle =
+
- 1,000,000 = $66,115.70
Using a financial calculator: CF0 = -1,000,000, C01 = 900,000, F01 = 1, C02 = 300,000, F02 = 1, NPV I = 10,
CPT NPV = $66,115.70
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27) Michigan Mattress Company is considering the purchase of land and the construction of a new plant.
The land, which would be bought immediately (at t = 0), has a cost of $100,000 and the building, which
would be erected at the end of the first year (t = 1), would cost $500,000. It is estimated that the firm's
after-tax cash flow will increase by $100,000 starting at the end of the second year, and that this
incremental flow would increase at a 10 percent rate annually over the next 10 years. What is the
approximate payback period?
A) 2 years
B) 4 years
C) 6 years
D) 8 years
E) 10 years
Answer: C
Explanation: C) This problem is best solved by building a payback table like the following:
Year
0
1
2
3
4
5
6
Investment
-$100,000
-$500,000
Cash Inflow
$0
$0
$100,000
$110,000
$121,000
$133,100
$146,410
Accumulated
Inflow
$0
-$500,000
-$400,000
-$290,000
-$169,000
-$35,900
$110,510
Balance
-$100,000
-$600,000
-$500,000
-$390,000
-$269,000
-$135,900
$10,510
Looking at the table, we see the project's balance turns positive in Year 6.
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28) Sara Flea Collar Inc. is evaluating an overseas expansion that will cost $1 million and is expected to
generate the following cash flows: year 1: -$250,000; year 2: +$450,000; year 3: +$550,000; and year 4:
+$800,000. What is the payback period?
A) 3.00 years
B) 3.13 years
C) 3.31 years
D) 3.75 years
E) 4.00 years
Answer: C
Explanation: C) Step 1 - Build a payback table with the cash flows like the following:
Year
0
1
2
3
4
Investment
-$1,000,000
-$250,000
Cash Inflow
$0
$0
$450,000
$550,000
$800,000
Accumulated
Inflow
$0
-$250,000
$200,000
$750,000
$1,550,000
Balance
-$1,000,000
-$1,250,000
-$800,000
-$250,000
$550,000
Step 2 - We see that the project turns positive in the fourth year, we need the amount of that year needed
to finish recouping the investment.
= .31 + 3 full years = 3.31 years payback period
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29) What is the payback period for the Airbus A380 project? The Airbus A380 is the largest civilian
aircraft ever built. It can carry 555 passengers on two decks. Initial project investments were $13B.
Assume that the initial investment was paid on Dec 31, 2008. Assume that Airbus will produce 60 aircraft
per year for five years. Each aircraft will be sold for $230M and total operating costs are 75% of revenues.
Assume that revenues and costs occur at year-end with the first revenues (and costs) occurring on Dec 31,
2009. Ignore taxes and assume that there are no terminal year cash flows. Select the earliest year such that
the initial investments are completely paid off.
A) 3 years
B) 4 years
C) 5 years
D) The project is not paid off in this time frame.
E) Need the cost of capital to answer this question.
Answer: B
Explanation: B) Payback =
Payback =
= 3.768 or 4 years
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30) What is the payback period of the F-22 Raptor project? The Lockheed Martin/Boeing F-22 Raptor is a
stealth fighter aircraft. It was designed primarily as an air superiority fighter, but it is also capable of
ground attack and other roles. Lockheed Martin Aeronautics is the prime contractor and is responsible
for the majority of the airframe, weapon systems and final assembly. Lockheed Martin invested over $10B
on design and manufacturing for the aircraft. Assume that those investments were paid for on Jan 1, 2003.
Each aircraft will be sold for $350M and the variable cost of building each airplane is $300M. Assume that
70 aircraft will be sold each year for 5 years. Assume that revenues and costs occur uniformly throughout
the year. What is the payback period of the project?
Date
Jan. 1, 2003
Dec. 31, 2003
Dec. 31, 2004
Dec. 31, 2005
Dec. 31, 2006
Dec. 31, 2007
Investments
-$10B
Revenues
Costs
$24.5B
$24.5B
$24.5B
$24.5B
$24.5B
$21B
$21B
$21B
$21B
$21B
A) 5 months
B) 2.86 years
C) 3.45 years
D) 3.39 years
E) 7.8 years
Answer: B
Explanation: B) Payback =
Payback =
= 2.86 years
Diff: 2
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AACSB: Analytical Thinking
31) The ________ method to analyze cash flows associated with a project does not consider the time value
of money.
A) payback period
B) net present value (NPV)
C) profitability index (PI)
D) internal rate of return (IRR)
E) modified internal rate of return
Answer: A
Explanation: A) One of the problems with the payback period is that it does not consider the time value
of money.
Diff: 1
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32) All of the following are considered to be disadvantages of using the payback method EXCEPT the fact
that it
A) ignores the time value of money.
B) has no clearly defined decision rule.
C) does not consider cash flows that occur beyond the payback period.
D) does not adjust for risk.
E) does not provide a good measure of the project's liquidity.
Answer: E
Explanation: E) Not providing a good measure of the project's liquidity is not a disadvantage of the
payback method.
Diff: 1
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33) The least desirable capital budgeting technique from a theoretical standpoint is
A) the payback method.
B) net present value.
C) the profitability index.
D) the internal rate of return.
E) the modified internal rate of return.
Answer: A
Explanation: A) The payback period is the least desirable capital budgeting technique.
Diff: 1
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34) Which of the following capital budgeting methods might not consider the salvage value of a machine
being considered for purchase?
A) Internal Rate of Return
B) Net present value
C) Payback
D) Profitability Index
Answer: C
Explanation: C) The payback period method will not consider the salvage value of a machine considered
for purchase.
Diff: 1
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AACSB: Analytical Thinking
35) The ________ is the exact amount of time it takes the firm to recover its initial investment.
A) average rate of return
B) internal rate of return
C) net present value
D) payback period
Answer: D
Explanation: D) The payback period is the exact amount of time it takes the firm to recover its initial
investment.
Diff: 1
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36) Unsophisticated capital budgeting techniques do not
A) examine the size of the initial outlay.
B) use net profits as a measure of return.
C) explicitly consider the time value of money.
D) take into account an unconventional cash flow pattern.
Answer: C
Explanation: C) Unsophisticated capital budgeting techniques do not explicitly consider the time value of
money.
Diff: 1
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AACSB: Analytical Thinking
37) All of the following are weaknesses of the payback period EXCEPT
A) a disregard for cash flows after the payback period.
B) only an implicit consideration of the timing of cash flows.
C) the difficulty of specifying the appropriate payback period.
D) it uses cash flows, not accounting profits.
Answer: D
Explanation: D) Using cash flows instead of accounting profits is not a weakness of the payback period
technique.
Diff: 1
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AACSB: Analytical Thinking
38) Among the reasons many firms DON'T use the payback period as a guideline in capital investment
decisions are all of the following EXCEPT
A) it gives consideration to the timing of cash flows.
B) it uses an appropriate measure of risk.
C) it recognizes cash flows which occur after the payback period.
D) it is easy to calculate.
Answer: D
Explanation: D) Being easy to calculate is not a reason firms choose not to use the payback period
technique.
Diff: 1
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AACSB: Analytical Thinking
39) Some firms use the payback period as a decision criterion or as a supplement to sophisticated decision
techniques, because
A) it explicitly considers the time value of money.
B) it can be viewed as a measure of risk exposure.
C) the determination of payback is an objectively determined criteria.
D) it can take the place of the net present value approach.
Answer: B
Explanation: B) The payback period can be used as a measure of risk exposure.
Diff: 1
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40) The New Watch Times is considering a new printing press to increase its productive capacity. If the
cost of the press is $500,000 and the relevant cash flows from the project are $75,000 per year over the next
ten years, what is the payback period?
A) 6.00 years
B) 6.50 years
C) 7.00 years
D) 6.67 years
E) 7.50 years
Answer: D
Explanation: D) Payback =
Payback =
= 6.67 years
Diff: 2
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AACSB: Analytical Thinking
41) What is the payback period for the Boeing 787 Dreamliner project? The Boeing 787-8 can carry 230
passengers up to 8,200 nautical miles at a cruising speed of mach 0.85. The Dreamliner is more
comfortable for passengers because of higher cabin humidity. Boeing completed construction of its final
assembly plant in Everett Washington in December 2007 at a total cost of $7B. Boeing has secured sales of
865 aircraft over the period 2008-2012 for total proceeds of $138.4B ($160M per aircraft). The cost of
building each plane is $140M. Assume that sales (and costs) occur in December of each year. Assume that
sales are spread evenly across the five years from 2008-2012. The project cash flows are shown in the
table, below. What is the payback period for the project? Ignore taxes.
Year
2007
2008
2009
2010
2011
2012
Capital
Investment
-$7,000M
Annual
Sales
Annual
Revenues
Annual
Costs
173
173
173
173
173
$27,680
$27,680
$27,680
$27,680
$27,680
$24,220
$24,220
$24,220
$24,220
$24,220
Cash Flows
-$7,000
$3,460
$3,460
$3,460
$3,460
$3,460
A) 2 months
B) 2.02 years
C) 3.4 years
D) 7 years
E) 24 years
Answer: B
Explanation: B) Payback =
Payback =
= 2.02 years
Diff: 2
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42) A firm is evaluating a proposal which has an initial investment of $35,000 and has cash flows of
$10,000 in year 1, $20,000 in year 2, and $10,000 in year 3. The payback period of the project is
A) 1 year.
B) 2 years.
C) between 1 and 2 years.
D) between 2 and 3 years.
Answer: D
Explanation: D) Build a playoff table like the following:
Year
0
1
2
3
Investment
-$35,000
Cash Inflow
$0
$10,000
$20,000
$10,000
Accumulated
Inflow
$0
$10,000
$30,000
$40,000
Balance
-$35,000
-$25,000
-$5,000
$5,000
Looking at the table, we see that the project turns positive between year 2 and year 3.
Diff: 2
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43) Genuine Products Inc. requires a new machine. Two companies have submitted bids, and you have
been assigned to the task of choosing one of the machines. Cash flow analysis indicates the following:
Year
0
1
2
3
4
Machine A
-$2,000
$0
$0
$0
$3,877
Machine B
-$2,000
$832
$832
$832
$832
What is the internal rate of return for each machine?
A) IRRa =16%; IRRb = 20%
B) IRRa = 24%; IRRb = 20%
C) IRRa = 18%; IRRb = 16%
D) IRRa = 18%; IRRb = 24%
E) IRRa = 24%; IRRb = 26%
Answer: D
Explanation: D) Using a financial calculator: Machine A - CF0 = -2,000, C01 = 0, F01 = 3, C02 = 3,877, F02 =
1, IRR CPT = 18%Machine B - CF0 = -2,000, C01 = 832, F01 = 4, IRR CPT = 24%
Diff: 3
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44) An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay a premium of $100 per
year at the end of each year of the 20 years. Find the internal rate of return to the nearest whole
percentage point.
A) 9%
B) 7%
C) 5%
D) 3%
E) 11%
Answer: C
Explanation: C) Using a financial calculator:
CF0 = 0, C01 = -100, F01 = 20, C02 = 3,310, F02 = 1, IRR CPT = 4.58% or 5%
Diff: 2
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AACSB: Analytical Thinking
45) Your company is planning to open a new gold mine which will cost $3 million to build, with the
expenditure occurring at the end of the year three years from today. The mine will bring year-end aftertax cash inflows of $2 million at the end of the two succeeding years, and then it will cost $.5 million to
close down the mine at the end of the 3rd year of operation. What is the project's IRR?
A) 14.36%
B) 10.17%
C) 17.42%
D) 12.70%
E) 21.53%
Answer: D
Explanation: D) Using a financial calculator: IRR = CF0 = -3,000,000, C01 = 2,000,000, F01 = 2, C02 = 500,000 F02 = 1, IRR CPT = 12.70%
Diff: 2
Section: 3.4
AACSB: Analytical Thinking
46) The underlying cause of ranking conflicts between the NPV and IRR methods is differing
A) initial cost.
B) reinvestment rate assumption.
C) cash flow timing.
D) profitability indices.
E) errors in calculating the discount rate.
Answer: B
Explanation: B) The IRR method does not evaluate the project at a particular discount rate, so it cannot be
used for ranking mutually exclusive projects.
Diff: 1
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47) Comparing net present value and internal rate of return analysis
A) always result in the same ranking of projects.
B) always result in the same accept/reject decision.
C) may give different accept/reject decisions.
D) is only necessary on mutually exclusive projects.
Answer: B
Explanation: B) NPV and IRR will always result in the same accept/reject decision.
Diff: 1
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AACSB: Analytical Thinking
48) In comparing the internal rate of return and net present value methods of evaluation,
A) Internal Rate of Return is theoretically superior, but financial managers prefer Net Present Value.
B) financial managers prefer net present value, because it measures benefits relative to the costs.
C) financial mangers prefer net present value, because it is presented as a rate of return.
D) Net Present Value is not theoretically superior, but financial mangers prefer to use it anyway.
Answer: B
Explanation: B) NPV measures benefits relative to the costs of a project.
Diff: 1
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49) A project requires a current expenditure of $300 and expects to generate $100 cash inflows at the end
of each of the next 5 years. What conclusion can be drawn from examining an NPV profile for this
project?
A) Accept the project if the cost of capital exceeds 20%
B) Accept the project if the cost of capital is below 20%
C) Reject the project if the cost of capital exceeds 10%
D) Reject the project if the cost of capital exceeds 7%
E) Reject the project if the cost of capital exceeds 5%
Answer: B
Explanation: B) Using a financial calculator:
CF0 = -300, C01 = 100, F01 = 5, IRR CPT = 19.86% or 20%
Diff: 2
Section: 3.4
AACSB: Analytical Thinking
50) A project requires an investment outlay of $100 immediately. The project will generate after-tax cash
flows of $50 one year from now and $60 two years from now. What is the IRR of the project?
A) 5.39%
B) 6.39%
C) 10.39%
D) 12.39%
E) 14.39%
Answer: B
Explanation: B) Using a financial calculator:
CF0 = -100, C01 = 50, F01 = 1, C02 = 60, F02 = 1, IRR CPT = 6.39%
Diff: 2
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51) What is the internal rate of return for a project that requires a current cash outlay of $15,187 and is
expected to generate cash inflows of $5,000 at the end of each of the next four years?
A) 12.0%
B) 11.5%
C) 12.3%
D) 14.1%
E) 13.0%
Answer: A
Explanation: A) Using a financial calculator:IRR = CF0 = -15,187, C01 = 5,000, F01 = 4, IRR CPT = 12%
Diff: 2
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52) What is the IRR for a project with a current cost of $7,000 that is expected to produce cash inflows of
$1,000 at the end of each of the next 10 years? Round answer to the nearest whole percent.
A) 10%
B) 8%
C) 7%
D) 11%
E) 6%
Answer: C
Explanation: C) Using a financial calculator:IRR = CF0 = -7,000, C01 = 1,000, F01 = 10, IRR CPT = 7.07%
Diff: 2
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AACSB: Analytical Thinking
53) The internal rate of return may be defined as the
A) percentage increase in the value of an investment over its useful life.
B) the minimum return required by investors to hold a firm's securities.
C) the discount rate at which a project's NPV is negative.
D) the discount rate at which a project's NPV equals zero.
E) the maximum rate of return expected from a project.
Answer: D
Explanation: D) The internal rate of return is the discount rate which sets NPV equal to zero.
Diff: 1
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54) Perhaps the greatest disadvantage of using the IRR method to evaluate investment opportunities is
A) dealing with uncertain cash flows from the project.
B) the assumption that all cash flows from the project will be reinvested at the IRR.
C) the inability to calculate most IRRs without a computer.
D) the need to compare IRR with the firm's cost of capital which cannot be estimated precisely.
E) the fact that the technique does not account for risk.
Answer: B
Explanation: B) The greatest disadvantage of using the IRR method to evaluate investment opportunities
is the assumption that all cash flows from the project will be reinvested at the IRR.
Diff: 1
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AACSB: Analytical Thinking
55) If the ________ is greater than or equal to the ________, the project should be accepted.
A) IRR; NPV
B) cost of capital; IRR
C) IRR; cost of capital
D) NPV; IRR
E) NPV; discount rate
Answer: C
Explanation: C) We accept the project if the IRR is greater than or equal to our cost of capital.
Diff: 1
Section: 3.4
AACSB: Analytical Thinking
56) According to the internal rate of return method, a firm should accept a project if the
A) internal rate of return is less than the cost of capital.
B) internal rate of return exceeds the cost of capital.
C) cost of capital exceeds the internal rate of return.
D) internal rate of return exceeds the firm's cost of debt.
E) internal rate of return exceeds the firm's cost of equity.
Answer: B
Explanation: B) We accept the project if the IRR is greater than or equal to our cost of capital.
Diff: 1
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AACSB: Analytical Thinking
57) If the calculated NPV is negative, then which of the following must be true? The discount rate used is
A) equal to the IRR.
B) too high.
C) greater than the IRR.
D) too low.
E) less than the IRR.
Answer: C
Explanation: C) If the discount rate is higher than the IRR, then NPV will be negative.
Diff: 1
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58) Which of the following statements is incorrect?
A) It is possible to compute multiple IRRs for a single project.
B) A problem with IRR is that it does not adjust for the scale of the project.
C) A NPV profile plots the relationship between the riskiness of a project and the associated NPVs.
D) The NPV and IRR always provide the same rankings for a set of possible projects.
E) IRR provides information in a form that is useful to managers.
Answer: D
Explanation: D) NPV and IRR do not provide the same rankings for possible projects.
Diff: 1
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59) When the net present value is negative, the internal rate of return is ________ the cost of capital.
A) greater than
B) greater or equal to
C) less than
D) equal to
Answer: C
Explanation: C) A negative NPV value means the IRR generates from the project is less than the firm's
cost of capital.
Diff: 1
Section: 3.4
AACSB: Analytical Thinking
60) For mutually exclusive projects the underlying cause of conflicts in ranking for projects by internal
rate of return and net present value methods is
A) the reinvestment rate assumption regarding cash flows.
B) that neither method explicitly considers the time value of money.
C) the assumption made by the IRR method that intermediate cash flows are reinvested at the cost of
capital.
D) the assumption made by the NPV method that intermediate cash flows are invested at the internal rate
of return.
Answer: A
Explanation: A) The reinvestment rate assumption regarding cash flows is the underlying cause of
conflicts when ranking mutually exclusive projects between IRR and NPV.
Diff: 1
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61) An investment of $1,000 will return $60 annually forever. What is its internal rate of return?
A) 6%
B) 0.60%
C) 16.67%
D) 60%
E) Cannot be determined.
Answer: A
Explanation: A) This problem is solved like a perpetuity where:
Rate =
Rate =
= 6%
Diff: 2
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AACSB: Analytical Thinking
62) Two projects being considered by a firm are mutually exclusive and have the following projected cash
flows:
Year
0
1
2
3
Project A
-$100,000
$39,500
$39,500
$39,500
Project B
-$100,000
0
0
$133,000
Which project(s) should be accepted?
A) A, because it has a shorter payback period.
B) B, because it has a higher IRR.
C) Indifferent, because the projects have equal IRRs.
D) Include both in the capital budget, since the sum of the cash inflows exceeds the initial investment in
both cases.
E) Choose neither, since their NPVs are negative.
Answer: B
Explanation: B) Using a financial calculator:Project A - CF0 = -100,000, C01 = 39,500, F01 = 3, IRR CPT =
8.99%Project B - CF0 = -100,000, C01 = 0, F01 = 2, C02 = 133,000, F02 = 1, IRR CPT = 9.97%
Diff: 3
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63) Given the following net cash flows, determine the IRR of the project. (to the nearest whole percent)
Time
0
1
2
3
Net Cash Flow
$1,520
-$1,000
-$1,500
$500
A) 36%
B) 32%
C) 28%
D) 24%
E) 20%
Answer: D
Explanation: D) Using a financial calculator:IRR = CF0 = 1,520, C01 = -1,000, F01 = 1, C02 = -1,500, F02 = 1,
C03 = 500, F03 = 1,
IRR CPT = 23.98%
Diff: 2
Section: 3.4
AACSB: Analytical Thinking
64) The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is
expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year.
If the firm's cost of capital is 14% and its tax rate is 40%, what is the projected IRR?
A) 8%
B) 14%
C) 18%
D) -5%
E) 12%
Answer: C
Explanation: C) Using a financial calculator: IRR = CF0 = -200,000, C01 = 44,503, F01 = 10, IRR CPT = 18%
Diff: 2
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65) As the capital budgeting director for Chapel Hill Coffins Inc., you are evaluating construction of a
new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of
$1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3
through 5. Within what range is the plant's IRR?
A) 14-15%
B) 15-16%
C) 16-17%
D) 17-18%
E) 18-19%
Answer: E
Explanation: E) Using a financial calculator:IRR = CF0 = -5,000,000, C01 = 1,000,000, F01 = 1, C02 =
1,500,000 F02 = 1, C03 = 2,000,000, F03 = 3, IRR CPT = 18.37%
Diff: 2
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66) A firm is evaluating two independent projects utilizing the internal rate of return technique. Project X
has an initial investment of $80,000 and cash inflows at the end of each of the next five years of $25,000.
Project Z has a initial investment of $120,000 and cash inflows at the end of each of the next four years of
$40,000. The firm should
A) accept both if their cost of capital is 15% at the maximum.
B) accept only Z if their cost of capital is 15% at the maximum.
C) accept only X if their cost of capital is 15% at the maximum.
D) reject both if their cost of capital is 12% at the maximum.
Answer: C
Explanation: C) Using a financial calculator:Project X - CF0 = -80,000, C01 = 25,000, F01 = 5, IRR CPT =
16.99%Project Z - CF0 = -120,000, C01 = 40,000, F01 = 4, IRR CPT = 12.59%
Diff: 3
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67) Your lawyer presents you with a three year investment. You must invest $1,000 immediately, but you
are promised after-tax cash flows of $600 after one year and another $600 after two years. What is the IRR
of the investment? (Round answer to nearest percent.)
A) 10%
B) 11%
C) 12%
D) 13%
E) 14%
Answer: D
Explanation: D) Using a financial calculator:CF0 = -1,000, C01 = 600, F01 = 2, IRR CPT = 13.07%
Diff: 2
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68) The Barby Division at Mattel Toys is considering the acquisition of a laser tattoo applicator that will
be able to add custom-designed tattoos to the Barby doll. The machine costs $300M. The addition of
tattoos to the iconic toy is expected to increase demand and raise free cash flow by $90 million over the
next five years (at the end of each year). The machine has no anticipated resale value in five years. What
is the project's IRR?
A) 14.24%
B) 15.24%
C) 15.74%
D) 16.24%
E) 16.74%
Answer: B
Explanation: B) Using a financial calculator:CF0 = -300, C01 = 90, F01 = 5, IRR CPT = 15.24%
Diff: 2
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69) What is the IRR of the F-22 Raptor project? The Lockheed Martin/Boeing F-22 Raptor is a stealth
fighter aircraft. It was designed primarily as an air superiority fighter, but it is also capable of ground
attack and other roles. Lockheed Martin Aeronautics is the prime contractor and is responsible for the
majority of the airframe, weapon systems and final assembly. Lockheed Martin invested over $10B on
design and manufacturing for the aircraft. Assume that those investments were paid for on Jan 1, 2003.
Each aircraft will be sold for $350M and the variable cost of building each airplane is $300M. Assume that
70 aircraft will be sold each year for 5 years. Thus annual revenues are $24.5B and annual costs are $21B.
Assume that revenues and costs occur at year-end with the first year of operating cash flows occurring on
Dec 31, 2003. Lockheed-Martin's cost of capital is 10% and the NPV of the project is $3.268B. What is the
IRR of the project?(Assume that there are no taxes.)
Date
Jan. 1, 2003
Dec. 31, 2003
Dec. 31, 2004
Dec. 31, 2005
Dec. 31, 2006
Dec. 31, 2007
Investments
-$10B
Revenues
Costs
$24.5B
$24.5B
$24.5B
$24.5B
$24.5B
$21B
$21B
$21B
$21B
$21B
A) 7.24%
B) 8.50%
C) 9.76%
D) 10.50%
E) 22.11%
Answer: E
Explanation: E) Using a financial calculator:CF0 = -10, C01 = 3.5, F01 = 5, IRR CPT = 22.11%
Diff: 2
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70) Alyeska salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new
automated production line project it is considering. The project has a cost of $275,000 and is expected to
provide after-tax annual cash flows of $73,306 for eight years. The firm's management is uncomfortable
with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a
cost of capital for the firm of 12 percent. What is the project's MIRR?
A) 15%
B) 14%
C) 12%
D) 16%
E) 17%
Answer: D
Explanation: D) Step 1 - Find the PV of all cash outflows.The initial investment is the only outflow, so PV
= -275,000
Step 2 - Find the FV of all cash inflows.
FV = PMT
FV = 73,306
= $901,641.31
Step 3 - Use a financial calculator to solve for the interest rate.N = 8, PV = -275,000, PMT = 0, FV =
901,641.31, CPT I/Y = 16%
Diff: 3
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71) A project costs $1,000 today and is expected to produce cash inflows of $800 at the end of each of the
next two years. If the firm's cost of capital is 10%, what is the modified internal rate of return? Round
answer to the nearest whole percent.
A) 30%
B) 23%
C) 13%
D) 21%
E) 33%
Answer: A
Explanation: A) Step 1 - Find the PV of all cash outflows.The initial investment is the only outflow, so PV
= -1,000
Step 2 - Find the FV of all cash inflows.
FV = PMT
FV = 800
= $1,680
Step 3 - Use a financial calculator to solve for the interest rate.N = 2, PV = -1,000, PMT = 0, FV = 1,680, CPT
I/Y = 29.61, or 30%
Diff: 3
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72) Los Angeles Lumber Company (LALC) is considering a project with a cost of $1,000 at Time = 0 and
inflows of $300 at the end of Years 1-5. LALC's cost of capital is 10%. What is the project's modified IRR
(MIRR)?
A) 10.0%
B) 12.9%
C) 15.2%
D) 18.3%
E) 20.7%
Answer: B
Explanation: B) Step 1 - Find the PV of all cash outflows.The initial investment is the only outflow, so PV
= -1,000.
Step 2 - Find the FV of all cash inflows.
FV = PMT
FV = 300
= $1,831.53
Step 3 - Use a financial calculator to solve for the interest rate.N = 5, PV = -1,000, PMT = 0, FV = 1,831.53,
CPT I/Y = 12.9%
Diff: 3
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AACSB: Analytical Thinking
73) The modified internal rate of return corrects which problem inherent in IRR?
A) Adjustments for scale differences
B) Difficulty in ranking projects
C) Differing risk attributes of projects
D) Incorporates the time value of money
E) It allows for reinvestment of cash inflows from the project at the firm's cost of capital.
Answer: E
Explanation: E) The modified internal rate of return allows for reinvestment of cash inflows from the
project at the firm's cost of capital.
Diff: 1
Section: 3.5
AACSB: Analytical Thinking
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74) What is the profitability index of a project that has a current cost of $100,000 and expected cash flows
of $50,000 at the end of each of the next 7 years if the cost of capital is 20%?
A) .001
B) .018
C) 1.80
D) 1.18
E) 1.25
Answer: C
Explanation: C) PI =
PV(Inflows) = PMT ×
PV(Inflows) = 50,000 ×
= $180,229.59
Using a financial calculator:
N = 7, I/Y = 20, PMT = -50,000, FV = 0, cpt PV = $180,229.59
PI =
= 1.80
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
75) What is the Profitability Index of the Airbus A380 project? The Airbus A380 is the largest civilian
aircraft ever built. It can carry 555 passengers on two decks. Initial project investments were $13B.
Assume that the initial investment was paid on Dec 31, 2008. Assume that Airbus will produce 60 aircraft
per year for five years. Each aircraft will be sold for $230M and total operating costs are 75% of revenues.
Assume that revenues and costs occur at year-end with the first revenues (and costs) occurring on Dec 31,
2009. Assume that Airbus' cost of capital is 11%. Calculate the Profitability Index as of Dec 31, 2008.
Assume that there are no terminal year cash flows.
A) 0.935
B) 0.981
C) 0.995
D) 1.333
E) 1.981
Answer: B
Explanation: B) PI =
PV(Inflows) = PMT
PV(Inflows) = (230,000,000 × 60 × 0.25)
PI =
= $12,750,844,710
= 0.981
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
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76) The major advantage provided by the profitability index is it
A) eliminates the need to estimate the firm's cost of capital.
B) reduces the forecast error of cash flow estimates.
C) provides a better measure of the effects of a project on shareholder wealth than NPV.
D) is useful as an aid in raking projects from best to worst.
E) is easier to calculate than NPV.
Answer: D
Explanation: D) The major advantage of the profitability index is its use in helping rank projects from
best to worst.
Diff: 1
Section: 3.3
AACSB: Analytical Thinking
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77) What is the Profitability Index of the Boeing 787 Dreamliner project? The Boeing 787-8 can carry 230
passengers up to 8,200 nautical miles at a cruising speed of mach 0.85. The Dreamliner is more
comfortable for passengers because of higher cabin humidity. Boeing completed construction its
assembly plant in Everett Washington in December 2007 at a total cost of $7B. Boeing has secured sales of
865 aircraft over the period 2008-2012 for total proceeds of $138.4B ($160M per aircraft). The cost of
building each plane is $140M. Assume that sales (and costs) occur in December of each year. Assume that
sales are spread evenly across the five years from 2008-2012. The project cash flows are shown in the
table, below. What is the Profitability Index of the project if Boeing's cost of capital is 10%? Calculate the
index as of December 1, 2007. Ignore taxes.
Year
2007
2008
2009
2010
2011
2012
Capital
Investment
-$7,000M
Annual
Sales
Annual
Revenues
Annual
Costs
173
173
173
173
173
$27,680
$27,680
$27,680
$27,680
$27,680
$24,220
$24,220
$24,220
$24,220
$24,220
Cash Flows
-$7,000
$3,460
$3,460
$3,460
$3,460
$3,460
A) -1.52
B) -0.44
C) 1.06
D) 1.87
E) 2.43
Answer: D
Explanation: D) PI =
PV(Inflows) = PMT
PV(Inflows) = 3,460
PI =
= $13,116.12
= 1.87
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
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78) A project costs $12,000 and has a discount rate of 15%. Calculate the profitability index of the project
that has cash flows of $2,500 in years 1 and 2, and $4000 in years 3 and 4.
A) 0.75
B) 0.98
C) 1.08
D) 1.14
E) 1.28
Answer: A
Explanation: A) PI =
PV(Inflows) =
PI =
+
+
+
= $8,981.34
= 0.75
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
79) The project cash flows and NPVs for Projects A and B are provided in the table below. Which project
has a higher profitability index?
Year 0
Year 1
Year 2
NPV
Project A
-$1,900
$2,500
$1,500
$1,408.12
Project B
-$2,000
$1,550
$1,900
$784.50
A) Project A
B) Project B
C) The two projects have the same Profitability Index
Answer: A
Explanation: A) PI =
=
=
= 1.74
= 1.39
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
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80) The project cash flows and Profitability Indexes for Projects A and B are provided in the table below.
If the two projects are mutually exclusive, which project should you select?
Year 0
Year 1
Year 2
PI
Project A
-$1,900
$2,500
$1,500
1.7411
Project B
-$2,000
$1,550
$1,900
1.3923
A) Project A
B) Project B
C) Either Project A or Project B
D) Both Projects
Answer: A
Explanation: A) The profitability index can be used as a ranking system for mutually exclusive projects.
Since Project A has a higher PI, it should be accepted.
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
81) The project cash flows and Profitability Indexes for Projects A and B are provided in the table below.
If the two projects are not mutually exclusive and there are no capital constraints, which project(s) should
you select?
Year 0
Year 1
Year 2
PI
Project A
-$1,900
$2,500
$1,500
1.7411
Project B
-$2,000
$1,550
$1,900
1.3923
A) Project A
B) Project B
C) Either Project A or Project B
D) Both Projects
Answer: D
Explanation: D) Projects with a PI greater than 1 should be accepted. Since the projects are not mutually
exclusive, they should both be accepted.
Diff: 2
Section: 3.3
AACSB: Analytical Thinking
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82) A firm is considering the following independent investments:
Project
F
G
H
I
J
Investment
$50M
$80M
$60M
$70M
$40M
NPV
$1.00M
$4.40M
$4.00M
($3.00M)
$1.30M
PI
1.02
1.06
1.07
0.96
1.03
In the absence of capital rationing, what is the total NPV of the projects that should be selected? Which
projects should be selected if the company only has $200M to invest?
A) $7.70; F, G, H, J
B) $7.70; G, H, J
C) $10.70; F, G, H, J
D) $10.70; G, H, J
E) $13.70; F, G, H, J
Answer: D
Explanation: D) Step 1 - Sum the NPV's of all the positive NPV projects.
NPV = $1.00 + $4.40 + $4.00 + $1.30 = $10.70M
Step 2 - Using the PI to rank projects, determine which projects should be accepted with $200M to spend.
Project H ($60M) + Project G ($80M) + Project J ($40M) = $180M. No other projects can be afforded.
Diff: 3
Section: 3.3
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 10 Capital Budgeting: Cash Flows
LO1: Calculate Depreciation and Taxes
1) The undepreciated capital cost (book value) of an asset is equal to the after-tax proceeds received after
the asset has been sold.
Answer: FALSE
Explanation: The correct answer is False, because:
The book value is the initial purchase price minus accumulated depreciation.
Diff: 1
Section: 1
AACSB: Analytical Thinking
2) Droids-R-Us Inc. (DRU), is considering the installation of a new production line to make service
mechanoids. The cost of the new manufacturing equipment is $2.2 million. The equipment is in Class 43
with a 30% depreciation rate. The machines will be purchased at the beginning of Year 1. DRU's
engineers estimate that the new assembly line could be ready for operations at the beginning of Year 1just after the equipment purchase. Annual EBITDA is forecasted to be $1.3M for every year of the project.
DRU's marginal tax rate is 35%. What is the value of the depreciation tax shield in Year 2? (Do NOT
assume that the equipment is salvaged in 2015.) Round your answers to the nearest dollar.
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A) $115,500
B) $196,350
C) $234,673
D) $330,000
E) $561,000
Answer: B
Explanation: B)
Tax Shield = T × Depreciation Expense
Tax Shield = 0.35 × 561,000
Tax Shield = 196,350
Diff: 2
Section: 1.2 Depreciation Tax Shield
AACSB: Analytical Thinking
3) Bill Sharpe, owner of Sharper Knives Inc., is closing the scissor sharpening division of his business at
the end of the current fiscal year. The division's sole asset, the scissor-sharpening machine, was
purchased four years ago for $250,000. The asset is in Class 43 with a depreciation rate of 30%. A
depreciation table for the asset is shown below. Bill has agreed to sell the machine at the end of the year
(Year 4) for $100,000. What is the present value of the tax shields gained (lost) as a result of the sale of the
machine? (As of Year 4.) The tax rate is 35% and Bill's cost of capital is 9.7%. Round your answers to the
nearest dollar.
A) -$7,430
B) -$7,171
C) -$6,146
D) $7,171
E) $7,430
Answer: B
Explanation: B) PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = -$7,171
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Diff: 2
Section: 1.3 Tax Impact of Salvage
AACSB: Analytical Thinking
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4) Bill Sharpe, owner of Sharper Knives Inc., is closing the scissor sharpening division of his business at
the end of the current fiscal year. The division's sole asset, the scissor-sharpening machine, was
purchased three years ago for $250,000. The asset is in Class 43 with a depreciation rate of 30%. A
depreciation table for the asset is shown below. Bill has agreed to sell the machine at the end of the year
(Year 3) for $100,000. What is the present value of the tax shields gained (lost) as a result of the sale of the
machine? (As of Year 3.) The tax rate is 35% and Bill's cost of capital is 9.7%. Round your answers to the
nearest dollar.
A) -$3,524
B) -$1,091
C) -$935
D) $935
E) $1,091
Answer: E
Explanation: E) PV Tax Shieldsn =
PV Tax Shieldsn =
PV Tax Shields = $1,091
Diff: 2
Section: 1.3 Tax Impact of Salvage
AACSB: Analytical Thinking
5) The cash flows in an expansion project are different from those in a replacement project. In an
expansion project, the cash flows from the old asset
A) will always be zero.
B) will be evaluated on an after-tax basis.
C) will always be negative.
D) will always equal the terminal cash flow.
Answer: A
Explanation: A) The correct answer is A (will always be zero), because:
If the project is an expansion project, there aren't any old cash flows.
Diff: 1
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LO2: Calculate Cash Flows for an Expansion Project
1) Projects will usually have an initial investment, cash inflows, and a terminal cash flow.
Answer: TRUE
Explanation: The correct answer is True, because:
Cash flows for a project usually include an initial cash flow, annual cash flows, and a terminal cash flow.
Diff: 1
Section: 2
AACSB: Analytical Thinking
2) Projects should be evaluated on the basis of accounting profits, as these profits actually cover the
company's obligations.
Answer: TRUE
Explanation: The correct answer is True, because:
Free cash flows aren't the same as accounting profits. Free cash flows omit interest and add back
depreciation.
Diff: 1
Section: 2
AACSB: Analytical Thinking
3) A project having the conventional pattern of cash flows exhibits all of the following EXCEPT
A) a terminal cash flow.
B) initial investment.
C) operating cash outflows.
D) operating cash inflows.
Answer: C
Explanation: C) The correct answer is C, because:
A project following a conventional pattern of cash flows consists of an initial investment, operating cash
inflows, and a terminal cash flow.
Diff: 1
Section: 2
AACSB: Analytical Thinking
4) An outlay for installation costs is not considered part of the depreciable capital cost of the asset to be
purchased.
Answer: FALSE
Explanation: The correct answer is False, because:
Installation and shipping costs are considered part of the initial cost of acquiring the asset and are
depreciated as if they were included in the initial cost of the item.
Diff: 1
Section: 2
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5) The relevant cash flows for capital budgeting analysis are
A) incremental cash flows.
B) ordinary cash flows.
C) necessary cash flows.
D) consistent cash flows.
Answer: A
Explanation: A) The correct answer is A, because:
Incremental cash flows are those that change as a result of accepting a project.
Diff: 1
Section: 2
AACSB: Analytical Thinking
6) The relevant cash flows for a proposed project are the incremental after-tax cash outflows and the
resulting cash inflows.
Answer: TRUE
Explanation: The correct answer is True, because:
The analysis of a project is substantially simplified by considering only incremental cash flows. An
analysis of the incremental cash flows replaces an analysis of two scenarios: 1) the value of the firm
without the project; and 2) the value of the firm with the project. Incremental cash flows are those that
change as a result of accepting a project.
Diff: 1
Section: 2
AACSB: Analytical Thinking
7) When calculating the cash flows for a project, you should include interest payments.
Answer: FALSE
Explanation: The correct answer is False, because:
The financing decision is separate from the capital budgeting decision. NPV and IRR include the cost of
funds by using a discount rate that reflects the required return. If we were to include interest expense in
the cash flow estimate, we would be, in essence, double charging the project for financing.
Diff: 1
Section: 2
AACSB: Analytical Thinking
8) Operating cash flow (OCF) is calculated by adding back depreciation to the net operating profit after
taxes.
Answer: TRUE
Explanation: The correct answer is True, because:
When calculating operating cash flows, you subtract depreciation from EBITDA (Gross profit) and add it
back to net operating profit after tax. The reason you first subtract depreciation and then add it back is to
adjust taxable income so that the correct tax amount will be computed.
Diff: 1
Section: 2
AACSB: Analytical Thinking
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9) The sale of an ordinary asset for its undepreciated (book) value results in
A) no tax benefit (or loss).
B) recaptured depreciation.
C) terminal loss.
D) a capital gain.
E) an ordinary tax benefit.
Answer: A
Explanation: A) The correct answer is "no tax benefit", because:
The sale of an ordinary asset for its book value results in no subsequent impact on depreciation expenses
and tax shields.
Diff: 1
Section: 2
AACSB: Analytical Thinking
10) A corporation has decided to replace an existing machine with a newer model. The old machine had
an initial purchase price of $35,000, and has $20,000 in accumulated depreciation at a rate of 20%. It can be
sold for $10,000. If the corporation has a 26% tax rate and a cost of capital of 9%, then what is the present
value of the future tax shields gained (lost) as a result of the sale (as of the date of the sale).
A) -$900
B) $0
C) +$900
D) +$5,000
Answer: C
Explanation: C) The correct answer is C (benefit of $900), because:
PV Tax Shieldsn =
UCC = $35,000 - $20,000 = $15,000
PV Tax Shields =
PV Tax Shields = $897
Diff: 1
Section: 2
AACSB: Analytical Thinking
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11) Using the following data, what is the change in net working capital?
Account
Cash
Accounts Payable
Accrued Liabilities
Depreciation
Inventories
Change in Balance
+ $12,000
+ $21,000
+ $ 6,000
+ $10,000
+ $24,000
A) -$4,000
B) -$1,000
C) +$9,000
D) +$19.000
Answer: C
Explanation: C) The correct answer is C, because:
Change in NWC = Change in current assets - Change in current liabilities.
Change = (12,000 + 24,000) - (21,000 + 6,000) = 9,000
Diff: 1
Section: 2
AACSB: Analytical Thinking
12) Fritz Electronics is evaluating the proposed acquisition of a new Turboencabulator. The machine will
cost $290,000. Shipping and installation are an additional $33,000. The machine is in Class 43 with a
depreciation rate of 30%, and can be sold after 2 years of use for $190,000. The machine will require an
increase in net working capital of $9,000. The company's cost of capital is 10% and the marginal tax rate is
40%. What is the initial cash flow for the project?
A) -281,000
B) -290,000
C) -299,000
D) -323,000
E) -332,000
Answer: E
Explanation: E) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial Cash Flow = -290,000 - 33,000 - 9,000
Initial Cash Flow = -332,000.
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
AACSB: Analytical Thinking
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13) Goodweek Tire, Inc., has recently developed a new tire, the SuperTread, and must decide whether to
make the investment. The research and development costs so far total $10 million. Market research
(costing $5 million) shows that there is significant demand for the new tire. The SuperTread will be
produced and sold for the next two years. Goodweek Tire must initially invest $120 million in production
equipment. Goodweek expects sales revenues of $90 million each year. Working capital is equal to 15% of
sales. Investments in working capital are made at the beginning of each year. At the end of the terminal
year, the working capital is liquidated. What is the initial cash flow for the project?
A) -118,500,000
B) -123,500,000
C) -133,500,000
D) -138,500,000
E) -148,500,000
Answer: C
Explanation: C) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial cash flows = -120,000,000 - 0.15 × $90,000,000
Initial cash flows = -133,500,000
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
AACSB: Analytical Thinking
14) Last year, Dr. Magneto took a MRI diagnostic course for $20,000. Now he is evaluating whether to
open a private MRI clinic. To start the clinic, Dr. Magneto needs to immediately invest in $20,000 of
computer equipment and one MRI machine. The MRI machine (GE 3.0T Signa Excite HD) costs $2.4M.
Both assets are in Class 43 with a depreciation rate of 30%. Assume that the MRI machine will be sold for
$500,000 when the business is closed (in two years). The computer equipment will be worthless at that
time. The clinic will charge $600 per scan and Dr. Magneto expects total revenues of $2.1168 million per
year. Operating expenses, including payroll, supplies and rent, are expected to total $535,000 per year.
What is the initial cash flow for the project?
A) -$2,440,000
B) -$2,420,000
C) -$2,400,000
D) -$2,380,000
E) -$2,335,000
Answer: B
Explanation: B) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial cash flows = -2,400,000- 20,000
Initial cash flows = -2,420,000
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
AACSB: Analytical Thinking
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15) Orange Inc., the Cupertino-based computer manufacturer, has developed a new all-in-one device
called the iPip, and it is considering whether it should produce and sell the product. The company has
identified a prime piece of real estate for the plant and must purchase it immediately for $100,000. In
addition, R&D expenditures, related to the manufacturing process, of $175,000 must be made
immediately. During the first year the manufacturing plant will be constructed. The plant will be ready
for operation at the end of Year 1. The construction costs are $500,000 and will be paid upon completion.
At the end of the Year 1, an inventory of raw materials will be purchased costing $50,000. Production and
sales will occur during years 2 and 3. The manufacturing plant (and its equipment) is in Class 43 with a
30% depreciation rate. When the plant is closed it will be sold for $200,000. (Note: Assume the investment
in plant is depreciated during years 2 and 3.) The tax rate is 34%. The cost of capital is 12%. What is the
undiscounted sum of the initial cash flows incurred at Year 0 and Year 1 for the iPip project?
A) -$100,000
B) -$175,000
C) -$275,000
D) -$550,000
E) -$825,000
Answer: E
Explanation: E) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital) - R&D - (Land Cost)
Initial cash flows = - 500,000 - 50,000 - 175,000 - 100,000
Initial cash flows = - 825,000
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
AACSB: Analytical Thinking
16) You are considering opening a restaurant based on Restaurant L'Entrecote in Bordeaux France. You
will offer a fixed menu of steak and frites. Your innovation is that you will use a bordelaise sauce instead
of a tarragon butter sauce. You plan to run the restaurant for two years and then retire. Start-up costs
(kitchen equipment and supplies, renovations, furniture, fixtures, and the point-of-sales system), to be
incurred immediately, are $500,000. Assume that all of the assets are in Class 8 and depreciated at 20% .
The assets can be sold for $150,000 after two years. The restaurant will be open for 300 nights per year
and you expect 100 diners per night who each purchase $50 worth of food and beverages. The small
business tax rate is 20%. When the restaurant opens you will have to invest in an inventory of wine, beer
and liquor costing $50,000. What is initial cash flow for the L'Entrecote project?
A) -$50,000
B) -$175,000
C) -$275,000
D) -$500,000
E) -$550,000
Answer: E
Explanation: E) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial cash flows = - 500,000 - 50,000
Initial cash flows = - 550,000
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
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AACSB: Analytical Thinking
17) John Kay Inc. is considering the installation of a new production line to make automated flying
shuttles for weaving machines. The capital cost of the equipment is $2.2 million. The machines on the
new line are in Class 43 with a depreciation rate of 30%. Kay plans to operate the line for 2 years, at which
time the project will end and the assets will be disposed of for $1,000,000. The new line requires an
increase in net working capital of $20,000, which would be liquidated at the end of the project. The
investment outlays would occur immediately. Sales are expected to be constant at $2,000,000, and
operating expenses at $800,000. Assume that all revenues and operating expenses are received (paid) at
the end of each of the two years of operations. What is initial cash flow for the flying shuttle project?
A) $2,220,000
B) $2,200,000
C) $0
D) -$2,200,000
E) -$2,220,000
Answer: E
Explanation: E) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial cash flows = - 2,200,000 - 20,000
Initial cash flows = - 2,220,000
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
AACSB: Analytical Thinking
18) Tom Morrison Inc., a leading manufacturer of golf equipment, is currently evaluating a new golf ball
called the 'Feathery'. The secret to the Feathery is that its core is made from goose down, which causes the
ball to fly further. The production machinery is estimated to cost $480,000. Further, Morrison's
inventories would have to be increased by $50,000 to handle the new line. The machinery is in Class 43
with a depreciation rate of 30%. The machinery will be used for 2 years and have an expected salvage
value of $200,000 at the end of that time. Morrison's tax rate is 30%. Assume that the purchase of the
machine and increase in inventory occur at the beginning of the first year of operations. What is initial
cash flow for the Feathery project?
A) -$530,000
B) -$480,000
C) -$430,000
D) -$50,000
E) $0
Answer: A
Explanation: A) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial Cash flow = - 480,000 - 50,000
Initial Cash flow = - 530,000
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
AACSB: Analytical Thinking
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19) The Boeing Corp. is considering building a new aircraft, the 787 — larger than the 747 and larger than
the Airbus A380. The company's Renton WA Facility would have to be expanded. Expansion costs are
forecast to be $2.5B, incurred at t = 0. Also at time t = 0, before production begins, inventory will be
increased by $1.855B. Assume that this inventory is sold at the end of the project at t = 2. The company is
in the 34% marginal tax bracket. Boeing's cost of capital is 12%. What is the initial cash flow for the
project?
A) -$645M
B) -$1,885M
C) -$2,500M
D) -$4,355M
E) -$5,000M
Answer: D
Explanation: D) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial cash flows = -$2,500M + (-$1,855M) = -$4,355M
Diff: 2
Section: 2.1 Initial Cash Flows - Expansion
AACSB: Analytical Thinking
20) Fisher Autobody is considering a proposal from GM to produce body panels for its new model, the
EV1. The stamping line will occupy a 100,000 square foot plant expansion that was completed at the end
of last year for $2 million. The initial purchase price of the new stamps is $6 million. The firm will spend
$500,000 on shipping and installation. If Fisher goes ahead, then its inventory of rolled steel must increase
by $300,000. If Fisher goes ahead with the project, that what is the initial cash flow? Sign your cash flows
negative for outflows and positive for inflows.
A) -$8.8 million
B) -$6.8 million
C) -$6.5 million
D) -$6.3 million
E) -$6.0 million
Answer: B
Explanation: B) Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working
Capital)
Initial Cash Flow = - 6,500,000 - 300,000
Initial Cash Flow = - 6,800,000
The $2 million plant expansion is not included as it is a sunk cost.
Diff: 1
Section: 2.1 Initial Cash Flows - Expansion
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21) Fritz Electronics is evaluating the proposed acquisition of a new Turboencabulator. The machine will
cost $290,000. Shipping and installation are an additional $33,000. The machine is in Class 43 with a
depreciation rate of 30%, and can be sold after 2 years of use for $190,000. The machine will require an
increase in net working capital of $9,000 and will have no effect on revenues, but is expected to save the
firm $150,000 per year in before-tax operating costs, mainly labour. The company's cost of capital is 10%
and the marginal tax rate is 40%. What is the operating cash flow from the project for year 1?
A) 60,930
B) 83,730
C) 101,550
D) 109,380
E) 122,946
Answer: D
Explanation: D) EBIT = Revenues - Costs - Depreciation
EBIT = 150,000 - (323,000 × 0.30/2) = 101,550
OCF = EBIT × (1 - T) + Depreciation
OCF = 101,550 * (1 - 40%) + (323,000 × 0.30/2)
OCF = 109,380
Diff: 3
Section: 2.2 Operating Cash Flows - Expansion
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22) The Boeing Corp. is considering building a new aircraft, the 787 — larger than the 747 and larger than
the Airbus A380. The company's Renton WA Facility would have to be expanded. Expansion costs are
forecast to be $2.5B, incurred at t = 0. Assume that the expanded production facility and all of the
machinery are depreciated at the rate of 25%. The first sales from operation of the new plant will occur at
the end of year 1 (t = 1). Boeing forecasts sales of 220 planes in each of the two years. Each plane, will be
priced at $130M for total revenues of $28.6B. The cost of manufacturing a plane is $115M. Annual
overhead expenses are $775M. When the plant is closed it will be sold for $1B. The company is in the 34%
marginal tax bracket. What are the operating cash flows at the end of Year 1 (t = 1)?
A) $1,460M
B) $1,709M
C) $1,773M
D) $2,213M
E) $2,525M
Answer: C
Explanation: C) EBIT = Revenues - Operating Expenses - Depr.
Depr. = 0.25/2 × 2,500
Depr. = 313
EBIT = 220 × (130 - 115) - 775 - 313 = 2,213
NOPAT = EBIT × (1 - T)
NOPAT = 2,213 × (1 - 0.34) = 1,460
OCF = NOPAT + Depreciation
OCF = 1,460 + 313
OCF = 1,773
Diff: 2
Section: 2.2 Operating Cash Flows - Expansion
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23) Goodweek Tire, Inc., has recently developed a new tire, the SuperTread, and must decide whether to
make the investment. The SuperTread will be produced and sold for the next two years. Goodweek Tire
must initially invest $120 million in production equipment. The equipment is in Class 43 with a 30%
depreciation rate. The SuperTread is expected to sell for $45 per tire. The cost for each SuperTread tire is
$15. Goodweek expects to sell 2 million tires each year. Assume that revenues and expenses occur at the
end of each of the two years of production. Working capital is equal to 15% of sales. Investments in
working capital are made at the beginning of each year. At the end of the terminal year, the working
capital is liquidated. The company's tax rate is 40%. What are the operating cash flows at the end of Year
1?
A) 25.2M
B) 35.4M
C) 42.0M
D) 43.2M
E) 50.4M
Answer: D
Explanation: D) EBIT = Revenues - Operating Expenses - Depr.
Depr. = 0.30/2 × 120 million
Depr. = 18 million
EBIT = ($45 - $15) × 2M - 18M = 42M
NOPAT = EBIT × (1 - T)
NOPAT = 42 × (1 - 0.4) = 25.2
OCF = NOPAT + Depreciation
OCF = 25.2 + 18
OCF = 43.2 million
Diff: 2
Section: 2.2 Operating Cash Flows - Expansion
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24) Dr. Magneto is evaluating whether to open a private MRI clinic. To start the clinic, Dr. Magneto needs
to immediately invest in $20,000 of computer equipment and one MRI machine. The MRI machine (GE
3.0T Signa Excite HD) costs $2.4M. Both assets are in Class 43 with a depreciation rate of 30%. The clinic
will charge $600 per scan and Dr. Magneto expects total revenues of $2.1168 million per year. Operating
expenses, including payroll, supplies and rent, are expected to total $535,000 per year. Assume that all
revenues (and expenses) occur at the end of the year. The tax rate is 40%. What are the operating cash
flows at the end of Year 1?
A) $1.094M
B) $1.125M
C) $1.751M
D) $1.219M
E) $1.239M
Answer: A
Explanation: A) EBIT = Revenues - Operating Expenses - Depr.
Depr. = 0.30/2 × 2.42 million
Depr. = 0.363 million
EBIT = 2.1168 - 0.535 - 0.363 = 1.219 million
NOPAT = EBIT × (1 - T)
NOPAT = 1.219 × (1 - 0.4) = 0.731
OCF = NOPAT + Depreciation
OCF = 0.731 + 0.363
OCF = 1.094 million
Diff: 3
Section: 2.2 Operating Cash Flows - Expansion
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25) Orange Inc., the Cupertino-based computer manufacturer, has developed a new all-in-one device
called the iPip, and it is considering whether it should produce and sell the product. During the first year
the manufacturing plant will be constructed. The construction costs are $500,000 and will be paid upon
completion at the end of Year 1. At the end of the Year 1, an inventory of raw materials will be purchased
costing $50,000. Production and sales will occur during years 2 and 3. (Assume that all revenues and
operating expenses are received (paid) at the end of each year.) Annual revenues are expected to be
$850,000 and costs are $350,000. The manufacturing plant (and equipment) is in Class 43 with a 30%
depreciation rate. (Note: Assume the investment in plant is depreciated during years 2 and 3.) The tax
rate is 30%. The cost of capital is 12%. What are the operating cash flows at the end of Year 2?
A) $297,500
B) $305,500
C) $355,500
D) $368,775
E) $372,500
Answer: C
Explanation: C) EBIT = Revenues - Operating Expenses - Depr.
Depr. = 0.30/2 × 500,000
Depr. = 75,000
EBIT = 850,000 - 350,000 - 75,000 = 425,000
NOPAT = EBIT × (1 - T)
NOPAT = 425,000 × (1 - 0.3) = 297,500
OCF = NOPAT + Depreciation
OCF = 297,500 + 75,000
OCF = 372,500
Diff: 3
Section: 2.2 Operating Cash Flows - Expansion
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26) You are considering opening a restaurant based on Restaurant L'Entrecote in Bordeaux France. You
will offer a fixed menu of steak and frites. Your innovation is that you will use a bordelaise sauce instead
of a tarragon butter sauce. You plan to run the restaurant for two years and then retire. Start-up costs
(kitchen equipment and supplies, renovations, furniture, fixtures, and the point-of-sales system), to be
incurred immediately, are $500,000. Assume that all of the assets are in Class 8 and depreciated at 20% .
The restaurant will be open for 300 nights per year and you expect 100 diners per night who each
purchase $50 worth of food and beverages. Thus total revenues will be $1.5 million. Cost of goods sold
and other operating expenses are expected to total $582,000 per annum. Assume that all revenues and
operating expenses are received (paid) at the end of each year. The small business tax rate is 20%. When
the restaurant opens you will have to invest in an inventory of wine, beer and liquor costing $50,000.
What are the operating cash flows at the end of Year 1?
A) $601,080
B) $694,400
C) $744,400
D) $754,400
E) $868,000
Answer: C
Explanation: C) EBIT = Revenues - Operating Expenses - Depr.
Depr. = 0.20/2 × 500,000
Depr. = 50,000
EBIT = 1,500,000 - 582,000 - 50,000 = 868,000
NOPAT = EBIT × (1 - T)
NOPAT = 868,000 × (1 - 0.2) = 694,400
OCF = NOPAT + Depreciation
OCF = 694,400 + 50,000
OCF = 744,400
Diff: 3
Section: 2.2 Operating Cash Flows - Expansion
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27) John Kay Inc. is considering the installation of a new production line to make automated flying
shuttles for weaving machines. The capital cost of the equipment is $2.2 million. The machines on the
new line are in Class 43 with a depreciation rate of 30%. Kay plans to operate the line for 2 years, at
which time the project will end and the assets will be disposed of for $1,000,000. The new line requires an
increase in net working capital of $20,000, which would be liquidated at the end of the project. The
investment outlays would occur immediately. Sales are expected to be constant at $2,000,000, and
operating expenses at $800,000. Assume that all revenues and operating expenses are received (paid) at
the end of each of the two years of operations. Kay's marginal tax rate is 26%. Kay's cost of capital is 11%.
What are the operating cash flows at the end of Year 1?
A) $870,000
B) $893,800
C) $910,000
D) $923,800
E) $973,800
Answer: E
Explanation: E) EBIT = Revenues - Operating Expenses - Depr.
Depr. = 0.30/2 × 2,200,000
Depr. = 330,000
EBIT = 2,000,000 - 800,000 - 330,000 = 870,000
NOPAT = EBIT × (1 - T)
NOPAT = 870,000 × (1 - 0.26) = 643,800
OCF = NOPAT + Depreciation
OCF = 643,800 + 330,000
OCF = 973,800
Diff: 3
Section: 2.2 Operating Cash Flows - Expansion
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28) Tom Morrison Inc., a leading manufacturer of golf equipment, is currently evaluating a new golf ball
called the 'Feathery'. The secret to the Feathery is that its core is made from goose down, which causes the
ball to fly further. The production machinery is estimated to cost $480,000. Further, Morrison's
inventories would have to be increased by $50,000 to handle the new line. The machinery is in Class 43
with a depreciation rate of 30%. Morrison's tax rate is 30%. Operating earnings (EBITDA) are expected to
be $330,000 per year for each of the two 2 years. Assume that the purchase of the machine and increase in
inventory occur at the beginning of the first year of operations. Assume that operating cash flows occur at
the end of each of the two years of operations. What are the operating cash flows at the end of Year 1?
A) $180,600
B) $211,700
C) $225,400
D) $252,600
E) $258,000
Answer: D
Explanation: D) EBIT = Revenues - Operating Expenses - Depr.
Depr. = 0.30/2 × 480,000
Depr. = 72,000
EBIT = 330,000 - 72,000 = 258,000
NOPAT = EBIT × (1 - T)
NOPAT = 258,000 × (1 - 0.3) = 180,600
OCF = NOPAT + Depreciation
OCF = 180,600 + 72,000
OCF = 252,600
Diff: 3
Section: 2.2 Operating Cash Flows - Expansion
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29) Fritz Electronics is evaluating the proposed acquisition of a new Turboencabulator. The machine will
cost $290,000. Shipping and installation are an additional $33,000. The machine is in Class 43 with a
depreciation rate of 30%, and will have a UCC of $192,185 after 2 years of use. The salvage value is
expected to be $170,000 after two years. The machine will require an increase in net working capital of
$9,000. The company's cost of capital is 10% and the marginal tax rate is 40%. What are the terminal year
cash flows (not including operating cash flows)?
A) 167,656
B) 170,000
C) 176,656
D) 179,000
E) 185,656
Answer: E
Explanation: E) PV Tax Shieldsn =
PV Tax Shieldsn =
PV Tax Shields = $6,656
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $170,000 + $6,656
Net Salvage = $176,656
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$176,656
$9,000
$185,656
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
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30) The Boeing Corp. is considering building a new aircraft, the 787 — larger than the 747 and larger than
the Airbus A380. The company's Renton WA Facility would have to be expanded. Expansion costs are
forecast to be $2.5B, incurred at t = 0. Assume that the expanded production facility and all of the
machinery are depreciated at the rate of 25%. Also at time t = 0, before production begins, inventory will
be increased by $0.8B. Assume that this inventory is sold at the end of the project at t = 2. The first sales
from operation of the new plant will occur at the end of year 1 (t = 1). Boeing forecasts sales revenues of
$29 billion and annual operating expenses of $37 billion in both years of the project. When the plant is
closed it will be sold for $1B, but its undepreciated value will be $1.641B. The company is in the 34%
marginal tax bracket. Boeing's cost of capital is 12%. What are the terminal year cash flows? (Not
including operating cash flows.)
A) $1,147M
B) $1,547M
C) $1,647M
D) $1,847M
E) $1,947M
Answer: E
Explanation: E) PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $147 million
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $1,000 + $147
Net Salvage = $1,147 million
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$1.147 billion
$0.8 billion
$1.947 billion
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
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31) Goodweek Tire, Inc., has recently developed a new tire, the SuperTread, and must decide whether to
make the investment. The SuperTread will be produced and sold for the next two years. Goodweek Tire
must initially invest $120 million in production equipment. This equipment can be sold for $60 million at
the end of two years. The equipment is in Class 43 with a 30% depreciation rate. Goodweek expects to sell
2 million tires each year. Working capital is equal to 15% of sales. Investments in working capital are
made at the beginning of each year. At the end of the terminal year, the working capital is liquidated. The
company's tax rate is 40% and its cost of capital is 10%. What are the terminal year cash flows? (Not
including operating cash flows.)
A) 30,540,000
B) 44,377,500
C) 95,806,071
D) 105,928,048
E) 127,195,000
Answer: E
Explanation: E)
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $3.42 million
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $60M + $3.42M
Net Salvage = $63.42 million
ΔNWC = 0.15 × $90M = $13.5M
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$63.42 million
$13.5 million
$76.92 million
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
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32) Dr. Magneto is evaluating whether to open a private MRI clinic. To start the clinic, Dr. Magneto needs
to immediately invest in $20,000 of computer equipment and one MRI machine. The MRI machine (GE
3.0T Signa Excite HD) costs $2.4M. Both assets are in Class 43 with a depreciation rate of 30%. Assume
that the MRI machine will be sold for $500,000 when the business is closed (in two years). The computer
equipment will be worthless at that time. Dr. Magneto expects total revenues of $2.1168 million per year.
The tax rate is 40% and Dr. Magneto's cost of capital is 10%. What are the terminal year cash flows? (Not
including the operating cash flows.)
A) $0.500M
B) $0.782M
C) $0.982M
D) $1.196M
E) $1.440M
Answer: B
Explanation: B) Terminal Cash Flows = (Decrease in net working capital) + (Net salvage)
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $282,000
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $500,000 + $282,000
Net Salvage = $782,000
ΔNWC = 0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$782,000
0
$782,000
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
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33) Orange Inc., the Cupertino-based computer manufacturer, has developed a new all-in-one device
called the iPip, and it is considering whether it should produce and sell the product. The company has
identified a prime piece of real estate for the plant and must purchase it immediately for $100,000. During
the first year the manufacturing plant will be constructed. The construction costs are $500,000 and will be
paid upon completion at the end of Year 1. At the end of the Year 1, an inventory of raw materials will be
purchased costing $50,000. Production and sales will occur during years 2 and 3. The manufacturing
plant (and equipment) is in Class 43 with a 30% depreciation rate. When the plant is closed it will be sold
for $200,000 and the land will be sold for $100,000. The tax rate is 30%. The cost of capital is 12%. What
are the terminal year (Year 3) cash flows? (Don't include the operating cash flows.)
A) $220,893
B) $270,893
C) $290,893
D) $320,893
E) $370,893
Answer: E
Explanation: E) Terminal Cash Flows = (Decrease in net working capital) + (Net salvage)
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $20,893
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $200,000 + $20,893
Net Salvage = $220,893
ΔNWC = 0
+
+
+
=
Net Salvage
Decrease in Net Working Capital
Sale price of land
Terminal cash flow
$220,893
$50,000
$100,000
$370,893
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
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34) You are considering opening a restaurant based on Restaurant L'Entrecote in Bordeaux France. You
will offer a fixed menu of steak and frites. Your innovation is that you will use a bordelaise sauce instead
of a tarragon butter sauce. You plan to run the restaurant for two years and then retire. Start-up costs
(kitchen equipment and supplies, renovations, furniture, fixtures, and the point-of-sales system), to be
incurred immediately, are $500,000. Assume that all of the assets are in Class 8 and depreciated at 20%.
The assets can be sold for $150,000 after two years. The restaurant will be open for 300 nights per year
and you expect 100 diners per night who each purchase $50 worth of food and beverages. The small
business tax rate is 20% and the company's cost of capital is 10%. When the restaurant opens you will
have to invest in an inventory of wine, beer and liquor costing $50,000. What is the terminal year cash
flow for the L'Entrecote project? (Do not include operating cash flows.)
A) $50,000
B) $150,000
C) $178,000
D) $228,000
E) $980,400
Answer: D
Explanation: D)
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $28,000
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $150,000 + $28,000
Net Salvage = $178,000
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$178,000
$50,000
$228,000
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
AACSB: Analytical Thinking
341
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35) John Kay Inc. is considering the installation of a new production line to make automated flying
shuttles for weaving machines. The capital cost of the equipment is $2.2 million. The machines on the
new line are in Class 43 with a depreciation rate of 30%. Kay plans to operate the line for 2 years, at
which time the project will end and the assets will be disposed of for $1,000,000. The new line requires an
increase in net working capital of $20,000, which would be liquidated at the end of the project. The
investment outlays would occur immediately. Sales are expected to be constant at $2,000,000, and
operating expenses at $800,000. Assume that all revenues and operating expenses are received (paid) at
the end of each of the two years of operations. Kay's marginal tax rate is 26 percent. Kay's cost of capital is
11%. What are the terminal year cash flows? (Do not include the terminal year operating cash flows.)
A) $1,000,000
B) $1,033,860
C) $1,058,785
D) $1,078,785
E) $1,112,645
Answer: D
Explanation: D)
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $58,785
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $1,000,000 + $58,785
Net Salvage = $1,058,785
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$1,058,785
$20,000
$1,078,785
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
AACSB: Analytical Thinking
342
Copyright © 2015 Pearson Canada, Inc.
36) Tom Morrison Inc., a leading manufacturer of golf equipment, is currently evaluating a new golf ball
called the 'Feathery'. The secret to the Feathery is that its core is made from goose down, which causes the
ball to fly further. The production machinery is estimated to cost $480,000. Further, Morrison's
inventories would have to be increased by $50,000 to handle the new line. The machinery is in Class 43
with a depreciation rate of 30%. The machinery will be used for 2 years and have an expected salvage
value of $300,000 at the end of that time. Morrison's tax rate is 30% and its weighted average cost of
capital is 10%. Assume that the purchase of the machine and increase in inventory occur at the beginning
of the first year of operations. What are the terminal year cash flows? (Do not include operating cash
flows.)
A) $267,720
B) $296,760
C) $310,720
D) $346,760
E) $350,000
Answer: D
Explanation: D)
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = -$3,240
Net Salvage = Salvage + PV of Tax Shields
Net Salvage = $300,000 + (-$3,240)
Net Salvage = $296,760
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$296,760
$50,000
$346,760
Diff: 3
Section: 2.3 Terminal Cash Flows - Expansion
AACSB: Analytical Thinking
343
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37) Dr. Magneto is evaluating whether to open a private MRI clinic. To start the clinic, Dr. Magneto needs
to immediately invest in $20,000 of computer equipment and one MRI machine. The MRI machine (GE
3.0T Signa Excite HD) costs $2.4M. Both assets are in Class 43 with a depreciation rate of 30%. Assume
that the MRI machine will be sold for $1.4M when the business is closed (in two years). The computer
equipment will be worthless at that time. The clinic will charge $600 per scan and Dr. Magneto operating
cash flows of $1.12M in the first year and $1.222M in the second. Assume that all revenues (and expenses)
occur at the end of the year. The tax rate is 40% and Dr. Magneto's cost of capital is 10%. What is the NPV
of the clinic?
A) $0.589M
B) $0.762M
C) $0.798M
D) $1.196M
E) $1.440M
Answer: C
Explanation: C) 1. Initial Cash Flows
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial cash flows = -2,400,000 - 20,000
Initial cash flows = -2,420,000
2. Operating Cash Flows
OCF1 = $1.12M
OCF2 = $1.222M
3. Terminal Year Cash Flows
UCC2 = $1.44M
S = $1.44M
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$1.44M
0
$1.44M
4. Calculate the NPV
NPV = -2.42M + 1.12M/(1.10) + 2.662/(1.10)^2
NPV = $0.798M
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
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AACSB: Analytical Thinking
38) Fritz Electronics is evaluating the proposed acquisition of a new Turboencabulator. The machine will
cost $233,000. The machine is in Class 43 with a depreciation rate of 30%, and will be worth $138,635 after
2 years of use. The machine will require an increase in net working capital of $9,000 and will have no
effect on revenues, but is expected to save the firm $150,000 per year in before-tax operating costs, mainly
labour. The company's cost of capital is 10% and the marginal tax rate is 40%. What is the NPV for the
proposed acquisition? The operating cash flows in each of the two years are $103,980 and $113,766,
respectively.
A) $65,388
B) $68,388
C) $69,123
D) $70,123
E) $71,123
Answer: B
Explanation: B) 1. Initial Cash Flows
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial Cash Flow = -223,000 - 9,000
Initial Cash Flow = -232,000
2. Operating Cash Flows
OCF1 = 103,980
OCF2 = 113,766
3. Terminal Year Cash Flows
UCC2 = 138,635
S = 138,635
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$138,635
$90,000
$147,635
4. Calculate the NPV
NPV = -232,000 + 103,980/(1.10) + 261,401/(1.10)^2
NPV = $78,561
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
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39) The Boeing Corp. is considering building a new aircraft, the 787—larger than the 747 and larger than
the Airbus A380. The company's Renton WA Facility would have to be expanded. Expansion costs are
forecast to be $2B, incurred at t = 0. Assume that the expanded production facility and all of the
machinery are depreciated at the rate of 25%. Also at time t = 0, before production begins, inventory will
be increased by $0.5B. Assume that this inventory is sold at the end of the project at t = 2. The first sales
from operation of the new plant will occur at the end of year 1 (t = 1). Boeing forecasts operating cash
flows of $2.395B and $2.459B in Years 1 and 2. When the plant is closed it will be sold for $1.313B. The
company is in the 34% marginal tax bracket. Boeing's cost of capital is 12%. What is the NPV for the new
aircraft?
A) $2,745M
B) $2,845M
C) $2,944M
D) $3,044M
E) $3,145M
Answer: D
Explanation: D) 1. Initial Cash Flows
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial Cash Flow = -2,000 - 500
Initial Cash Flow = -2,500 million
2. Operating Cash Flows
OCF1 = $2,395M
OCF2 = $2,459M
3. Terminal Year Cash Flows
UCC2 = $1,313M
S = $1,313M
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$1,313M
$500M
$1,813M
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4. Calculate the NPV
NPV = -2,500 + 2,395/(1.12) + 4,272/(1.12)^2
NPV = $3,044M
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
AACSB: Analytical Thinking
40) The Boeing Corp. is considering building a new aircraft, the 787 — larger than the 747 and larger than
the Airbus A380. The company's Renton WA Facility would have to be expanded. Expansion costs are
forecast to be $5B, incurred at t = 0. Assume that the expanded production facility and all of the
machinery are depreciated at the rate of 25%. Also at time t = 0, before production begins, inventory will
be increased by $0.5B. Assume that this inventory is sold at the end of the project at t = 2. The first sales
from operation of the new plant will occur at the end of year 1 (t = 1). Boeing forecasts operating cash
flows of $2.523B and $2.682B in Years 1 and 2. When the plant is closed it will be sold for $3.281B. The
company is in the 34% marginal tax bracket. Boeing's cost of capital is 12%. What is the IRR for the new
aircraft?
A) 26%
B) 28%
C) 30%
D) 32%
E) 34%
Answer: E
Explanation: E) 1. Initial Cash Flows
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial Cash Flow = -5,000 - 500
Initial Cash Flow = -5,500 million
2. Operating Cash Flows
OCF1 = $2,523M
OCF2 = $2,682M
3. Terminal Year Cash Flows
UCC2 = $3,281M
S = $3,281M
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$3,281M
$500M
$3,781M
4. Set the NPV = 0, solve for the IRR
0 = -5,500 + 2,523/(1 + k) + 6,463/(1 + k)^2
k = 33.73%.
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
AACSB: Analytical Thinking
347
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41) Orange Inc., the Cupertino-based computer manufacturer, has developed a new all-in-one device
called the iPip, and it is considering whether it should produce and sell the product. The company has
identified a prime piece of real estate for the plant and must purchase it immediately for $100,000. During
the first year the manufacturing plant will be constructed. The construction costs are $500,000 and will be
paid upon completion at the end of Year 1. At the end of the Year 1, an inventory of raw materials will be
purchased costing $50,000. Production and sales will occur during years 2 and 3. (Assume that all
revenues and operating expenses are received (paid) at the end of each year.) Operating cash flows are
expected to be $337,500 in Year 2 and $353,250 in Year 3. The manufacturing plant (and equipment) is in
Class 43 with a 30% depreciation rate. When the plant is closed it will be sold for $297,500 and the land
will be sold for $100,000. The tax rate is 30%. The cost of capital is 10%. What is the NPV of the project?
A) $95,833
B) $134,419
C) $151,136
D) $162,140
E) $223,750
Answer: C
Explanation: C) 1. Initial Cash Flows Year 0
Initial Cash Flow = - (Initial purchase price of Land)
Initial cash flows0 = -100,000
2. Initial Cash Flows Year 1
Initial Cash Flow = - (Initial purchase price of new asset) - Increase in Net Working Capital)
Initial cash flows1 = -500,000 - 50,000
Initial cash flows = -550,000
3. Operating Cash Flows
OCF2 = $337,500
OCF3 = $353,250
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4. Terminal Year Cash Flows
UCC3 = $297,500
S = $297,500
Therefore
PV of Tax Shields = $0
+
+
+
=
Net Salvage
Decrease in Net Working Capital
Sale of Land
Terminal cash flow
$297,500
$50,000
$100,000
$447,500
5. Calculate the NPV
NPV = -100,000 - 550,000/(1.10) + 337,500/(1.10)^2 + 800,750/(1.10)^3
NPV = $280,541
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
AACSB: Analytical Thinking
349
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42) You are considering opening a restaurant based on Restaurant L'Entrecote in Bordeaux France. You
will offer a fixed menu of steak and frites. Your innovation is that you will use a bordelaise sauce instead
of a tarragon butter sauce. You plan to run the restaurant for two years and then retire. Start-up costs
(kitchen equipment and supplies, renovations, furniture, fixtures, and the point-of-sales system), to be
incurred immediately, are $500,000. Assume that all of the assets are in Class 8 and depreciated at 20%.
The assets can be sold for $360,000 after two years. The restaurant will be open for 300 nights per year
and you expect 100 diners per night who each purchase $50 worth of food and beverages. You forecast
operating cash flows of $192,880 in Year 1 and 200,880 in Year 2. Assume that all revenues and operating
expenses are received (paid) at the end of each year. The small business tax rate is 20%. When the
restaurant opens you will have to invest in an inventory of wine, beer and liquor costing $50,000. What is
the NPV for the proposed acquisition if the cost of capital is 10%?
A) $692,435
B) $751,136
C) $949,372
D) $950,474
E) $959,151
Answer: C
Explanation: C) 1. Initial Cash Flows Year 0
Initial Cash Flow = - (Initial purchase price of assets) - (Increase in net working capital)
Initial cash flows0 = -500,000 - 50,000 = -550,000
2. Operating Cash Flows
OCF1 = $192,880
OCF2 = $200,880
3. Terminal Year Cash Flows
UCC2 = $360,000
S = $360,000
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$360,000
$50,000
$410,000
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4. Calculate the NPV
NPV = -550,000 + 192,880/(1.10) + 610,880/(1.10)^2
NPV = $130,205
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
AACSB: Analytical Thinking
351
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43) John Kay Inc. is considering the installation of a new production line to make automated flying
shuttles for weaving machines. The capital cost of the equipment is $2.2 million. The machines on the
new line are in Class 43 with a depreciation rate of 30%. Kay plans to operate the line for 2 years, at
which time the project will end and the assets will be disposed of for $1,309,000. The new line requires an
increase in net working capital of $20,000, which would be liquidated at the end of the project. The
investment outlays would occur immediately. Operating cash flows are expected to be $825,800 in Year 1
and $885,860 in Year 2. Assume that all revenues and operating expenses are received (paid) at the end of
each of the two years of operations. Kay's marginal tax rate is 26 percent. Kay's cost of capital is 11%.
What is the NPV for the proposed acquisition?
A) $287,942
B) $291,709
C) $321,594
D) $341,505
E) $430,816
Answer: C
Explanation: C) 1. Initial Cash Flow
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial cash flows = - 2,200,000 - 20,000
Initial cash flows = - 2,220,000
2. Operating Cash Flows
OCF1 = $825,800
OCF2 = $885,860
3. Terminal Year Cash Flows
UCC2 = $1,309,000
S = $1,309,000
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$1,309,000
$20,000
$1,329,000
4. Calculate the NPV
NPV = -2,220,000 + 825,800/(1.11) + 2,214,860/(1.11)^2
NPV = $321,594
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
352
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AACSB: Analytical Thinking
44) Tom Morrison Inc., a leading manufacturer of golf equipment, is currently evaluating a new golf ball
called the 'Feathery'. The secret to the Feathery is that its core is made from goose down, which causes the
ball to fly further. The production machinery is estimated to cost $480,000. Further, Morrison's
inventories would have to be increased by $50,000 to handle the new line. The machinery is in Class 43
with a depreciation rate of 30%. The machinery will be used for 2 years and have an expected salvage
value of $285,600 at the end of that time. Morrison's tax rate is 30% and its weighted average cost of
capital is 10%. Operating cash flows are expected to be $231,600 In Year 1 and $246,720 in Year 2. Assume
that the purchase of the machine and increase in inventory occur at the beginning of the first year of
operations. Assume that operating cash flows occur at the end of each of the two years of operations.
What is the NPV of the project?
A) $119,894
B) $125,373
C) $148,643
D) $157,320
E) $161,802
Answer: E
Explanation: E) 1. Initial Cash Flows
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial cash flows = -480,000 - 50,000
Initial cash flows = -530,000
2. Operating Cash Flows
OCF1 = $231,600
OCF2 = $246,720
3. Terminal Year Cash Flows
UCC2 = $285,600
S = $285,600
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$285,600
$50,000
$335,600
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4. Calculate the NPV
NPV = -530,000 + 231,600/(1.10) + 582,320/(1.10)^2
NPV = $161,802
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
AACSB: Analytical Thinking
354
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45) Goodweek Tire, Inc., has recently developed a new tire, the SuperTread, and must decide whether to
make the investment. The SuperTread will be produced and sold for the next two years. Goodweek Tire
must initially invest $120 million in production equipment. This equipment can be sold for $71.4 million
at the end of two years. The equipment is in Class 43 with a 30% depreciation rate. Goodweek expects to
sell 1.75 million tires each year and so operating cash flows are forecast to be $38.7M in Year 1 and
$43.74M in Year 2. An investment in net working capital of $11 million is required to star the project. The
company's tax rate is 40% and its cost of capital is 10%. What is the NPV of the project?
A) $8.4M
B) $10.3M
C) $12.0M
D) $12.2M
E) $12.4M
Answer: A
Explanation: A) 1. Initial Cash Flows
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial cash flows = -120 - 11
Initial cash flows = -131M
2. Operating Cash Flows
OCF1 = $38.7M
OCF2 = $43.74M
3. Terminal Year Cash Flows
UCC2 = $71.4M
S = $71.4M
Therefore
PV of Tax Shields = $0
+
+
=
Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$71.4M
$11M
$82.4M
4. Calculate the NPV
NPV = -131M + 38.7M/(1.10) + 126.14/(1.10)^2
NPV = $8.430M
Diff: 4
Section: 2.4 Comprehensive Example of an Expansion Project
AACSB: Analytical Thinking
355
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LO3: Calculate Cash Flows for a Replacement Project
1) The Mountain Jam Company purchased a machine 5 years ago for $70,000. It has an estimated life of 7
th
years from the time of purchase and is expected to have zero salvage value at the end of the 7 year. Last
year, the jam machine was overhauled at a cost of $5,000. The old machine can be sold today for $20,000.
A new machine can be purchased for $69,300. It has a 2-year life and is expected to reduce operating
expenses by $50,000 per year. After 2 years, the new machine can be sold for $20,000. Both machines are
in Class 43 with a depreciation rate of 30%. The tax rate is 40%. What is the initial cash flow for the
project?
A) -69,300
B) -49,300
C) -25,300
D) -33,300
E) 60,000
Answer: B
Explanation: B) Initial Cash Flow = - (Price of new asset) + (Net Salvage value of old asset) - (Increase in
Net Working Capital)
Initial Cash Flow = -69,300 + 20,000
Initial Cash Flow = -49,300
The machine overhaul is a sunk cost and so irrelevant.
Diff: 1
Section: 3.1 Initial Cash Flows - Replacement
AACSB: Analytical Thinking
356
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2) Juicy Good Burgers (JGB) Inc., which supplies prepared hamburgers for commercial airlines, needs to
purchase new broilers. The new broilers would replace broilers purchased 10 years ago, which can be
sold today for $63,000. The new broilers will cost $202,000. The firm expects to increase its revenues by
$27,000 per year if the new broilers are purchased, but cash expenses will also increase by $3,000 per year.
Annual interest expense will be $2,000, and net working capital will increase by $5,000. The new broilers
will occupy space currently leased to another firm for $530 per month, and $5,000 has already been spent
preparing the building for new broilers. The firm's tax rate is 40%. What is the firm's initial cash flow?
Round your answers to the nearest dollar.
A) -160,200
B) -155,200
C) -148,200
D) -145,200
E) -144,000
Answer: E
Explanation: E) Initial Cash Flow = - (Price of new asset) + (Salvage value of old asset) - (Increase in Net
Working Capital)
Initial Cash Flow = -202,000 + 63,000 - 5,000
Initial Cash Flow = -144,000.
The $5,000 is irrelevant. It is a sunk cost.
The $530 of lease (rental) income will be lost if the boilers are replaced. This is an opportunity cost, but it
does not affect the initial cash flows of the replacement project. The lost rental income would reduce the
incremental annual operating cash flows.
Diff: 3
Section: 3.1 Initial Cash Flows - Replacement
AACSB: Analytical Thinking
357
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3) Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are hand rolled, boiled
and then baked in a wood-burning oven. Uncle Benjy thinks that the wood oven should be replaced by a
modern gas oven, which would reduce costs by $0.02 per bagel. Duddy is considering Uncle Benjy's idea.
Last week, Duddy hired a plumber (for $500) to explore the feasibility of running a gas pipe into the
store. The current oven was purchased thirty years ago for $20,000. It could be sold today for $5,000 and
will be worth $3,000 in two years. A new oven costs $105,000 today and could be sold for $55,000 in two
years. Assume that investment cash flows occur immediately, and that sales and production costs occur
at the end of the year. The tax rate is 35%. What is the incremental initial cash flow for the project if he
replaces the oven?
A) -$110,000
B) -$105,000
C) -$100,500
D) -$100,000
E) -$99,500
Answer: D
Explanation: D) Initial Cash Flow = - (Price of new asset) + (Salvage value of old asset) - (Increase in Net
Working Capital)
Initial Cash Flow = -105,000 + 5,000 - $0
Initial Cash Flow = -100,000
The cost of the plumber is a sunk cost and so irrelevant.
Diff: 2
Section: 3.1 Initial Cash Flows - Replacement
AACSB: Analytical Thinking
4) The Mountain Jam Company purchased a machine 5 years ago for $70,000. It had an estimated life of 7
years from the time of purchase and is expected to have zero salvage value at the end of the 7th year. The
old machine can be sold today for $20,000. A new machine can be purchased for $69,300. It has a 2-year
life and is expected to reduce operating expenses by $50,000 per year. Both machines are in Class 43 with
a depreciation rate of 30%. The tax rate is 40%. What is the incremental operating cash flow from the
replacement project in Year 1?
A) 25,563
B) 31,544
C) 32,958
D) 34,316
E) 39,860
Answer: C
Explanation: C) Incremental Capital Cost = ΔC0 = 69,300 - 20,000 = 49,300
Incremental Depreciation1 = 49,300 × 0.3/2 = $7,395
NOPAT =(EBITDA - Depr) × (1 - T)
NOPAT = (50,000 - 7,395) × (1 - 0.40) = 25,563
OCF = 25,563 + 7,395 = 32,958
Diff: 3
Section: 3.2 Operating Cash Flows - Replacement
AACSB: Analytical Thinking
358
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5) Juicy Good Burgers (JGB) Inc., which supplies prepared hamburgers for commercial airlines, needs to
purchase new broilers. The new broilers would replace broilers purchased 10 years ago, which can be
sold today for $63,000. The new broilers will cost $202,000 and will last two years. Broilers are in class 8
with a 20% depreciation rate. With the new broilers, JGB expects to increase its revenues by $27,000 per
year and lower costs by $3,000 per year. Annual interest expense will be $2,000, and net working capital
will increase by $5,000. The new broilers will occupy space currently leased to another firm for $530 per
month, and $5,000 has already been spent preparing the building for new broilers. The firm's tax rate is
40%. What is the operating cash flow from the replacement project for Year 1?
A) 16,600
B) 19,144
C) 20,344
D) 22,960
E) 23,944
Answer: B
Explanation: B) Incremental Capital Cost = ΔC0 = 202,000 - 63,000 = 139,000
Incremental Depreciation1 = 139,000 × 0.2/2 = $13,900
ΔNOPAT =(ΔEBITDA - Depr - Foregone Rent) × (1 - T)
NOPAT = (27,000 - (-2,000) - 13,900 - (12 × 530)) × (1 - 0.40) = 5,244
OCF = 5,244 + 13,900 = 19,144
Diff: 3
Section: 3.2 Operating Cash Flows - Replacement
AACSB: Analytical Thinking
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6) Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are hand rolled, boiled
and baked in a wood-burning oven. The store sells 5,000 bagels per day and is open 365 days of the year.
Uncle Benjy thinks that the wood oven should be replaced by a modern gas oven, which would reduce
costs by $0.02 per bagel. Duddy is considering Uncle Benjy's idea, but he only plans to be in business for
another two years. The bagels are sold for $0.75 each. The cost of producing each bagel with the woodburning oven is $0.50 which includes labour and raw materials. The current oven was purchased thirty
years ago for $20,000. It could be sold today for $5,000 and will be worth $3,000 in two years. A new oven
costs $105,000 today and could be sold for $55,000 in two years. Ovens are in class 8 with a 20%
depreciation rate. Assume that investment cash flows occur immediately, and that sales and production
costs occur at the end of the year. The tax rate is 35%. What is the incremental operating cash flow from
the replacement project for year 1?
A) $17,225
B) $26,500
C) $27,225
D) $30,725
E) $32,755
Answer: C
Explanation: C) Incremental Capital Cost = ΔC0 = 105,000 - 5,000 = 100,000
Incremental Depreciation1 = 100,000 × 0.2/2 = $10,000
Incremental EBITDA = 0.02 × 5,000 × 365 = 36,500
NOPAT =(EBITDA - Depr) × (1 - T)
NOPAT = (36,500 - 10,000) × (1 - 0.35) = 17,225
OCF = 17,225 + 10,000 = 27,225
Diff: 3
Section: 3.2 Operating Cash Flows - Replacement
AACSB: Analytical Thinking
360
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7) The Mountain Jam Company purchased a machine 5 years ago for $70,000. It had an estimated life of 7
years from the time of purchase and is expected to have zero salvage value at the end of the 7th year. The
old machine can be sold today for $20,000. A new machine can be purchased for $69,300. It has a 2-year
life and is expected to reduce operating expenses by $50,000 per year. Both machines are in Class 43 with
a depreciation rate of 30%. After 2 years, the new machine can be sold for $20,000. The company's cost of
capital is 9% and the tax rate is 40%. What are the incremental terminal year cash flows? (Not including
the operating cash flows.)
A) 20,000
B) 22,872
C) 24,860
D) 27,872
E) 29,334
Answer: B
Explanation: B) Incremental Salvage = ΔS = $20,000 - $0 = $20,000
Incremental UCC2 is obtained from the Depreciation Schedule, below.
UCC_t-1
dr
Depreciation Expense
UCC_t
Year 1
49,300.00
0.15
7,395.00
41,905.00
Year 2
41,905.00
0.3000
12,571.50
29,333.50
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $2,871.85
ΔNet Salvage = ΔS + PV of Tax Shields
ΔNet Salvage =$20,000 + $2,871.85
ΔNet Salvage = $22,871.85
+
+
=
ΔNet Salvage
Decrease in Net Working Capital
Terminal cash flow
$22,871.85
$0
$22,871.85
Diff: 3
Section: 3.3 Terminal Cash Flows - Replacement
AACSB: Analytical Thinking
361
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8) Juicy Good Burgers (JGB) Inc., which supplies prepared hamburgers for commercial airlines, needs to
purchase new broilers. The new broilers would replace broilers purchased 10 years ago, which can be
sold today for $63,000. The new broilers will cost $202,000 and will last two years. In two years the new
broiler will be worth $100,080 and the old broiler will be worth $10,000. Broilers are in class 8 with a 20%
depreciation rate. With the new broilers, JGB expects to increase its revenues and reduce its costs. Annual
interest expense will be $2,000, and net working capital will increase by $5,000. The firm's tax rate is 40%
and its cost of capital is 9%. What are the terminal year cash flows? (Do not include terminal year
operating cash flows.)
A) 87,839
B) 90,080
C) 92,839
D) 95,080
E) 97,839
Answer: E
Explanation: E) Incremental Salvage = ΔS = $100,080 - $10,000 = $90,080
Incremental UCC2 is obtained from the Depreciation Schedule, below.
UCC_t-1
dr
Depreciation Expense
UCC_t
Year 1
139,000.00
0.1
13,900.00
125,100.00
Year 2
125,100.00
0.2000
25,020.00
100,080.00
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $2,758.62
ΔNet Salvage = ΔS + PV of Tax Shields
ΔNet Salvage = $90,080 + $2,758.62
ΔNet Salvage = $92,838.62
+
+
=
∆Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$92,838.62
$5,000
$97,838.62
Diff: 3
Section: 3.3 Terminal Cash Flows - Replacement
AACSB: Analytical Thinking
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9) Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are hand rolled, boiled
and baked in a wood-burning oven. The store sells 5,000 bagels per day and is open 365 days of the year.
Uncle Benjy thinks that the wood oven should be replaced by a modern gas oven, which would reduce
costs by $0.02 per bagel. Duddy is considering Uncle Benjy's idea, but he only plans to be in business for
another two years. The current oven was purchased thirty years ago for $20,000. It could be sold today for
$5,000 and will be worth $3,000 in two years. A new oven costs $105,000 today and could be sold for
$55,000 in two years. Ovens are in class 8 with a 20% depreciation rate. Assume that investment cash
flows occur immediately, and that sales and production costs occur at the end of the year. Duddy's cost of
capital is 9% and the tax rate is 35%. What is the terminal year cash flow from the replacement project
(ignoring operating cash flows)?
A) $52,000
B) $53,828
C) $55,000
D) $56,828
E) $59,828
Answer: D
Explanation: D) Incremental Salvage = ΔS = $55,000 - $3,000 = $52,000
Incremental UCC2 is obtained from the Depreciation Schedule, below.
UCC_t-1
dr
Depreciation Expense
UCC_t
Year 1
100,000.00
0.1
10,000.00
90,000.00
Year 2
90,000.00
0.2000
18,000.00
72,000.00
PV Tax Shieldsn =
PV Tax Shields =
PV Tax Shields = $4,827.59
ΔNet Salvage = ΔS + PV of Tax Shields
ΔNet Salvage =$52,000 + $4,827.59
ΔNet Salvage = $56,827.59
+
+
=
ΔNet Salvage
Decrease in Net Working Capital
Terminal cash flow
$56,827.59
$0
$56,827.59
Diff: 3
Section: 3.3 Terminal Cash Flows - Replacement
AACSB: Analytical Thinking
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10) The Mountain Jam Company (MJC) purchased a machine 5 years ago for $70,000. It had an estimated
life of 7 years from the time of purchase and is expected to have zero salvage value at the end of the 7th
year. The old machine can be sold today for $25,000. A new machine will have a 2-year life and can be
purchased for $70,000. Both machines are in Class 43 with a depreciation rate of 30%. After 2 years, the
new machine can be sold for $26,775. The new machine will reduce operating expenses by $50,000 per
year. MJC forecasts operating cash flows of $32,700 and $34,590 in Years 1 and 2. The company's cost of
capital is 9% and the tax rate is 40%. What is the NPV of the project?
A) $7,536
B) $14,114
C) $35,650
D) $36,650
E) $37,650
Answer: D
Explanation: D) 1. Initial Cash Flows
ΔInitial Cash Flow = - (Price of new asset) + (Net Salvage value of old asset) - (Increase in Net Working
Capital)
ΔInitial Cash Flow = -70,000 +25,000 - 0
ΔInitial Cash Flow = -45,000
2. Operating Cash Flows
ΔOCF1 = $32,700
ΔOCF2 = $34,590
3. Terminal Year Cash Flows
ΔUCC2 = $26,775
ΔS = $26,775 - $0
Therefore
PV of Tax Shields = $0
ΔNet Salvage = ΔS - PV of Tax Shields = ΔS - $0
+
+
=
ΔNet Salvage
Decrease in Net Working Capital
Terminal cash flow
$26,775
$0
$26,775
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4. Calculate the NPV
NPV = -45,000 + $32,700 /(1.09) + 61,365/(1.09)^2
NPV = $36,650
Diff: 4
Section: 3.4 Comprehensive Example of a Replacement Project
AACSB: Analytical Thinking
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11) Juicy Good Burgers (JGB) Inc., which supplies prepared hamburgers for commercial airlines, needs to
purchase new broilers. The new broilers would replace broilers purchased 10 years ago, which can be
sold today for $63,000. The new broilers will cost $202,000 and will last two years. In two years the new
broiler will be worth $100,080 and the old broiler will be worthless. Broilers are in class 8 with a 20%
depreciation rate. With the new broilers, JGB expects operating cash flows of $22,960 in Year 1 and
$27,408 in Year 2. Annual interest expense will be $2,000, and net working capital will increase by $5,000.
The firm's tax rate is 40%. What is the NPV for the proposed acquisition if the cost of capital is 9%?
A) -$16,329
B) -$15,632
C) -$13,534
D) -$11,423
E) -$10,632
Answer: D
Explanation: D) 1. Initial Cash Flows
ΔInitial Cash Flow = - (Price of new asset) + (Net Salvage value of old asset) - (Increase in Net Working
Capital)
ΔInitial Cash Flow = -202,000 + 63,000 - 5,000
ΔInitial Cash Flow = -144,000
2. Operating Cash Flows
ΔOCF1 = $22,960
ΔOCF2 = $27,408
3. Terminal Year Cash Flows
ΔUCC2 = $100,080
ΔS = $100,080 - $0
Therefore
PV of Tax Shields = $0
ΔNet Salvage = ΔS - PV of Tax Shields = ΔS - $0
+
+
=
∆Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$100,080
$5,000
$105,080
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4. Calculate the NPV
NPV = -144,000 + $22,960/(1.09) + 132,488/(1.09)^2
NPV = -$11,423
Diff: 4
Section: 3.4 Comprehensive Example of a Replacement Project
AACSB: Analytical Thinking
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12) Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are hand rolled, boiled
and baked in a wood-burning oven. Uncle Benjy thinks that the wood oven should be replaced by a
modern gas oven, which would reduce costs by $36,500 per year. Duddy is considering Uncle Benjy's
idea, but he only plans to be in business for another two years. The current oven was purchased thirty
years ago for $20,000. It could be sold today for $5,000 and will be worth $3,000 in two years. A new oven
costs $105,000 today and could be sold for $75,000 in two years. Ovens are in class 8 with a 20%
depreciation rate. Assume that investment cash flows occur immediately, and that sales and production
costs occur at the end of the year. Duddy forecasts that incremental operating cash flows will be $27,225
in Year 1 and $30,025 in Year 2. Duddy's cost of capital is 9% and the tax rate is 35%. What is the NPV for
the proposed acquisition if the cost of capital is 9%?
A) -$14,422
B) -$1,921
C) $849
D) $6,356
E) $10,849
Answer: E
Explanation: E) 1. Initial Cash Flows
ΔInitial Cash Flow = - (Price of new asset) + (Net Salvage value of old asset) - (Increase in Net Working
Capital)
ΔInitial Cash Flow = -105,000 + 5,000 - 0
ΔInitial Cash Flow = -100,000
2. Operating Cash Flows
ΔOCF1 = $27,225
ΔOCF2 = $30,025
3. Terminal Year Cash Flows
UCC_t-1
dr
Depreciation Expense
UCC_t
Year 1
100,000.00
0.1
10,000.00
90,000.00
Year 2
90,000.00
0.2000
18,000.00
72,000.00
ΔUCC2 = $72,000
ΔS = $75,000 - $3,000 = $72,000
Therefore
PV of Tax Shields = $0
ΔNet Salvage = ΔS - PV of Tax Shields = ΔS - $0
+
+
=
∆Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$72,000
$0
$72,000
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4. Calculate the NPV
NPV = -100,000 + $27,225 /(1.09) + 102,025/(1.09)^2
NPV = $10,849
Diff: 4
Section: 3.4 Comprehensive Example of a Replacement Project
AACSB: Analytical Thinking
369
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13) Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are hand rolled, boiled
and baked in a wood-burning oven. Uncle Benjy thinks that the wood oven should be replaced by a
modern gas oven, which would reduce costs by $36,500 per year. Duddy is considering Uncle Benjy's
idea, but he only plans to be in business for another two years. The current oven was purchased thirty
years ago for $20,000. It could be sold today for $5,000 and will be worth $3,000 in two years. A new oven
costs $105,000 today and could be sold for $75,000 in two years. Ovens are in class 8 with a 20%
depreciation rate. Assume that investment cash flows occur immediately, and that sales and production
costs occur at the end of the year. Duddy forecasts that incremental operating cash flows will be $27,225
in Year 1 and $30,025 in Year 2. Duddy's cost of capital is 9% and the tax rate is 35%. What is the NPV for
the proposed acquisition if the cost of capital is 9%?
A) -$14,422
B) -$1,921
C) $849
D) $6,356
E) $10,849
Answer: E
Explanation: E) 1. Initial Cash Flows
ΔInitial Cash Flow = - (Price of new asset) + (Net Salvage value of old asset) - (Increase in Net Working
Capital)
ΔInitial Cash Flow = -105,000 + 5,000 - 0
ΔInitial Cash Flow = -100,000
2. Operating Cash Flows
ΔOCF1 = $27,225
ΔOCF2 = $30,025
3. Terminal Year Cash Flows
UCC_t-1
dr
Depreciation Expense
UCC_t
Year 1
100,000.00
0.1
10,000.00
90,000.00
Year 2
90,000.00
0.2000
18,000.00
72,000.00
ΔUCC2 = $72,000
ΔS = $75,000 - $3,000 = $72,000
Therefore
PV of Tax Shields = $0
ΔNet Salvage = ΔS - PV of Tax Shields = ΔS - $0
+
+
=
∆Net Salvage
Decrease in Net Working Capital
Terminal cash flow
$72,000
$0
$72,000
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4. Set the NPV = 0, solve for the IRR
0 = -$100,000 + $27,225/ (1 + k) + $102,025/ (1 + k)
k = 15.53%
2
Diff: 4
Section: 3.4 Comprehensive Example of a Replacement Project
AACSB: Analytical Thinking
LO4: Learn Some Refinements to Capital Budgeting
1) When evaluating a new project, the firm should consider all of the following factors EXCEPT
A) previous expenditures associated with a market testing.
B) changes in working capital attributable to the project.
C) the current market value of any equipment to be replaced.
D) the resulting difference in depreciation expense if the project involves replacement.
Answer: A
Explanation: A) The correct answer is A, because:
Previous expenditures associated with a market test is a sunk cost. Sunk costs are costs that have already
been paid and cannot be recovered.
Diff: 1
Section: 4
AACSB: Analytical Thinking
2) Equal annual annuities assume projects are renewable indefinitely.
Answer: TRUE
Explanation: The correct answer is True, because:
The equal annual annuity approach assumes that both short-term and long-term projects can be repeated
forever.
Diff: 1
Section: 4
AACSB: Analytical Thinking
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3) Tom Morrison Inc., a leading manufacturer of golf equipment, is currently evaluating a new golf ball
called the 'Feathery'. The secret to the Feathery is that its core is made from goose down. The advantage
of down is that the ball flies higher and longer. You have completed an analysis of the Feathery project
and estimated the NPV to be $148,643. After completing your analysis, your boss tells you that the
Feathery project will occupy an unused portion of the Morrison plant and that Morrison could have
leased the space to another user for $15,000 per annum. Morrison's tax rate is 30% and its weighted
average cost of capital is 10%. What is the NPV of the project with this fact included?
A) $118,643
B) $127,643
C) $128,229
D) $130,420
E) Doesn't affect NPV of this project
Answer: D
Explanation: D) Subtract the opportunity cost of using the space in the plant (i.e. the foregone $15,000 of
rent after tax).
2
NPV = $148,643 - $15,000 × (1 - 0.3)/(1.1) - $15,000 × (1 - 0.3)/(1.1)
NPV = $148,643 - $18,223.14
NPV = $130,420
Diff: 2
Section: 4.1 Incremental Cash Flows.
AACSB: Analytical Thinking
4) You are evaluating two projects. You may accept only one of them. Project one will cost $379,000
initially and will pay $134,000 each year for the next 5 years. Project two will cost $454,000 initially, but
will pay $101,000 for the next 10 years. The firm's cost of capital is 15%.
Compute the NPV of each project. Which project has the highest NPV and by how much? Round your
answers to the nearest dollar.
A) Project 2 has a higher NPV by $17,293.
B) Project 2 has a higher NPV by $37,636.
C) Project 1 has a higher NPV by $17,293.
D) Project 1 has a higher NPV by $37,636.
E) The two projects have equal NPV.
Answer: C
Explanation: C) NPV of Project 1 = -C0 + $CF × PVIFA5,15%
NPV of Project 1 = - 379,000 + 134,000 × 3.35216
NPV of Project 1 = 70,189.
NPV of Project 2 = -C0 + $CF × PVIFA10,15%
NPV of Project 2 = - 454,000 + 101,000 × 5.01877
NPV of Project 2 = 52,896.
Project 1 has a higher NPV by 17,293.
Diff: 2
Section: 4.2 Projects with Different Lives
AACSB: Analytical Thinking
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5) You are evaluating two projects. You may accept only one of them. Project one will cost $379,000
initially and will pay $134,000 each year for the next 5 years. Project two will cost $454,000 initially, but
will pay $101,000 for the next 10 years. The firm's cost of capital is 15%.
Use the replacement chain approach to compute the NPV of each project. Which project has the highest
NPV and by how much? Round your answers to the nearest dollar.
A) Project 2 has a higher NPV by $240,619.
B) Project 2 has a higher NPV by $52,189.
C) Project 1 has a higher NPV by $240,619.
D) Project 1 has a higher NPV by $52,189.
E) The two projects have equal NPV.
Answer: B
Explanation: B) The NPV of repeating project one TWICE is:
NPV = - C0 + $CF × PVIFA10,15% - C0 /(1.15)
5
5
NPV = - 379,000 × (1 + 1/(1.15) ) - (-134,000) × 5.01877
NPV = - 379,000 × (1.49717667) + 672,515
NPV = 105,085
Or
5
NPV of Project 1 = 70,189 + 70,189/(1.15) = 105,085
NPV of Project 2 = -C0 + $CF × PVIFA10,15%
NPV of Project 2 = - 454,000 + 101,000 × 5.01877
NPV of Project 2 = 52,896
So Project 1 has a higher NPV by 52,189
Diff: 2
Section: 4.2 Projects with Different Lives
AACSB: Analytical Thinking
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6) You are evaluating two projects. You may accept only one of them. Project one will cost $379,000
initially and will pay $134,000 each year for the next 5 years. Project two will cost $454,000 initially, but
will pay $101,000 for the next 10 years. The firm's cost of capital is 15%.
Use the equal annual annuity method (EAA) to select between the two projects. Which project has the
highest EAA and by how much? Round your answers to the nearest dollar.
A) Project 2 has a higher EAA by $10,398.
B) Project 2 has a higher EAA by $1,794.
C) Project 1 has a higher EAA by $10,398.
D) Project 1 has a higher EAA by $1,794.
E) The two projects have equal EAA.
Answer: C
Explanation: C) PART 3:
NPV of Project 1 = -C0 + $CF × PVIFA5,15%
NPV of Project 1 = - 379,000 + 134,000 × 3.35216
NPV Project 1 = 70,188.78
EAA of Project 1 = NPV/ PVIFA5,15%
EAA of Project 1 = 70,188.78/3.352155 = 20,938.41
NPV of Project 2 = -C0 + $CF × PVIFA10,15%
NPV of Project 2 = - 454,000 + 101,000 × 5.01877
NPV of Project 2 = 52,896
EAA of Project 2 = NPV/ PVIFA5,15%
EAA of Project 2 = 52,896/5.01877
EAA of Project 2 = 10,539.56
So Project 1 has a higher EAA, by 10,398
Diff: 2
Section: 4.2 Projects with Different Lives
AACSB: Analytical Thinking
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7) Laurie wants to buy a used sports car. She is looking at three: 1) a 3-year old Porsche 911 Turbo
Cabriolet; 2) a 4-year old Ferrari F430; or 3) a 4-year old Lamborghini Gallardo. The purchase price,
annual operating costs and resale value for each car is given in the table, below. Laurie wants to buy the
cheapest of the three cars. Which should she buy?
A) Porsche
B) Ferrari
C) Lamborghini
D) Either the Ferrari or the Lamborghini (both the same)
E) All three are equally expensive
Answer: A
Explanation: A) EAA = NVP/PVIFA
EAAP = -$169.87/3.99271 = -$42.55
EAAF = -$110.33/2.577097 = -$42.81
EAAL = -$76.39/1.783265= -$42.83
The Porsche has the lowest equivalent annual annuity, so it is the least expensive on an annual, present
value basis.
Diff: 2
Section: 4.2 Projects with Different Lives
AACSB: Analytical Thinking
375
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8) The cash flows for two projects, A and B, are shown in the table, below. Notice that Project A has a life
of 3 years and Project B has a 2 year life. Use the replacement chain approach to calculate the NPV of each
project over a common life-span. What is the NPV of the Project A chain minus the NPV of the Project B
chain?
A) $0.45
B) $0.47
C) $0.49
D) $0.51
E) $0.53
Answer: E
Explanation: E)
Method 1:
2
3
4
PV of Difference = -46 + 104/(1.08) -150/(1.08) + 104/(1.08)
PV of Difference = -46 + 104 × 0.8573 - 150 × 0.7938 + 104 × 0.7350
PV of Difference = 0.532
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Method 2:
NPVA Chain = $20.09 + $20.09/(1.08)
NPVA Chain = $20.09 × (1.7938)
3
NPVA Chain = $36.035
2
4
NPVB Chain = $13.07 + $13.07 /(1.08) + $13.07 /(1.08)
NPVB Chain = $13.07 + $13.07 × 0.8573 + $13.07 × 0.7350
NPVB Chain = $35.504
NPVA Chain - NPVB Chain = $36.035 - $35.504 = $0.532
Diff: 2
Section: 4.2 Projects with Different Lives
AACSB: Analytical Thinking
9) The cash flows for two projects, A and B, are shown in the table, below. Notice that Project A has a life
of 3 years and Project B has a 5 year life. Calculate the NPV of each project and calculate which should be
adopted using the equivalent annual annuity approach. Assume that the cost of capital is 10%.
A) Project A is better
B) Project B is better
C) The two projects are the same
Answer: B
Explanation: B) EANPVA = NPVA/PVAF(10%,5) = $6.7097/3.7908 = $1.77
EANPVB = NPVB/PVAF(10%,3) = $5.3343/2.4869 = $2.15
Project B is the better project.
Diff: 2
Section: 4.2 Projects with Different Lives
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 11 Cost of Capital
LO1: Compute the Cost of Debt, Preferred Shares, and Equity
1) A firm can raise its value without earning at least the WACC.
Answer: FALSE
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Explanation: A firm must earn at least the weighted average cost of capital or the value of the firm will
fall.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
2) The opportunity cost associated with the firm's capital investment in a project is called its
A) cost of capital.
B) beta coefficient.
C) capital gains yield.
D) sunk cost.
E) internal rate of return.
Answer: A
Explanation: A) A firm's cost of capital is its opportunity cost of making a capital investment.
Diff: 1
Section: 1
AACSB: Analytical Thinking
3) The cost of capital
A) will decrease as the risk level of a firm increases.
B) is primarily dependent on the source of the funds used in a project.
C) implies that a project will produce a positive net present value only when the rate of return on the
project is less than the cost of capital.
D) remains constant for all projects sponsored by the same firm.
E) depends on how the funds are going to be utilized.
Answer: E
Explanation: E) The cost of capital for a firm depends on how the funds are going to be utilized.
Diff: 1
Section: 1
AACSB: Analytical Thinking
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4) The overall cost of capital for a retail store
A) is equivalent to the after-tax cost of the firm's liabilities.
B) should be used as the required return when analyzing a potential acquisition of a wholesale
distributor.
C) reflects the return investors require on the total assets of the firm.
D) remains constant even when the debt-equity ratio changes.
E) is unaffected by changes in corporate tax rates.
Answer: C
Explanation: C) The overall cost of capital reflects the return investors require on the total assets of the
firm.
Diff: 1
Section: 1
AACSB: Analytical Thinking
5) The discount rate assigned to an individual project should be based on
A) the firm's weighted average cost of capital.
B) the actual sources of funding used for the project.
C) an average of the firm's overall cost of capital for the past five years.
D) the current risk level of the overall firm.
E) the risk level of the project itself.
Answer: E
Explanation: E) The discount rate assigned to an individual project should be based on the risk level of
the project itself.
Diff: 1
Section: 1
AACSB: Analytical Thinking
6) When evaluating a project, a firm's managers should select projects whose cash flows
A) exceed some target cash flow level set by management.
B) result in a return that exceeds the cost of funds to finance the project.
C) have the lowest NPVs after discounting cash flows by the project's capital cost.
D) are subject to less risk than competing projects.
E) produce higher returns than the firm's average cost of capital.
Answer: E
Explanation: E) Decision criterion for internal rate of return required the project's IRR exceed the cost of
capital.
Diff: 1
Section: 1
AACSB: Analytical Thinking
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7) The weighted average of the firm's costs of equity, preferred shares, and after tax debt is the
A) reward to risk ratio for the firm.
B) expected capital gains yield for the stock.
C) expected capital gains yield for the firm.
D) portfolio beta for the firm.
E) weighted average cost of capital (WACC).
Answer: E
Explanation: E) The WACC is the weighted average of a firm's cost of equity, preferred shares, and after
tax debt.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
8) Assigning separate discount rates to individual projects when determining which projects should be
accepted by the firm
A) may cause the firm's overall weighted average cost of capital to vary over time if the projects accepted
change the overall risk level of the firm.
B) will cause the firm's overall cost of capital to remain constant over time.
C) will cause the firm's overall cost of capital to decrease over time.
D) will change the debt-equity ratio of the firm over time.
E) negates the principle goal of creating the most value for the shareholders.
Answer: A
Explanation: A) A firm's overall weighted average cost of capital can vary over time if the projects
accepted change the overall risk level of the firm.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
9) The cost of capital assigned to an individual project should be that rate which
A) corresponds to the risk level of the firm's division which has responsibility for the project.
B) corresponds to the source of the funds used for the project.
C) corresponds to the latest pre-tax cost of debt and equity for the overall firm.
D) is the firm's current weighted average cost of capital.
E) considers both the nature and the characteristics of the actual project.
Answer: E
Explanation: E) The cost of capital assigned to an individual project should consider both the nature and
the characteristics of the actual project.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
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10) The return that shareholders require on their investment in the firm is called the
A) dividend yield.
B) cost of equity.
C) capital gains yield.
D) cost of capital.
E) income return.
Answer: B
Explanation: B) The cost of equity is the return shareholders require on their investment in a firm.
Diff: 1
Section: 1.6
AACSB: Analytical Thinking
11) The Delta Co. owns retail stores that market home building supplies. Largo, Inc. builds single family
homes in residential developments. Delta has a beta of 1.22 and Largo has a beta of 1.34. The risk-free rate
of return is 4 percent and the market risk premium is 6.5 percent. What should Delta use as their cost of
equity if they decide to purchase some land and create a new residential community?
A) 11.93 percent
B) 12.32 percent
C) 12.43 percent
D) 12.57 percent
E) 12.71 percent
Answer: E
Explanation: E) ke = kF + β(kM - kF)
ke = 0.04 + 1.34(.065)
ke = 12.71%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
12) Pan American Airlines' shares are currently trading at $69.25 each. The yield on Pan Am's debt is 4%
and the firm's beta is 0.7. The T-Bill rate is 4% and the expected return on the market (E (k M)) is 9%. The
company's target capital structure is 25% debt and 75% equity. Pan American Airlines pays a combined
federal and state tax rate of 35%. What is Pan Am's cost of equity?
A) 7.0%
B) 7.5%
C) 8.0%
D) 8.5%
E) 9.0%
Answer: B
Explanation: B) ke = kF + β(kM - kF)
ke = 0.04 + 0.70(0.09 - 0.04)
ke = 7.5%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
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13) The Bet-r-Bilt Company has a six-year bond outstanding with a 5 percent coupon. Interest payments
are paid semi-annually. The face amount of the bond is $1,000. This bond is currently selling for 98
percent of its face value. What is the company's pre-tax cost of debt?
A) 4.72 percent
B) 5.31 percent
C) 5.35 percent
D) 5.39 percent
E) 5.42 percent
Answer: D
Explanation: D) Using a financial calculator:
PV = -980, FV = 1,000, PMT = 25, N = 12, CPT I/Y = 2.697 × 2 = 5.39%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
14) Use the data provided on Cadbury to answer the question below. The risk free rate is 4.25%. The
expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face value of
Cadbury's outstanding bonds is 2.450 billion pounds sterling. The coupon rate on Cadbury's bonds is
4.5%. Assume that the bonds pay annual coupons. The yield to maturity on Cadbury's bonds is 4.5%.
Cadbury's bonds mature in 7 years. Cadbury has 1.650 billion common shares outstanding. The market
price of Cadbury's common shares as of Dec 31, 2008 is 6.25 pounds sterling. Cadbury's Beta is 0.8. What
is Cadbury's cost of debt (after-tax)?
A) 2.70%
B) 4.50%
C) 7.80%
D) 8.65%
E) 8.70%
Answer: A
Explanation: A) After-tax cost of debt = kd(1 - T)
0.045(1 - 0.40) = 0.027 or 2.70%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
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15) Pan American Airlines' shares are currently trading at $69.25 each. The yield on Pan Am's debt is 4%
and the firm's beta is 0.7. The T-Bill rate is 4% and the expected return on the market (E (k M)) is 9%. The
company's target capital structure is 25% debt and 75% equity. Pan American Airlines pays a combined
federal and state tax rate of 35%. What is Pan Am's cost of debt (after tax)?
A) 2.6%
B) 3.0%
C) 3.3%
D) 3.5%
E) 4.0%
Answer: A
Explanation: A) The pre-tax cost of debt is the yield to maturity on the company's bonds, or 4%.
After-tax cost of debt = kd(1 - T)
0.04(1 - 0.35) = 2.6%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
16) A firm's cost of debt often differs from the yield reported on its bonds because
A) the firm's cost of debt is unknown when the bonds are first sold.
B) the underwriting costs for new bond issues are not tax deductible, raising the cost of debt relative to
bond yields.
C) the cost of debt changes infrequently since bond rating agencies do not change their recommendations
often.
D) the interest paid on corporate bonds is tax deductible.
E) speculators can drive the cost of debt down so that bond yields exceed it.
Answer: D
Explanation: D) Interest on debt is tax deductible, which lowers the cost of debt financing.
Diff: 1
Section: 1.4
AACSB: Analytical Thinking
17) Which of the following statements is incorrect?
A) The cost of debt changes when market yields change.
B) The cost of debt should only be adjusted when the firm sells new bonds.
C) The cost of debt should always incorporate the net proceeds from bond sales.
D) The cost of debt reflects the borrowing costs at current market interest rates.
E) The cost of debt should include any broker's fees incurred when selling new bonds.
Answer: B
Explanation: B) The cost of debt rises and falls with market rates, regardless of whether any new debt is
issued.
Diff: 1
Section: 1.4
AACSB: Analytical Thinking
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18) Wilson's Cabinets has bonds outstanding that mature in eight years, have a 6 percent coupon and pay
interest annually. These bonds have a face value of $1,000 and a current market price of $1,020. What is
the company's pre-tax cost of debt?
A) 5.68 percent
B) 6.19 percent
C) 6.34 percent
D) 6.82 percent
E) 7.57 percent
Answer: A
Explanation: A) Using a financial calculator:
PV = -1,020, FV = 1,000, PMT = 60, N = 8, CPT I/Y = 5.68%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
19) Katie's Boutique has zero-coupon bonds outstanding that mature in four years. The bonds have a face
value of $1,000 and a current market price of $820. What is the company's pre-tax cost of debt?
A) 5.01 percent
B) 5.09 percent
C) 5.18 percent
D) 5.36 percent
E) 5.49 percent
Answer: B
Explanation: B) Using a financial calculator:
PV = -820, FV = 1,000, PMT = 0, N = 4, CPT I/Y = 5.09%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
20) Ernst's Electrical has a bond issue outstanding with ten years to maturity. These bonds have a $1,000
face value, a 5 percent coupon, and pay interest semi-annually. The bonds are currently quoted at 96
percent of face value. What is Ernst's pre-tax cost of debt?
A) 4.47 percent
B) 4.97 percent
C) 5.33 percent
D) 5.53 percent
E) 5.94 percent
Answer: D
Explanation: D) Using a financial calculator:
PV = -960, FV = 1,000, PMT = 25, N = 20, CPT I/Y = 2.763 × 2 = 5.53%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
384
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21) Blackwater Adventures has a bond issue outstanding that matures in sixteen years. The bonds pay
interest semi-annually. Currently, the bonds are quoted at 103 percent of face value and carry a 9 percent
coupon. The firm's tax rate is 34 percent. What is the firm's after-tax cost of debt?
A) 5.19 percent
B) 5.71 percent
C) 7.86 percent
D) 8.65 percent
E) 11.41 percent
Answer: B
Explanation: B) Step 1 - Use a financial calculator to solve for the pre-tax cost of debt.
PV = -1,030, FV = 1,000, PMT = 45, N = 32, CPT I/Y = 4.325 × 2 = 8.65%
Step 2 - Account for taxes.
kd(1 - T)
8.65% (1 - .34) = 5.71%
Diff: 3
Section: 1.4
AACSB: Analytical Thinking
22) A $1,000 par bond is currently selling for $1,100. It has a 9% coupon rate, fifteen years remaining to
maturity, and pays interest semi-annually. If the firm's tax rate is 35%, what is the after-tax cost of debt?
A) 9.00%
B) 7.84%
C) 6.07%
D) 5.85%
E) 5.10%
Answer: E
Explanation: E) Step 1 - Use a financial calculator to solve for the pre-tax cost of debt.
PV = -1,100, FV = 1,000, PMT = 45, N = 30, CPT I/Y = 3.927 × 2 = 7.85%
Step 2 - Account for taxes.
kd(1 - T)
7.85%(1 - .35) = 5.10%
Diff: 3
Section: 1.4
AACSB: Analytical Thinking
23) Gaunt Computer Displays plans to issue bonds to finance research and development for computer
monitors that can be read while sleeping. The firm's investment bankers report that the bonds should be
sold to yield 10%. What is Gaunt's cost of debt if its marginal tax rate is 30%?
A) 3.0%
B) 9.3%
C) 9.0%
D) 7.0%
E) 10.0%
Answer: D
Explanation: D) After-tax cost of debt = kd(1 - T)
0.10(1 - .30) = 0.07 or 7%
Diff: 2
Section: 1.4
385
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AACSB: Analytical Thinking
24) Rekall Inc., the memory implant company, has 7 million shares of common stock outstanding and
100,000 semi-annual bonds. The bonds have 6 years to maturity, a 9.05% coupon rate and a face value of
$1,000 each. The common stock currently sells for $29.94 and just paid a dividend of $2.50. Dividends are
paid annually and are expected to grow in perpetuity at 3%. The bonds sell for 94% of face value and
have a 10.42% yield to maturity. The market risk premium is 5.5%, T-bills are yielding 5% and the tax rate
is 30%. What is Rekall's cost of debt (after-tax)? Round to one decimal place.
A) 7.3%
B) 7.8%
C) 8.6%
D) 9.4%
E) 10.4%
Answer: A
Explanation: A) After-tax cost of debt = kd(1 - T)
0.1042(1 - 0.30) = 0.07294 or 7.3%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
25) Ray Stokes is raising capital for a new company called NO Balloons Inc. NO Balloons will
manufacture and sell festive balloons. Because of the shortage of helium, the balloons will be filled with
nitrous oxide instead. NO Balloons plans to finance the business with common equity and long-term
debt. It plans to sell 12 million shares of common stock and 200,000 bonds. Each bond will have a coupon
rate of 5%, will pay its coupons semi-annually and will have a face value of $1,000.The common stock will
be issued at a price of $19.5 a share and has a beta of 1.1. The bonds will sell for 89% of face value and
have a 6.25% yield to maturity. The market risk premium is 5.25%, T-bills are yielding 3.5%, and NO
Balloons' tax rate is 36%. What is NO Balloons' cost of debt (after tax)?
A) 3.6%
B) 4.0%
C) 4.3%
D) 5.3%
E) 6.3%
Answer: B
Explanation: B) The pre-tax cost of debt is the yield to maturity on the company's bonds, or 6.25%.
After-tax cost of debt = kd(1 - T)
0.0625(1 - 0.36) = 0.04 or 4%
Diff: 2
Section: 1.4
AACSB: Analytical Thinking
386
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26) The outstanding bonds of The Purple Fiddle are priced at $898 and mature in nine years. These bonds
have a 6 percent coupon and pay interest annually. The firm's tax rate is 35 percent. What is the firm's
after-tax cost of debt?
A) 4.94 percent
B) 5.24 percent
C) 5.30 percent
D) 7.18 percent
E) 7.61 percent
Answer: A
Explanation: A) Step 1 - Use a financial calculator to solve for the pre-tax cost of debt.
PV = -898, FV = 1,000, PMT = 60, N = 9, CPT I/Y = 7.61%
Step 2 - Account for taxes.
kd(1 - T)
7.61% (1 - .35) = 4.94%
Diff: 3
Section: 1.4
AACSB: Analytical Thinking
27) Tom's Ventures has a zero coupon bond issue outstanding that matures in thirteen years. The bonds
are selling at 48 percent of par value. The company's tax rate is 34 percent. What is the company's aftertax cost of debt?
A) 3.83 percent
B) 4.11 percent
C) 4.73 percent
D) 4.80 percent
E) 5.81 percent
Answer: A
Explanation: A) Step 1 - Use a financial calculator to solve for the pre-tax cost of debt.
PV = -480, FV = 1,000, PMT = 0, N = 13, CPT I/Y = 5.81%
Step 2 - Account for taxes.
kd (1 - T)
5.81% (1 - .34) = 3.83%
Diff: 3
Section: 1.4
AACSB: Analytical Thinking
387
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28) Jensen's Travel Agency has a 7 percent preferred stock outstanding that is currently selling for $48 a
share. The preferred stock has a $100 par value. The market rate of return is 10 percent and the firm's tax
rate is 34 percent. What is the Jensen's cost of preferred stock?
A) 8.75 percent
B) 9.62 percent
C) 11.98 percent
D) 13.25 percent
E) 14.58 percent
Answer: E
Explanation: E) kp =
kp =
= 14.58%
Diff: 2
Section: 1.5
AACSB: Analytical Thinking
29) Donnelly and Son pay $8 as the annual dividend on their preferred stock. Currently, this stock is
selling for $72 a share. What is Donnelly's cost of preferred stock?
A) 7.78 percent
B) 9.00 percent
C) 9.72 percent
D) 11.11 percent
E) 11.99 percent
Answer: D
Explanation: D) kp =
kp =
= 11.11%
Diff: 2
Section: 1.5
AACSB: Analytical Thinking
30) Teri's Tires has 7 percent preferred stock outstanding that sells for $68 a share. The preferred stock has
a $100 par value. What is Teri's cost of preferred stock?
A) 9.52 percent
B) 9.71 percent
C) 10.29 percent
D) 10.78 percent
E) 11.76 percent
Answer: C
Explanation: C) kp =
kp =
= 10.29%
Diff: 2
Section: 1.5
388
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AACSB: Analytical Thinking
31) What is the after-tax cost of preferred stock if its price is $25 per share and it pays a $1 per share
dividend? Assume the firm's marginal tax rate is 25% and there are no flotation costs.
A) 5%
B) 9%
C) 3%
D) 4%
E) 1%
Answer: D
Explanation: D) kp =
kp =
= 4%
Diff: 2
Section: 1.5
AACSB: Analytical Thinking
32) If investors require a 10% after-tax return from a firm's preferred stock and its dividend is $5.00 per
share, what is the price per share assuming a marginal tax rate of 25% and no flotation costs?
A) $50.00
B) $12.50
C) $37.50
D) $18.75
E) $20.00
Answer: A
Explanation: A) kp =
Ppreferred =
Ppreferred =
= $50
Diff: 2
Section: 1.5
AACSB: Analytical Thinking
389
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33) Swiss Cheeses, Inc. has paid annual dividends of $1.00, $1.04, $1.09, and $1.15 per share over the last
four years, respectively. The stock is currently selling for $42 a share. What is this firm's cost of equity?
A) 7.45 percent
B) 7.64 percent
C) 7.83 percent
D) 7.87 percent
E) 8.02 percent
Answer: B
Explanation: B) Step 1 - Compute the growth rate of dividends.
g=
-1
g=
-1
g = .04769
Step 2 - Use the constant growth model to estimate the cost of equity.
ke =
+g
ke =
+ .04769
ke = 7.64%
Diff: 3
Section: 1.6
AACSB: Analytical Thinking
390
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34) Neeson Co. paid dividends in the last three years of $3.00, $3.15, and $3.31, respectively. The current
stock price of Neeson is $30.00. Assuming the next dividend will grow at the same rate as the last three
years, what is Neeson's cost of equity?
A) 16.62%
B) 10.00%
C) 11.59%
D) 16.03%
E) 12.52%
Answer: A
Explanation: A) Step 1 - Compute the growth rate of dividends.
g=
-1
g=
-1
g = .050397
Step 2 - Compute D1.
D1 = D0(1 + g)
D1 = $3.31(1.050397) = $3.4765
Step 3 - Use the constant growth model to estimate the cost of equity.
ke =
ke =
+g
+ .050397
ke = 0.1662 or 16.62%
Diff: 3
Section: 1.6
AACSB: Analytical Thinking
391
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35) The dividend just paid on Thompson Industry stock was $2 per share and it is expected to grow 8%
each year. If the stock is currently selling at $30 per share, what is Thompson's cost of equity? (Round to
the nearest percent.)
A) 13%
B) 18%
C) 12%
D) 15%
E) 21%
Answer: D
Explanation: D) Step 1 - Compute D1.
D1 = D0(1 + g)
D1 = $2(1.08) = $2.16
Step 2 - Use the constant growth model to estimate the cost of equity.
ke =
ke =
+g
+ .08
ke = 0.152 or 15%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
36) Neal Enterprises common stock is currently priced at $36.80 a share. The company is expected to pay
$1.20 per share next month as their annual dividend. The dividends have been increasing by 2 percent
annually and are expected to continue doing so. What is the cost of equity for Neal Enterprises?
A) 5.18 percent
B) 5.22 percent
C) 5.26 percent
D) 5.33 percent
E) 5.67 percent
Answer: C
Explanation: C) ke =
ke =
+g
+ .02
ke = 5.26%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
392
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37) Rekall Inc., the memory implant company, has 7 million shares of common stock outstanding and
100,000 semi-annual bonds. The bonds have 6 years to maturity, a 9.05% coupon rate and a face value of
$1,000 each. The common stock currently sells for $29.94 and just paid a dividend of $2.50. Dividends are
paid annually and are expected to grow in perpetuity at 3%. The bonds sell for 94% of face value and
have a 10.42% yield to maturity. The market risk premium is 5.5%, T-bills are yielding 5% and the tax rate
is 30%. What is Rekall's cost of equity?
A) 8.6%
B) 10.4%
C) 10.5%
D) 11.4%
E) 11.6%
Answer: E
Explanation: E) ke =
ke =
+g
+ .03
ke = 11.6%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
38) If Fluppy Dog Grooming shareholders require a 20% return, what is the dividend growth rate if the
dividend yield is 12%?
A) 32%
B) 6%
C) 20%
D) 12%
E) 8%
Answer: E
Explanation: E) ke =
+g
0.20 = 0.12 + g
g = 0.08 or 8%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
393
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39) The common stock of Big Birds Unlimited has a required return of 8 percent and a growth rate of 4
percent. The last annual dividend was $.60 a share. What is the current price of this stock?
A) $7.50
B) $7.80
C) $10.00
D) $15.00
E) $15.60
Answer: E
Explanation: E) ke =
.08 =
+g
+ .04
.04(P0) = .624
P0 =
= $15.60
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
40) Ben's Ice Cream just paid their annual dividend of $.75 a share. The stock has a market price of $32
and a beta of .90. The return on the U.S. Treasury bill is 4 percent and the market has a 12 percent rate of
return. What is the cost of equity?
A) 7.24 percent
B) 8.67 percent
C) 11.20 percent
D) 12.92 percent
E) 14.80 percent
Answer: C
Explanation: C) ke = kF + β(kM - kF)
ke = .04 + 0.90(.12 - .04)
ke = 11.2%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
394
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41) Ray Stokes is raising capital for a new company called NO Balloons Inc. NO Balloons will
manufacture and sell festive balloons. Because of the shortage of helium, the balloons will be filled with
nitrous oxide instead. NO Balloons plans to finance the business with common equity and long-term
debt. It plans to sell 12 million shares of common stock and 200,000 bonds. Each bond will have a coupon
rate of 5%, will pay its coupons semi-annually and will have a face value of $1,000.The common stock will
be issued at a price of $19.5 a share and has a beta of 1.1. The bonds will sell for 89% of face value and
have a 6.25% yield to maturity. The market risk premium is 5.25%, T-bills are yielding 3.5%, and NO
Balloons' tax rate is 36%. What is NO Balloons' cost of equity?
A) 5.25%
B) 7.75%
C) 8.75%
D) 9.28%
E) 9.63%
Answer: D
Explanation: D) ke = kF + β(kM - kF)
ke = .035 + 1.10(0.0525)
ke = 9.275% or 9.28%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
42) Use the data provided on Cadbury to answer the question below. The risk free rate is 4.25%. The
expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face value of
Cadbury's outstanding bonds is 2.450 billion pounds sterling. The coupon rate on Cadbury's bonds is
4.5%. Assume that the bonds pay annual coupons. The yield to maturity on Cadbury's bonds is 4.5%.
Cadbury's bonds mature in 7 years. Cadbury has 1.650 billion common shares outstanding. The market
price of Cadbury's common shares as of Dec 31, 2008 is 6.25 pounds sterling. Cadbury's Beta is 0.8. What
is Cadbury's cost of equity?
A) 4.20%
B) 4.40%
C) 7.80%
D) 8.65%
E) 8.70%
Answer: D
Explanation: D) ke = kF + β(kM - kF)
ke = .0425 + 0.80(0.0975 - .0425)
ke = 8.65%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
395
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43) Rosie's Grill has a beta of 1.2, a stock price of $26 and an expected annual dividend of $1.30 a share
which is to be paid next month. The dividend growth rate is 4 percent. The market has a 10 percent rate
of return and a risk premium of 6 percent. What is the average expected cost of equity for Rosie's Grill?
A) 9.20 percent
B) 9.70 percent
C) 10.10 percent
D) 10.30 percent
E) 11.40 percent
Answer: C
Explanation: C) Step 1 - Use CAPM to estimate the cost of equity.
ke = kF + β(kM - kF)
ke = .04 + 1.2(.10 - .04)
ke = 11.2%
Step 2 - Use the constant growth model to estimate the cost of equity.
ke =
ke =
+g
+ .04
ke = 9%
Step 3 - Average the two models together.
(.112 + .09) / 2 = 10.1%
Diff: 3
Section: 1.6
AACSB: Analytical Thinking
396
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44) The return on the market is 11%. A firm's beta is 1.4, and the risk-free rate is 6%. The stock is currently
selling for $18 and the next dividend is expected to be $1.75. The firm's growth rate is 5%. The pre-tax cost
of debt is 10% and the equity risk premium is 5%. Estimate the cost of equity by taking an average of the
three methods to determine the cost of equity.
A) 15.0%
B) 14.2%
C) 13.0%
D) 14.7%
E) 11.5%
Answer: B
Explanation: B) Step 1 - Use CAPM to estimate the cost of equity.
ke = kF + β(kM - kF)
ke = .06 + 1.4(.11 - .06)
ke = 13%
Step 2 - Use the constant growth model to estimate the cost of equity.
ke =
ke =
+g
+ .05
ke = 14.72%
Step 3 - Compute the bond yield plus premium.
ke = kd + Θ
ke = 0.10 + 0.05 = 0.15 or 15%
Step 4 - Average the three methods together.
= 0.142 or 14.2%
Diff: 3
Section: 1.6
AACSB: Analytical Thinking
397
Copyright © 2015 Pearson Canada, Inc.
45) Daniel's Enterprises has a beta of 1.98 and a growth rate of 12 percent. The stock is currently selling
for $12 a share. The overall stock market has an 11 percent rate of return and a risk premium of 8 percent.
What is the expected rate of return on Daniel's Enterprises stock?
A) 10.00 percent
B) 15.85 percent
C) 16.67 percent
D) 18.84 percent
E) 19.06 percent
Answer: D
Explanation: D) ke = kF + β(kM - kF)
ke = .03 + 1.98(.11 - .03)
ke = 18.84%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
46) On-line broker Swab-Qtips has a beta of 1.1, and its market return and risk-free rates are 15% and 5%,
respectively. What is Swab's cost of equity?
A) 18%
B) 10%
C) 25%
D) 16%
E) 26%
Answer: D
Explanation: D) ke = kF + β(kM - kF)
ke = .05 + 1.10(.15 - .05)
ke = 16%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
47) Myopia Camera Stores has a cost of equity of 18% and the market return is 12%. What is the firm's
beta if the risk-free rate is 6%?
A) 2.0
B) 1.0
C) 0.8
D) 2.3
E) 1.3
Answer: A
Explanation: A) ke = kF + β(kM - kF)
β=
β=
=
=2
Diff: 3
Section: 1.6
AACSB: Analytical Thinking
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Copyright © 2015 Pearson Canada, Inc.
48) Martha' s Interiors has a current beta of 1.2. The market risk premium is 6 percent and the risk-free
rate of return is 4 percent. By how much will the cost of equity increase if the company completes an
acquisition such that their company beta rises to 1.4?
A) 0.12 percent
B) 0.24 percent
C) 1.20 percent
D) 2.40 percent
E) 2.47 percent
Answer: C
Explanation: C) Step 1 - Use CAPM to estimate the cost of equity at each Beta.
ke = kF + β(kM - kF)
ke = .04 + 1.2(.06)
ke = 11.2%
ke = kF + β(kM - kF)
ke = .04 + 1.4(.06)
ke = 12.4%
Step 2 - Compare the two to find the increase in the cost of equity.
.124 - .112 = 1.2%
Diff: 3
Section: 1.6
AACSB: Analytical Thinking
49) Martin Industries just paid an annual dividend of $1.20 a share. The market price of the stock is $26.60
and the growth rate is 4 percent. What is the firm's cost of equity?
A) 8.38 percent
B) 8.51 percent
C) 8.57 percent
D) 8.69 percent
E) 8.74 percent
Answer: D
Explanation: D) ke =
ke =
+g
+ .04
ke = 8.69%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
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Copyright © 2015 Pearson Canada, Inc.
50) The market yield on Spice Grills' bonds is 15%, and the firm's marginal tax rate is 33%. What is their
shareholders' required return if the equity risk premium is 4%?
A) 15%
B) 11%
C) 14%
D) 19%
E) 12%
Answer: D
Explanation: D) ke = kd + Θ
ke = 0.15 + 0.04 = 0.19 or 19%
Diff: 1
Section: 1.6
AACSB: Analytical Thinking
51) A firm's pre-tax cost of debt is 10%. If the firm is of average risk, what is the cost of equity using the
bond yield plus premium approach?
A) 15%
B) 13%
C) 14%
D) 10%
E) 11%
Answer: C
Explanation: C) ke = kd + Θ
ke = 0.10 + 0.04 = 0.14 or 14%
A firm of average risk should have a risk premium of 4%
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
52) Which component of a firm's capital structure is the most difficult to estimate?
A) Preferred shares
B) Equity
C) Bank loans
D) Bond-financed debt
E) Private placements of debt
Answer: B
Explanation: B) Finding the cost of equity is far more difficult than finding the cost of either debt or
preferred shares.
Diff: 2
Section: 1.6
AACSB: Analytical Thinking
400
Copyright © 2015 Pearson Canada, Inc.
53) When using the bond yield plus risk premium approach to estimating the cost of equity, the equity
risk premium is usually about
A) 3-5%.
B) 8-10%.
C) 20-25%.
D) 10-15%.
E) 30-33%.
Answer: A
Explanation: A) Most analysts project that the risk premium is usually between 3% and 5%.
Diff: 1
Section: 1.6
AACSB: Analytical Thinking
54) The return that lenders require on their loaned funds to the firm is called the
A) coupon rate.
B) current yield.
C) cost of debt.
D) capital gains yield.
E) cost of capital.
Answer: C
Explanation: C) The cost of debt is the return lenders require on their loaned funds to a firm.
Diff: 1
Section: 1.4
AACSB: Analytical Thinking
55) The cost of equity for a firm is
A) determined by directly observing the rate of return required by equity investors.
B) based on estimates derived from financial models.
C) equivalent to a leveraged firm's cost of capital.
D) equal to the risk-free rate of return plus the market risk premium.
E) equal to the risk-free rate of return plus the dividend growth rate.
Answer: B
Explanation: B) The cost of equity for a firm is based on estimates derived from financial models.
Diff: 1
Section: 1.6
AACSB: Analytical Thinking
56) The constant dividend growth model
A) can be used to estimate the cost of equity for any corporation.
B) is applicable only to firms that pay a constant dividend.
C) is highly dependent upon the estimated rate of growth.
D) is considered quite complex.
E) considers the risk of the firm.
Answer: C
Explanation: C) The constant dividend growth model is highly dependent upon the estimated rate of
growth.
Diff: 1
Section: 1.6
AACSB: Analytical Thinking
401
Copyright © 2015 Pearson Canada, Inc.
57) The constant dividend growth model
A) generally produces the same estimated cost of equity for a firm regardless of the source of information
used to predict the rate of growth.
B) can only be used if historical dividend information is available.
C) ignores the risk that future dividends may vary from their estimated values.
D) assumes that both the dividend amount and the stock price are not constant over time.
E) uses beta to measure the systematic risk of the firm.
Answer: C
Explanation: C) The constant dividend growth model ignores the risk that future dividends may vary
from their estimated values.
Diff: 1
Section: 1.6
AACSB: Analytical Thinking
58) The market risk premium
A) varies over time as both the risk-free rate of return and the market rate of return vary.
B) plus the risk-free rate of return equals the cost of capital for any firm with a beta of zero.
C) is equal to one percent for a risk-free asset.
D) is equal to the risk-free rate of return multiplied by the beta of a firm.
E) is modified by the standard deviation when computing the cost of equity.
Answer: A
Explanation: A) The market risk premium varies over time as both the risk-free rate of return and the
market rate of return vary.
Diff: 1
Section: 1.6
AACSB: Analytical Thinking
59) Which method is best to compute a firm's cost of equity?
A) CAPM
B) Bond yield plus risk premium
C) Constant growth model
D) All of these methods
E) None of these method; use the current market price per share.
Answer: D
Explanation: D) Use all of the methods for which you have the required data.
Diff: 1
Section: 1.6
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60) The pre-tax cost of debt for a firm
A) is equal to the yield to maturity on the outstanding bonds of the firm.
B) is equal to the coupon rate of the outstanding bonds of the firm.
C) is equivalent to the current yield on the outstanding bonds of the firm.
D) is based on the yield to maturity that existed when the currently outstanding bonds were originally
issued.
E) has to be estimated as it cannot be directly observed in the market.
Answer: A
Explanation: A) The pre-tax cost of debt for a firm is equal to the yield to maturity on the outstanding
bonds of the firm.
Diff: 1
Section: 1.4
AACSB: Analytical Thinking
61) The cost of preferred shares is computed the same as
A) the pre-tax cost of debt.
B) an annuity.
C) the after-tax cost of debt.
D) a perpetuity.
E) an irregular growth common stock.
Answer: D
Explanation: D) The cost of preferred shares is computed the same as a perpetuity.
Diff: 1
Section: 1.5
AACSB: Analytical Thinking
62) Preferred stock constitutes what percentage of the average firm's capital structure?
A) 50%
B) 25%
C) 5%
D) 10%
E) 75%
Answer: C
Explanation: C) About 5% of the average firm's capital is raised from issuing preferred shares.
Diff: 1
Section: 1.5
AACSB: Analytical Thinking
63) The cost of preferred shares
A) is equal to the dividend yield on the stock.
B) is equal to the yield to maturity.
C) is highly dependent on the growth rate.
D) varies directly with the stock's price.
E) is difficult to determine.
Answer: A
Explanation: A) The cost of preferred shares is equal to the dividend yield on the stock.
Diff: 1
Section: 1.5
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64) The weighted average cost of capital for a firm is the
A) discount rate which the firm should apply to all of the projects it undertakes.
B) overall rate which the firm must earn on its existing assets to maintain the value of its stock.
C) rate the firm should expect to pay on its next bond issue.
D) maximum rate which the firm should require on any projects it undertakes.
E) rate of return that the firm's preferred stockholders should expect to earn over the long term.
Answer: B
Explanation: B) The WACC is the overall rate which the firm must earn on its existing assets to maintain
the value of its stock.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
LO2: Computing a Weighted Average Cost of Capital (WACC)
1) The proportions of the market value of the firm's assets financed via debt, common stock, and
preferred stock are called the firm's
A) financing costs.
B) portfolio weights.
C) beta coefficients.
D) capital structure weights.
E) costs of capital.
Answer: D
Explanation: D) Capital structure weights are the proportion that each source of capital represents in the
firm's capital structure.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
2) The Auto Group has 1,200 bonds outstanding that are selling for $980 each. The company also has
7,500 shares of preferred stock at a market price of $40 each. The common stock is priced at $32 a share
and there are 32,000 shares outstanding. What is the weight of the preferred stock as it relates to the firm's
weighted average cost of capital?
A) 10 percent
B) 12 percent
C) 14 percent
D) 16 percent
E) 18 percent
Answer: B
Explanation: B) Step 1 - Calculate the value of the firm's securities.
V=E+D+P
E = 32 × 32,000 = 1,024,000D = 980 × 1,200 = 1,176,000P = 40 × 7,500 = 300,000V = 2,500,000
Step 2 - Calculate the weight of preferred shares.
Wp = P/V
Wp = 300,000 / 2,500,000 = 12%
Diff: 3
Section: 2.1
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AACSB: Analytical Thinking
3) Utility Muffin Research Kitchen Inc. is financed with debt, preferred stock and common equity.
Selected information for each of the securities is provided in the table below. Calculate the capital
structure weights which would be used to calculate the weighted average cost of capital.
Long-term Debt:
$5M Face Value, Coupon Rate = 3.5%, Annual Coupons, Time to Maturity = 10 Years, YTM = 5%.
Preferred Shares:
0.5M Shares outstanding, Par Value = $10 per share, Dividend Rate (Annual) = 4%, Equivalent preferred
shares yield 7%.
Common Shares:
0.5M Shares outstanding, Market price per share = $20.
A) Wd = 0.26, Wp = 0.17, We = 0.58
B) Wd = 0.22, Wp = 0.28, We = 0.50
C) Wd = 0.41, Wp = 0.13, We = 0.46
D) Wd = 0.36, Wp = 0.23, We = 0.41
E) Wd = 0.35, Wp = 0.20, We = 0.45
Answer: A
Explanation: A) First, compute the value of the long-term debt:
Pbond = C × PVIFAn, kd +
Pbond = (0.035 × $5) ×
+
= $4.42M
Compute the value of the preferred shares:
Market value of preferred shares = 0.5M × (0.04 × $10/0.07) = $2.857M
Compute the value of the common shares:
Market value of common shares = 0.5M × $20 = $10M
Calculate the capital structure weights:
V=E+D+P
V = $4.42 + $2.857 + $10 = $17.277M
Debt Weighting = D/V = 4.42/17.277 = 0.26
Preferred Shares Weighting = P/V = 2.857/17.277 = 0.17
Common Stock Weighting = E/V = 10/17.277 = 0.58
Diff: 4
Section: 2.1
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4) Watson's Automotive has a $400,000 bond issue outstanding that is selling at 102 percent of face value.
Watson's also has 4,500 shares of preferred stock and 21,000 shares of common stock outstanding. The
preferred stock has a market price of $44 a share compared to a price of $21 a share for the common stock.
What is the weight of the debt as it relates to the firm's weighted average cost of capital? Round answer to
nearest percent.
A) 38 percent
B) 39 percent
C) 40 percent
D) 41 percent
E) 42 percent
Answer: B
Explanation: B) Step 1 - Calculate the value of the firm's securities.
V=E+D+P
E = 21 × 21,000 = 441,000D = 1.02 × 400,000 = 408,000P = 44 × 4,500 = 198,000V = 1,047,000
Step 2 - Calculate the weight of debt.
Wd = D/V
Wd = 408,000 / 1,047,000 = 38.97% or 39%
Diff: 3
Section: 2.1
AACSB: Analytical Thinking
5) Initech has 7 million shares of common stock outstanding and 50,000 bonds outstanding. The bonds
pay semi-annual coupons at an annual rate of 9.05%, have 6 years to maturity and a face value of $1,000
each. The common stock currently sells for $30 a share and has a beta of 1. The bonds sell for 94% of face
value and have a 10.42% yield to maturity. The market risk premium is 5.5%, T-bills are yielding 5% and
the tax rate is 30%. What is the firm's capital structure weight for debt?
A) 18.3%
B) 19.3%
C) 20.3%
D) 21.3%
E) 22.3%
Answer: A
Explanation: A) Step 1 - Calculate the value of the firm's securities.
V=E+D
E = $30 × 7M = $210MD = $940 × 50,000 = $47MV = $257M
Step 2 - Calculate the weight of debt.
Wd = D/V
Wd = $47 / $257 = 18.3%
Diff: 2
Section: 2.1
AACSB: Analytical Thinking
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6) Rekall Inc., the memory implant company, has 7 million shares of common stock outstanding and
100,000 semi-annual bonds. The bonds have 6 years to maturity, a 9.05% coupon rate and a face value of
$1,000 each. The common stock currently sells for $29.94 and just paid a dividend of $2.50. Dividends are
paid annually and are expected to grow in perpetuity at 3%. The bonds sell for 94% of face value and
have a 10.42% yield to maturity. The market risk premium is 5.5%, T-bills are yielding 5% and the tax rate
is 30%. What is the capital structure weight for equity?
A) 0.67
B) 0.68
C) 0.69
D) 0.70
E) 0.71
Answer: C
Explanation: C) Step 1 - Calculate the value of the firm's securities.
V=E+D
E = $29.94 × 7M = $209.58MD = $940 × 100,000 = $94MV = $303.58M
Step 2 - Calculate the weight of debt and equity.
Wd = D/V
Wd = $94 / $303.58 = 30.96%
We = E/V
We = $209.58 / $303.58 = 69.04% or 0.69
Diff: 3
Section: 2.1
AACSB: Analytical Thinking
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7) Ray Stokes is raising capital for a new company called NO Balloons Inc. NO Balloons will manufacture
and sell festive balloons. Because of the shortage of helium, the balloons will be filled with nitrous oxide
instead. NO Balloons plans to finance the business with common equity and long-term debt. It plans to
sell 12 million shares of common stock and 200,000 bonds. Each bond will have a coupon rate of 5%, will
pay its coupons semi-annually and will have a face value of $1,000.The common stock will be issued at a
price of $19.5 a share and has a beta of 1.1. The bonds will sell for 89% of face value and have a 6.25%
yield to maturity. The market risk premium is 5.25%, T-bills are yielding 3.5%, and NO Balloons' tax rate
is 36%. What is the capital structure weight for equity for NO Balloons?
A) 57%
B) 58%
C) 59%
D) 60%
E) 61%
Answer: A
Explanation: A) Step 1 - Calculate the value of the firm's securities.
V=E+D
E = $19.50 × 12M = $234MD = 1,000 × 0.89 × 200,000 = $178MV = $234M + $178M = $412M
Step 2 - Calculate the weight of debt and equity.
Wd = D/V
Wd = $178 / $412 = 43.20%
We = E/V
We = $234 / $412 = 56.80% or 57%
Diff: 3
Section: 2.1
AACSB: Analytical Thinking
8) Use the data provided on Cadbury to answer the question below. The risk free rate is 4.25%. The
expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face value of
Cadbury's outstanding bonds is 2.450 billion pounds sterling. The coupon rate on Cadbury's bonds is
4.5%. Assume that the bonds pay annual coupons. The yield to maturity on Cadbury's bonds is 4.5%.
Cadbury's bonds mature in 7 years. Cadbury has 1.650 billion common shares outstanding. The market
price of Cadbury's common shares as of Dec 31, 2008 is 6.25 pounds sterling. Cadbury's Beta is 0.8. What
is the market value of Cadbury's bonds?
A) £0.13B
B) £1.65B
C) £1.80B
D) £2.45B
E) £2.49B
Answer: D
Explanation: D) Pbond = C × PVIFAn, kd +
Pbond = (0.045 × £2.45) ×
+
= £2.45B
Diff: 3
Section: 2.1
AACSB: Analytical Thinking
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9) Use the data provided on Cadbury to answer the question below. The risk free rate is 4.25%. The
expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face value of
Cadbury's outstanding bonds is 2.450 billion pounds sterling. The coupon rate on Cadbury's bonds is
4.5%. Assume that the bonds pay annual coupons. The yield to maturity on Cadbury's bonds is 4.5%.
Cadbury's bonds mature in 7 years. Cadbury has 1.650 billion common shares outstanding. The market
price of Cadbury's common shares as of Dec 31, 2008 is 6.25 pounds sterling. Cadbury's Beta is 0.8. What
is the capital structure weight for equity?
A) 0.149
B) 0.192
C) 0.808
D) 0.851
E) 0.862
Answer: C
Explanation: C) Calculate the market value of the debt:
Pbond = C × PVIFAn, kd +
Pbond = (0.045 x £2.45) ×
+
= £2.45B
Calculate the market value of the equity:
$6.25 × 1.650B = $10.3125B
V = D + E = 2.450B + 10.3125B = 12.7625B
Wd = D/V
Wd = 2.450 / 12.7625 = 19.2%
We = E/V
We = 10.3125 / 12.7625 = 80.8%
Diff: 4
Section: 2.1
AACSB: Analytical Thinking
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Copyright © 2015 Pearson Canada, Inc.
10) Use the data provided on Cadbury to answer the question below. The risk free rate is 4.25%. The
expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face value of
Cadbury's outstanding bonds is 2.450 billion pounds sterling. The coupon rate on Cadbury's bonds is
4.5%. Assume that the bonds pay annual coupons. The yield to maturity on Cadbury's bonds is 4.5%.
Cadbury's bonds mature in 7 years. Cadbury has 1.650 billion common shares outstanding. The market
price of Cadbury's common shares as of Dec 31, 2008 is 6.25 pounds sterling. Cadbury's Beta is 0.8.
Cadbury's cost of debt (after-tax) is 2.7%. Cadbury's cost of equity is 8.65%. What is Cadbury's WACC?
A) 6.37%
B) 7.51%
C) 7.76%
D) 8.02%
E) 8.16%
Answer: B
Explanation: B) First calculate the capital structure weights for debt and equity.
Calculate the market value of the debt:
Pbond = C × PVIFAn, kd +
Pbond = (0.045 x £2.45) ×
+
= £2.45B
Calculate the market value of the equity:
$6.25 × 1.650B = $10.3125B
V = D + E = 2.450B + 10.3125B = 12.7625B
Wd = D/V
Wd = 2.450 / 12.7625 = 19.2%
We = E/V
We = 10.3125 / 12.7625 = 80.8%
Compute the WACC:
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.192 × 0.027) + (0.808 × 0.0865) = 7.51%
Diff: 4
Section: 2.2
AACSB: Analytical Thinking
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11) Pan American Airlines' shares are currently trading at $69.25 each. The yield on Pan Am's debt is 4%
and the firm's beta is 0.7. The T-Bill rate is 4% and the expected return on the market (E (k M)) is 9%. Pan
American Airlines pays a combined federal and state tax rate of 35%. The company's target capital
structure is 25% debt and 75% equity. Pan Am's cost of debt is 2.6% and the company's cost of equity is
7.5%. What is the weighted average cost of capital for Pan Am?
A) 2.6%
B) 4.3%
C) 5.3%
D) 6.3%
E) 7.5%
Answer: D
Explanation: D) From the question we know that:
We = 75%
Wd = 25%
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.25 × 0.026) + (0.75 × 0.075) = 6.28% or 6.3%
Diff: 2
Section: 2.2
AACSB: Analytical Thinking
12) Ray Stokes is raising capital for a new company called NO Balloons Inc. NO Balloons will
manufacture and sell festive balloons. Because of the shortage of helium, the balloons will be filled with
nitrous oxide instead. NO Balloons plans to finance the business with common equity and long-term
debt. It plans to sell 12 million shares of common stock and 200,000 bonds. Each bond will have a coupon
rate of 5% and will have a face value of $1,000.The common stock will be issued at a price of $19.5 a share.
The bonds will sell for 89% of face value. The after-tax cost of debt is 4% and the cost of equity of 9.275%.
What is NO Balloons' WACC?
A) 5%
B) 6%
C) 7%
D) 8%
E) 9%
Answer: C
Explanation: C) Step 1 - Calculate the value of the firm's securities.
V=E+D
E = $19.50 × 12M = $234MD = 1,000 × 0.89 × 200,000 = $178MV = $234M + $178M = $412M
Step 2 - Calculate the weight of debt and equity.
Wd = D/V
Wd = $178 / $412 = 43.20%
We = E/V
We = $234 / $412 = 56.80%
Step 3 - Compute the WACC.
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.432 × 0.04) + (0.568 × 0.09275) = 7%
Diff: 3
Section: 2.2
AACSB: Analytical Thinking
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13) As a newly hired financial analyst, your first job at VersaLife Corporation is to calculate the
company's cost of capital. The present capital structure, which is considered optimal, is as follows:
Market Value
Debt
$80 million
Preferred Stock $10 million
Common
Equity
$110 million
Total Capital
$200 million
If VersaLife Corporation issues new debt, then the bond market expects a yield of 7.5%. Preferred stock is
trading for $96, has a $100 par value and pays an annual dividend of 8% (the next dividend is due in one
year). Common equity has a beta of 1.20, the market risk premium is 5%, and the risk-free rate is 3%. If
the firm's tax rate is 40%, what is the weighted average cost of capital? Round answers to the nearest
tenth.
A) 7.2%
B) 7.5%
C) 8.2%
D) 8.5%
E) 9.0%
Answer: A
Explanation: A) Step 1 - Calculate the capital structure weights.
Debt = 80 / 200 = 0.40
Preferred Shares = 10 / 200 = 0.05
Common Stock = 110 / 200 = 0.55
Step 2 - Calculate the cost of each component of the capital structure.
After-tax cost of debt = kd(1 - T)
0.075(1 - 0.40) = 0.045
Cost of preferred shares:
kp =
kp =
= 0.0833
Cost of common stock:
ke = kF + β(kM - kF)
ke = .03 + 1.20(.05)
ke = 0.09
Step 3 - Compute the WACC.
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.40 × 0.045) + (0.05 × 0.0833) + (0.55 × 0.09)
WACC = 0.018 + 0.00417 + 0.0495 = 0.0717 or 7.20%
Diff: 4
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Section: 2.2
AACSB: Analytical Thinking
14) Rekall Inc., the memory implant company, has 7 million shares of common stock outstanding and
100,000 semi-annual bonds. The bonds have 6 years to maturity, a 9.05% coupon rate and a face value of
$1,000 each. The common stock currently sells for $29.94 and just paid a dividend of $2.50. Dividends are
paid annually and are expected to grow in perpetuity at 3%. The bonds sell for 94% of face value and
have a 10.42% yield to maturity. The after-tax cost of debt is 7.294%, and the cost of equity is 11.6%. What
is Rekall's WACC?
A) 7.09%
B) 9.51%
C) 9.94%
D) 10.27%
E) 11.24%
Answer: D
Explanation: D) Step 1 - Calculate the value of the firm's securities.
V=E+D
E = $29.94 × 7M = $209.58MD = $940 × 100,000 = $94MV = $303.58M
Step 2 - Calculate the weight of debt and equity.
Wd = D/V
Wd = $94 / $303.58 = 30.96%
We = E/V
We = $209.58 / $303.58 = 69.04%
Step 3 - Compute the WACC.
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.3096 × 0.07294) + (0.6904 × 0.116) = 10.27%
Diff: 4
Section: 2.2
AACSB: Analytical Thinking
15) Gillian's Boutique has 850,000 shares of common stock outstanding at a market price of $16 a share.
The company also has 15,000 bonds outstanding that are quoted at 98 percent of face value. What weight
should be given to the common stock when Gillian's computes their weighted average cost of capital?
Round answer to nearest percent.
A) 48 percent
B) 49 percent
C) 50 percent
D) 51 percent
E) 52 percent
Answer: A
Explanation: A) Step 1 - Calculate the value of the firm's securities.
V=E+D+P
E = 16 × 850,000 = 13,600,000D = 980 × 15,000 = 14,700,000P = 0V = 28,300,000
Step 2 - Calculate the weight of common stock.
We = E/V
We = 13,600,000 / 28,300,000 = 48.1% or 48%
Diff: 3
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Section: 2.1
AACSB: Analytical Thinking
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16) Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar
characteristics are yielding 8.5 percent. The company also has 4 million shares of common stock
outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4
percent and the market risk premium is 8 percent. Jack's tax rate is 35 percent. What is Jack's weighted
average cost of capital?
A) 7.10 percent
B) 7.39 percent
C) 10.38 percent
D) 10.65 percent
E) 11.37 percent
Answer: C
Explanation: C) Step 1 - Calculate the value of the firm's securities.
V=E+D+P
E = 40 × 4,000,000 = 160,000,000D = 1,000 × 80,000 = 80,000,000P = 0V = 240,000,000
Step 2 - Calculate the weight of each component of the firm's capital.
Wd = 80,000,000 / 240,000,000 = 33.33%
We = 160,000,000 / 240,000,000 = 66.67%
Step 3 - Calculate the cost of each component of the firm's capital.
kd = 8.5%
ke = kF + β(kM - kF)
ke = .04 + 1.1(.08)
ke = 12.8%
Step 4 - Compute the WACC.
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (.3333 × .085 (1 - .35)) + (.6667 × .128) WACC = 10.38%
Diff: 4
Section: 2.2
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17) Peter's Audio Shop has a cost of debt of 7 percent, a cost of equity of 11 percent, and a cost of
preferred stock of 8 percent. The firm has 104,000 shares of common stock outstanding at a market price
of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The
bond issue has a total face value of $500,000 and sells at 102 percent of face value. The company's tax rate
is 34 percent. What is the weighted average cost of capital for Peter's Audio Shop?
A) 6.14 percent
B) 6.54 percent
C) 8.60 percent
D) 9.14 percent
E) 9.45 percent
Answer: D
Explanation: D) Step 1 - Calculate the value of the firm's securities.
V=E+D+P
E = 20 × 104,000 = 2,080,000D = 1.02 × 500,000 = 510,000P = 34 × 40,000 = 1,360,000V = 3,950,000
Step 2 - Calculate the weight of each component of the firm's capital.
Wd = 510,000 / 3,950,000 = 12.91%
We = 2,080,000 / 3,950,000 = 52.66%
Wp = 1,360,000 / 3,950,000 = 34.43%
Step 3 - Compute the WACC.
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (.1291 × .07 (1 - .34)) + (.3443 × .08) + (.5266 × .11) WACC = 9.14%
Diff: 3
Section: 2.2
AACSB: Analytical Thinking
18) Wilson's has 10,000 shares of common stock outstanding at a market price of $35 a share. The firm
also has a bond issue outstanding with a total face value of $250,000 which is selling for 102 percent of
face value. The cost of equity is 11 percent while the pre-tax cost of debt is 8 percent. The firm has a beta
of 1.1 and a tax rate of 34 percent. What is Wilson's weighted average cost of capital?
A) 8.59 percent
B) 8.72 percent
C) 9.08 percent
D) 9.63 percent
E) 10.05 percent
Answer: A
Explanation: A) Step 1 - Calculate the value of the firm's securities.
V=E+D+P
E = 35 × 10,000 = 350,000D = 1.02 × 250,000 = 255,000P = 0V = 605,000
Step 2 - Calculate the weight of each component of the firm's capital.
Wd = 255,000 / 605,000 = 42.15%
We = 350,000 / 605,000 = 57.85%
Step 3 - Compute the WACC.
WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (.4215 × .08 (1 - .34)) + (.5785 × .11) WACC = 8.59%
Diff: 3
Section: 2.2
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19) What is the weighted average cost of capital after taxes for Moss Diet Centres if the target weights are
25% equity and 75% debt, and the costs of equity and after-tax debt are 15% and 12%, respectively?
Assume the relevant tax rate is 20%.
A) 12.5%
B) 11.0%
C) 12.8%
D) 14.0%
E) 13.5%
Answer: C
Explanation: C) WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.25 × 0.15) + (0.75 × 0.12) = 12.8%
Diff: 2
Section: 2.2
AACSB: Analytical Thinking
20) The pre-tax cost of debt is 11%, preferred stock costs 14%, and equity costs 15%. What is the weighted
average cost of capital assuming a tax rate of 40% and a target capital structure of 40% debt, 20%
preferred stock, and 40% equity?
A) 10.6%
B) 11.2%
C) 14.0%
D) 11.4%
E) 12.8%
Answer: D
Explanation: D) WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.40 × 0.11)(1 - 0.40) + (0.20 × 0.14) + (0.40 × 0.15) = 11.4%
Diff: 3
Section: 2.2
AACSB: Analytical Thinking
21) What is the weighted average cost of capital after taxes if the desired capital structure is 40% debt and
60% equity, investors require a 10% pre-tax return from debt and 25% from equity, and the tax rate is
30%?
A) 18%
B) 20%
C) 11%
D) 15%
E) 19%
Answer: A
Explanation: A) WACC = WdKd(1 - T) + WpKp + WeKe
WACC = (0.40 × 0.10)(1 - 0.30) + (0.60 × 0.25) = 18%
Diff: 3
Section: 2.2
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22) The capital structure weights used in computing the weighted average cost of capital are
A) constant over time provided that the debt-equity ratio changes in unison with the market values.
B) based on the face value of the firm's debt.
C) computed using the book value of the long-term debt and the shareholder's equity.
D) based on the market value of the firm's debt and equity securities.
E) limited to the firm's debt and common stock.
Answer: D
Explanation: D) The capital structure weight used in computing the weighted average cost of capital are
based on the market value of the firm's debt and equity securities.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
23) Your firm uses both preferred and common stock as well as long-term debt to finance its operations.
Which one of the following will increase the capital structure weight of the debt, all else equal?
A) an increase in the market price of the common stock
B) an increase in the number of shares of preferred stock outstanding
C) an increase in the quoted price of the firm's bonds as a percentage of face value
D) the exercise of warrants by company employees
E) the conversion of convertible bonds into equity shares
Answer: C
Explanation: C) An increase in the quoted price of a firm's bonds as a percentage of face value would
increase the capital structure weight of the debt.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
24) Which one of the following statements is correct concerning the weighted average cost of capital
(WACC)?
A) The pre-tax rate of return on the debt is the rate that is relevant to the computation of the WACC.
B) When computing the WACC, the weight assigned to the preferred shares is equal to the coupon rate
multiplied by the par value assigned to the preferred shares.
C) A firm's WACC will decrease as their corporate tax rate decreases.
D) The weight of the common stock used in the computation of the WACC is based on the number of
shares outstanding multiplied by the book value per share.
E) The weight of the debt can be based on the face value of the bond issue(s) outstanding multiplied by
the quoted price(s) when expressed as a percentage of the face value.
Answer: E
Explanation: E) The weight of the debt can be based on the face value of the bond issue(s) outstanding
multiplied by the quoted price(s) when expressed as a percentage of the face value.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
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25) The proportions of the market value of the firm's assets financed via debt, common stock, and
preferred stock are called the firm's
A) financing costs.
B) beta coefficients.
C) capital structure weights.
D) costs of capital.
E) portfolio weights.
Answer: C
Explanation: C) The weights represent the proportion that each source of capital represents in the firm's
capital structure.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
LO3: Compute the Correct WACC in Multiple Division Companies
1) Doing a single corporate WACC is always the best way to evaluate a project.
Answer: FALSE
Explanation: Companies with multiple divisions should not use a single corporate WACC to evaluate
projects.
Diff: 1
Section: 3
AACSB: Analytical Thinking
2) For a firm with multiple business units, the cost of capital developed for each unit is called a
A) divisional cost of capital.
B) pure play approach.
C) subjective risk adjustment.
D) stratified beta coefficient.
E) fundamental beta coefficient.
Answer: A
Explanation: A) The divisional cost of capital is the cost of capital developed for each business unit
within a firm.
Diff: 1
Section: 3
AACSB: Analytical Thinking
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3) Benson's, Inc. has an overall cost of equity of 10.24 percent and a beta of 1.2. The firm is financed 100
percent with common stock. The risk-free rate of return is 4 percent. What is an appropriate cost of capital
for a division within the firm that has an estimated beta of 1.5?
A) 11.6 percent
B) 11.8 percent
C) 12.0 percent
D) 12.4 percent
E) 12.8 percent
Answer: B
Explanation: B) Step 1 - Use CAPM to solve for the return of the market.
ke = kF + β(kM - kF)
.1024 = .04 + 1.2(kM - .04)
.052 = (kM - .04)
kM = 9.2%
Step 2 - Use the return of the market with the new Beta to solve for the cost of capital.
ke = kF + β(kM - kF)
ke = .04 + 1.5(.092 - .04)
ke = 11.8%
Diff: 3
Section: 3
AACSB: Analytical Thinking
4) Bob's Tractor and Party Supply has two separate divisions: party supplies, and tractor supplies and
services. The party supply division has a beta of 1.2 and is financed by 25% debt. The tractor supply and
service division has a beta of 0.8 and is financed by 60% debt. The cost of debt for each division is 5%. The
risk free rate and market rate are 5% and 10% respectively. A project has recently become available for
each division with an expected return of 10%. Which division(s) should take on the project?
A) Party Supply
B) Tractor Supply and Services
C) Both
D) Neither
Answer: B
Explanation: B) ke = kF + β(kM - kF)
Party Supplies = 0.05 + 1.2(0.10 - 0.05) = 11%. 11% > 10%, so reject
Tractor Supply and Services = 0.05 + 0.80(0.10 - 0.05) = 9%. 9% < 10%, so accept
Diff: 3
Section: 3
AACSB: Analytical Thinking
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5) Swanson & Sons has two separate divisions. Each division is in a separate line of business. Division A
is the largest division and represents 65 percent of the firm's overall sales. Division A is also the riskier of
the two divisions. Division B is the smaller and least risky of the two. When the company is deciding
which of the various divisional projects should be accepted they should
A) allocate more funds to Division A since it is the largest of the two divisions.
B) fund all of Division B's projects first since they tend to be less risky and then allocate the remaining
funds to the Division A projects that have the highest net present values.
C) allocate the company funds to the projects with the highest net present values based on the firm's
weighted average cost of capital.
D) assign different discount rates to each project and then select the projects with the highest net present
values.
E) fund the highest net present value projects from each division based on an allocation of 65 percent of
the funds to Division A and 35 percent of the funds to Division B.
Answer: D
Explanation: D) When a company is deciding various divisional projects should be accepted, they should
assign different discount rates to each project and then select the projects with the highest net present
values.
Diff: 1
Section: 3
AACSB: Analytical Thinking
6) If a firm applies its overall cost of capital to all its proposed projects, then the divisions within the firm
will tend to
A) receive more funding if they represent the riskiest operations of the firm.
B) avoid risky projects so that they will receive more funding.
C) become less risky over time based on the projects that are accepted.
D) have equal probabilities of receiving funding for their projects.
E) propose less risky projects than if separate discount rates were applied to each project.
Answer: A
Explanation: A) If a firm applies its overall cost of capital to all its proposed projects, then the divisions
within the firm will tend to receive more funding if they represent the riskiest operations of the firm.
Diff: 1
Section: 3
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 12 Capital Structure
LO1: Calculate Operating, Financial, and Total Leverage
1)
421
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Refer to the table, above, which shows financial information for a company that makes rail cars (i.e., oil
tankers and grain hoppers) and a computer software company. Complete the table. Which company has a
larger degree of operating leverage?
A) Railcar Inc.
B) Software
C) Both are the same
D) Need additional information
Answer: A
Explanation: A) Railcar has a DOL of 7.3 whereas Software has a DOL of 4.1. This is not surprising given
Railcar's higher proportion of fixed assets (PP&E/TA).
Diff: 2
Section: 1 Learn How to Measure Leverage
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2)
Refer to the table, above, which shows financial information for a company that makes rail cars (i.e., oil
rankers and grain hoppers) and a computer software company. Complete the table. Which company has
a larger degree of financial leverage?
A) Railcar Inc.
B) Software
C) Both are the same
D) Need additional information
Answer: A
Explanation: A) Railcar has a DFL of 5.1 whereas Software has a DFL of 1.3. This is not surprising given
Railcar's higher debt-to-equity ratio.
Diff: 2
Section: 1 Learn How to Measure Leverage
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LO2: Evaluate the Impact of Leverage on EPS and ROE
1) Consider the following statements about leverage:
I. The level and variability of EPS is affected by the amount of leverage.
II. If EBIT is strong, leverage provides an even greater return to shareholders compared to the return
with no leverage.
III. Shareholders are exposed to more risk under a leveraged capital structure compared to an all equity
structure.
Which of these statements, if any, are true?
A) I only
B) II only
C) III only
D) I and II only
E) I, II, and III
Answer: E
Explanation: E) All three are correct statements about leverage.
Diff: 2
Section: 2 Explore the Impact of Leverage on EPS and ROE
AACSB: Analytical Thinking
2) Suppose you were to draw a graph in which the horizontal axis gave possible EBIT figures, and the
vertical axis held values for EPS. If you were to compare the graphs for a levered firm versus an
unlevered firm, which of the following is true? There are no taxes.
A) The levered firm has a higher y-axis intercept and a lower slope value than does the unlevered firm.
B) The levered firm has a higher y-axis intercept and a higher slope value than does the unlevered firm.
C) The levered firm has a lower y-axis intercept and a higher slope value than does the unlevered firm.
D) The levered firm has a lower y-axis intercept and a lower slope value than does the unlevered firm.
E) The two graphs will be identical for the levered and unlevered firms.
Answer: C
Explanation: C) The levered EBIT-EPS line is steeper and has a lower y-axis intercept.
Diff: 3
Section: 2 Explore the Impact of Leverage on EPS and ROE
AACSB: Analytical Thinking
3) Fritz Electric wants to expand into PC repair for manufacturers like Dell and HP. Fritz needs $10
million to build the repair depot. Fritz has been approached by two investment bankers with plans for
financing the business: one is an all equity plan and the other is an equal mix of debt and equity. Fritz has
drawn an EPS-EBIT diagram to help choose between the two alternatives. If the expected EBIT is greater
than the indifferent point value, which capital structure would Fritz's shareholders prefer?
A) All equity
B) 50% debt/50% equity
C) They are the same at the indifference point
Answer: B
Explanation: B) The EBIT-EPS line is steeper for the leveraged capital structure, so EPS will be higher for
EBIT values above the indifference point. Shareholders prefer a higher EPS.
Diff: 2
Section: 2 Explore the Impact of Leverage on EPS and ROE
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4) Fritz Electric wants to expand into PC repair for manufacturers like Dell and HP. Fritz needs $10
million to build the repair depot. Fritz has been approached by two investment bankers with plans for
financing the business: one is an all equity plan and the other is an equal mix of debt and equity. Fritz has
drawn an EPS-EBIT diagram to help choose between the two alternatives. If the expected EBIT is lower
than the indifferent point value, which capital structure would Fritz's shareholders prefer?
A) All equity
B) 50% debt/50% equity
C) They are the same at the indifference point
Answer: A
Explanation: A) The EBIT-EPS line is steeper for the leveraged capital structure, so EPS will be lower for
EBIT values below the indifference point. Shareholders prefer a higher EPS, so they will want the all
equity capital structure.
Diff: 2
Section: 2 Explore the Impact of Leverage on EPS and ROE
AACSB: Analytical Thinking
5) Which of the following capital structures has the highest EBIT-EPS break-even point compared to an all
equity capital structure?
A) 25% debt/75% equity
B) 50% debt/50% equity
C) 75% debt/25% equity
D) 95% debt/5% equity
Answer: D
Explanation: D) The EBIT-EPS line is steeper the greater is the leverage so the indifference point is
higher. The capital structure with the greatest leverage has the highest indifference point.
Diff: 2
Section: 2 Explore the Impact of Leverage on EPS and ROE
AACSB: Analytical Thinking
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LO3: Determine the Optimal Capital Structure
1) According to M&M Proposition I (no taxes) can a firm change its market value by splitting its cash
flows into different proportions of dividends and interest? That is, by adjusting its capital structure but
not changing its productive capacity?
A) Yes
B) No
C) Yes, but only if shareholders use homemade leverage
D) No, because the interest tax shields remain unchanged
Answer: B
Explanation: B) M&M Proposition I (no taxes) shows that firm value is not affected by capital structure.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
2) According to M&M Proposition II (no taxes) stockholders require higher returns as their company
increases its leverage, and so the weighted average cost of capital also rises with leverage.
Answer: FALSE
Explanation: False. M&M Proposition II (no taxes) shows that the required return of shareholders rises
with leverage, but the weighted average cost of capital is constant and does not change with leverage.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
3) According to M&M Proposition II (with taxes) stockholders require higher returns as their company
increases its leverage but this is offset by the fact that the cost of debt is lower, and so the weighted
average cost of capital does not change with leverage.
Answer: FALSE
Explanation: False. M&M Proposition II (with taxes) shows that the required return of shareholders rises
with leverage, but it does not rise fast enough to offset the heavier weighting on cheap debt so the
weighted average cost of capital is falls as leverage increases.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
4) A capital structure that maximizes firm value will minimize the company's weighted average cost of
capital. Assume that there are corporate taxes.
Answer: TRUE
Explanation: True. With taxes, firm value and WACC are inversely related.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
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5) Reefer Trucking Inc. is an all equity firm that generates EBIT of $3 million annually in perpetuity
(starting in one year). Reefer shareholders require a return of 11%, and the corporate tax rate is 35%. What
is the market value of Reefer Trucking?
A) $12.19M
B) $17.73M
C) $23.52M
D) $27.27M
Answer: B
Explanation: B) VU = EBIT × (1- T)/kU
VU = 3(1- 0.35)/0.11 = 17.727M
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
6) Reefer Trucking Inc. is expected to generate EBIT of $3 million annually in perpetuity (starting in one
year). Reefer is all equity financed and shareholders require a return of 11%. The corporate tax rate is
35%. Reefer is proposing to issue $4 million of perpetual bonds with an annual coupon of 9%. Assume the
debt is used to repurchase stock and that Reefer never borrows more or repays its debts. What is the
market value of Reefer Trucking after the new debt issue?
A) $17.73M
B) $19.13M
C) $21.73M
D) $28.67M
Answer: B
Explanation: B) VL = VU + TD
VU = EBIT × (1 - T)/kU
VU = 3(1 - 0.35)/0.11 = 17.727M
VL = 17.727 + 0.35 × 4 = 19.127
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
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7) Reefer Trucking Inc. is expected to generate EBIT of $5 million annually in perpetuity (starting in one
year). Reefer is all equity financed and shareholders require a return of 11%. The corporate tax rate is
35%. Reefer is proposing to issue $5 million of perpetual bonds with an annual coupon of 6%. The
company uses the $5M of debt to repurchase stock at $15.65 per share. Assume that, after borrowing the
$5M, Reefer never increases or decreases its debts. What is the share price after the new debt issue?
A) $14.77
B) $15.07
C) $15.65
D) $15.82
Answer: C
Explanation: C) VU = 5 × (1 - 0.35)/0.11 = 29.5455
VL = VU + TD = 29.5455 + 5 × 0.35 = 31.2955M
EL = VL - D = 31.2955 - 5 = 26.2955
Shares Purchased = $5M/15.65 = 0.31949
SharesAFTER = 2M - 0.31949 = 1.68051M
PriceAFT = EL/1.68051M = 26.2955/1.68051M = $15.65
Diff: 3
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
8) Reefer Trucking Inc. is expected to generate EBIT of $6 million annually in perpetuity (starting in one
year). Reefer is all equity financed and shareholders require a return of 9%. The corporate tax rate is 35%.
Reefer is proposing to issue $5 million of perpetual bonds with an annual coupon of 6%. The company
uses the $5M of debt to repurchase stock. Assume that, after borrowing the $5M, Reefer never increases
or decreases its debts. What price should Reefer offer to repurchase shares such that the post-repurchase
price is equal to the repurchase price?
A) $21.74
B) $22.14
C) $22.54
D) $22.74
Answer: C
Explanation: C) PA = EL/NA
NA = NB - D/PA
PA = (VU + TD - D)/(NB - D/PA)
PA = VL /NB
VL = VU + TD
VU = EBIT × (1 - T)/kU
VU = 6 × (1 - 0.35)/0.09 = 43.333M
VL = 43.3333 + 0.35 × 5 = 45.0833
PA = 45.0833/2M = $22.54
Diff: 4
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
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9) Reefer Trucking Inc. is expected to generate EBIT of $8 million annually in perpetuity (starting in one
year). Reefer is all equity financed and shareholders require a return of 9%. The corporate tax rate is 35%.
There are 3 million shares outstanding. Reefer is proposing to borrow $10 million of perpetual debt which
it will never increase or repay. The company intends to use the borrowed funds to repurchase shares at a
price of $19.26. You are a shareholder in Reefer. When it announces the share buyback, will you offer to
sell the company any (all) of your shares?
A) Yes, I will sell all of my shares. $19.26 is the fair stock price.
B) Yes, I will sell the same proportion of shares (@16.3%) that the company buys.
C) No. A repurchase at the pre-announcement price does not affect shareholder wealth.
D) No. I should wait, because the increase in leverage will raise the stock price above $19.26.
Answer: D
Explanation: D) VU = EBIT × (1 - T)/kU
VU = 8 × (1 - 0.35)/0.09 = 57.7778M
PB = 57.7778/3M = $19.26
The proposed price is equal to the pre-announcement price, which is the unlevered value. The additional
leverage will increase the price, so it is best to hold your shares and sell after the repurchase at the higher
price ($20.43).
Diff: 3
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
10) Brick Aviation Inc. has no debt but can borrow at 6% if it needs to. The company's WACC is 12%. The
tax rate is 35%. What is the required return of the company's shareholders?
A) 7.8%
B) 9.0%
C) 12.0%
D) Not enough information
Answer: C
Explanation: C) Since the company is all equity financed, the required return of shareholders is equal to
the WACC.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
11) Brick Aviation Inc. has no debt but can borrow at 8% if it needs to. The shareholders require a return
of 15%. The tax rate is 35%. If the company borrows such that its debt-to-value (D/V) ratio is 25%, then
will its cost of equity be?
A) 15.9%
B) 16.1%
C) 16.3%
D) 16.5%
Answer: D
Explanation: D) kE = kU + [kU - kD] × (1 - T) × (D/E)
= 0.15 + [0.15 - 0.08] × (1 - 0.35) × 0.3333
= 0.1652
Diff: 2
Section: 3 Determine the Optimal Capital Structure
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12) According to M&M Proposition II (with taxes), the required return of shareholders is larger when
A) the tax rate, T, is larger.
B) when the required return of lenders, kD, is larger.
C) when the required return of unlevered shareholders, kU, is larger.
D) leverage (D/E) is lower.
Answer: C
Explanation: C) kE = kU + [kU - kD] × (1 - T) × (D/E)
kE rises when kU rises and when leverage (D/E) rises. It falls when T is larger or kD.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
13) According to M&M Proposition II (with taxes) the required return of shareholders is less sensitive to
leverage compared to the no tax case. In other words, the return required by shareholders rises by less for
a one unit increase in leverage compared to the no-tax case.
Answer: TRUE
Explanation: True. With taxes, the slope of the required return line (vis-à-vis D/E) is equal to (kU - kD) ×
(1 - T) which is smaller than the no-tax case when T > 0.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
14) According to M&M Proposition I and II (with taxes) the WACC ________ as the amount of debt
increases?
A) Increases
B) Decreases
Answer: B
Explanation: B) As leverage increases, firm value increases so the WACC must decrease.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
15) If you are a CFO who wants to maximize the market value of your company, what is the optimal D/V
ratio according to M&M Proposition I (with taxes).
A) It doesn't matter
B) D/V = 0
C) D/V = 1
D) D/V = ∞
Answer: C
Explanation: C) Under M&M Prop I (with taxes), as leverage increases, firm value increases. So the
optimal capital structure is total debt-financing or D/V = 1.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
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16) If you are a CFO who wants to maximize the market value of your company, what is the optimal D/V
ratio according to M&M Proposition I (with NO taxes).
A) It doesn't matter
B) D/V = 0
C) D/V = 1
D) D/V = ∞
Answer: A
Explanation: A) Under M&M Prop I (no taxes), as leverage increases, firm value is unchanged. So there is
no optimal capital structure—all capital structures are equal so the D/V ratio doesn't matter.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
17) When companies are near bankruptcy, their suppliers may no longer extend them credit fearing nonpayment. This increases the investment in net working capital at the distressed firm. This is an example
of a(n) ________ costs of financial distress.
A) Direct
B) Indirect
Answer: B
Explanation: B) Indirect cost. Court filing fees and lawyer fees are examples of direct bankruptcy costs.
Loss of credit from suppliers is an example of an indirect cost.
Diff: 1
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
18) When companies are near bankruptcy, key employees may resign to take jobs with more financially
secure employers. This is an example of a(n) ________ costs of financial distress.
A) Direct
B) Indirect
Answer: B
Explanation: B) Indirect cost. Court filing fees and lawyer fees are examples of direct bankruptcy costs.
Loss of key employees is an example of an indirect cost.
Diff: 1
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
19) If the assumption of financial distress costs is added, then Modigliani and Miller (with taxes) predicts
that the optimal capital structure is 100% debt.
Answer: FALSE
Explanation: False. Adding financial distress costs to M&M yields the static trade-off theory. The static
tradeoff theory predicts that firm value is maximized with a capital structure that is lower than D/V = 1.
Diff: 2
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20) The static tradeoff theory argues that the optimal capital structure is a tradeoff between a benefit and
a cost. What is the primary benefit?
A) The amplified expected return due to increased leverage
B) The tax shields from debt
C) The concentration of profit amongst a reduced set of shareholders
D) The reduction in waste of free cash flow
Answer: B
Explanation: B) The primary benefit of debt is the present value of the tax shields.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
21) The static tradeoff theory argues that the optimal capital structure is a tradeoff between a benefit and
a cost. What is the primary cost?
A) The increase in the expected costs of financial distress
B) The increased risk due to leverage
C) The increase in interest payments
D) The increased costs due to asymmetric information
Answer: A
Explanation: A) According to the static tradeoff theory, the primary cost of debt is increase in expected
financial distress costs.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
22) If the static trade-off theory is correct, then which of the following does NOT lead to a more leveraged
optimal capital structure?
A) High corporate tax rate
B) Lower financial distress costs
C) Greater agency benefits (i.e., reduced managerial waste of free cash flow) from debt
D) Greater agency costs from debt
Answer: D
Explanation: D) A higher tax rate increases the present value of tax shields and increases firm value.
Lower financial distress costs reduce the cost of bankruptcy and lead to a more leveraged optimal capital
structure. Increased agency benefits from debt makes debt more attractive and also increases the optimal
amount of leverage. Increased agency costs from debt make debt less attractive and lead to a lower
optimal leverage.
Diff: 2
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AACSB: Analytical Thinking
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23) The process by which ownership of a firm passes from the equity holders to the debtholders is
A) bankruptcy.
B) going private.
C) leveraged buyout.
D) recapitalization.
Answer: A
Explanation: A) In bankruptcy the firm's owners' claim becomes worthless and the lenders take control
of the assets.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
24) A company that cannot pay its debts but tries to continue operations and regain profitability (under
court supervision) is
A) reorganized.
B) liquidated.
C) distressed.
D) protected.
Answer: A
Explanation: A) Reorganized. A bankrupt company can use bankruptcy laws to reorganize its business
and try to become profitable again. Management continues to run the business but is closely supervised
by lenders and the bankruptcy court.
Diff: 2
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
25) A company that cannot pay its debts and has its assets sold is
A) reorganized.
B) liquidated.
C) distressed.
D) protected.
Answer: B
Explanation: B) Liquidated. A bankrupt company can cease operations and go out of business. The assets
are liquidated by a trustee, and the proceeds are used to pay off debt.
Diff: 1
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
26) When a company is bankrupt, which of the following stakeholders gets paid last?
A) Employees
B) Lawyers
C) Unsecured lenders
D) Common stockholders
Answer: D
Explanation: D) Common stockholders are the residual claimants to a firm and are paid last in the event
of bankruptcy.
Diff: 1
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
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27) One CEO buys a fleet of private jets for the company. Another CEO uses company funds to host a
birthday for his wife in Sardinia.. These are examples of
A) free cash flow problem.
B) asymmetric information problem.
C) ownership separation problem.
D) principal-agent problem.
Answer: D
Explanation: D) Consumption of perquisites is a symptom of the principal-agent problem. The problem
is that managers do not act in the best interest of shareholders (the agent).
Diff: 1
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
28) The theory that predicts that increased interest payments will reduce managerial waste is the
A) Jensen free cash flow theory.
B) Berle and Means separation of ownership and control theory.
C) Jensen and Meckling bondholder-stockholder agency conflict theory.
D) Jensen and Meckling owner-manager agency conflict theory.
Answer: A
Explanation: A) Michael Jensen (1986) argued that debt might be a mechanism for reducing the waste
associated with the principal-agent problem. Jensen argued that waste can only arise in companies that
have free cash flow. He argued that one way to stop the waste is to remove the cash from management's
discretion by paying it out as interest on debt.
Diff: 1
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
29) If a company is near bankruptcy and shareholders approve a long-shot project with a negative NPV
this is an example of
A) a direct cost of financial distress.
B) an indirect cost of financial distress.
C) an agency benefit of debt.
D) an agency cost of debt.
Answer: D
Explanation: D) Asset substitution is an agency cost of debt. Jensen and Meckling (1976) argue that
agency conflicts arise between owners and lenders. When leverage is high and bankruptcy likely,
stockholders have an incentive to accept projects that are long shots. Long shots are projects with a low
probability of a very high payoff. If the long shot pays off, then the stockholders capture most of the
gains, if it turns out badly, the lenders bear the costs (because they own the bankrupt company).
Diff: 2
Section: 3 Determine the Optimal Capital Structure
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30) Firm U has no debt, its shareholders require a return of 15%, and EBIT of $15,000 which is paid
annually in perpetuity starting in one year. Firm L is identical except it is partially financed by $20,000 of
perpetual bonds with an annual coupon of 10%. The tax rate is zero. What is the cost of equity for Firm
L?
A) 10.00%
B) 15.00%
C) 15.75%
D) 16.25%
E) 16.00%
Answer: D
Explanation: D) VU = $15,000/0.15 = $100,000
EL = VU - D = 100,000 - 20,000 = 80,000
D/E = 20,000/80,000 = 0.25
kE = kU + [kU - kD] × (D/E)
= 0.15 + [0.15 - 0.18] × 0.25
= 0.1625
Diff: 3
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
31) Analysts expect M&M Inc. to generate EBIT of $100,000 at the end of the current year. Earnings are
expected to remain constant in perpetuity. M&M has $100,000 of perpetual bonds outstanding with a
yield (and coupon) of 10%. M&M has 100,000 shares outstanding which trade for $4.4. The tax rate is 40%.
What is the WACC for M&M Inc.?
A) 10.00%
B) 11.11%
C) 11.75%
D) 12.00%
E) 12.27%
Answer: B
Explanation: B) Since VL = EBIT × (1 - T)/kW
kW = EBIT × (1 - T)/ VL
VL = E + D = $4.4 × 100,000 + 100,000 = 540,000
kW = 100,000 × (1- 0.4)/540,000 = 0.11111
Diff: 3
Section: 3 Determine the Optimal Capital Structure
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32) In November of 1988, KKR, an investment firm, won a bidding war to buy all of the shares (250
million) of RJR Nabisco for $108 per share. RJR shares had been trading for $55 prior to the buyout. The
purchase was debt financed ($27 billion). The new debt was added to the $4.5 billion of debt that
predated the buyout. KKR intended to hold the debt of RJR constant at that level (in dollar terms) in
perpetuity. Analysts expected RJR to generate free cash flow of $1.41 billion in the year after the buyout.
Assume that cash flows occur on Dec 31 and today is January 1. Analysts expected RJR's cash flow to
grow at 5% in perpetuity. RJR's cost of debt was 10% and its cost of unlevered equity was 12%. The tax
rate was 40%. What was the value of KKR's equity in the company after the buyout?
A) $343 million
B) $543 million
C) $943 million
D) $1,243 million
Answer: D
Explanation: D) New debt is equal to cost of buyout:
$108 × 250 million shares = $27,000 million
Total Debt after buyout:
D = $27,066.096 + $4,500 = $31,500
The value of the company is (by M&M Prop I with taxes):
VL = VU + PVTS = VU + TD
VL = FCF/(kU - g) +TD
Where
FCF= Free Cash Flow
kU = required return of unlevered shareholders
T = tax rate = 40%
g = annual growth rate of free cash flow = 0.05
VL = 1,410/(0.12 - 0.05) + 0.4 × $31,500
VL = $32,742.857
E = VL - D = $32,742.857 - $31,500 = $1,242.857 million
Diff: 3
Section: 3 Determine the Optimal Capital Structure
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 13 Dividends, Repurchases and Splits
LO1: Explain Distributions
1) Over the last thirty years, the trend (in the U.S.) has been that a bigger proportion of firms pay
dividends every year.
Answer: FALSE
Explanation: False. Over the last 30 years the proportion of companies paying dividends has declined.
Diff: 1
Section: 1 Distributions
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AACSB: Analytical Thinking
2) On average, companies increase their repurchases when the economy is strong and decrease them
when the economy is weak but they tend not to change their dividends through the business cycle.
Answer: TRUE
Explanation: True. Over time, aggregate dividends have generally risen, but aggregate repurchases rise
and fall with the business cycle.
Diff: 1
Section: 1 Distributions
AACSB: Analytical Thinking
3) Which of the following is a correct statement about the distribution of the dollar value of dividends
across firms that pay dividends?
A) Dividends are equally distributed across firms. i.e., the top 10% of firms pay 10% of all dividends.
B) Dividends are quite concentrated with the top 10% of firms accounting for one third of all dividends.
Answer: B
Explanation: B) DeAngelo, DeAngelo and Skinner find that a small number of companies pay most of the
dividends.
Diff: 2
Section: 1 Distributions
AACSB: Analytical Thinking
4) If taxes on dividends rise and taxes on capital gains fall, then you would expect some firms to reduce
their stock repurchases and increase their dividends.
Answer: FALSE
Explanation: False. If taxes on dividends rise, then their will be a smaller dividend clientele and
companies will reduce dividends and increase stock repurchases.
Diff: 2
Section: 1 Distributions
AACSB: Analytical Thinking
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5)
Refer to the table of marginal tax rates by income bracket. Assume that shareholders can choose the form
in which they receive income from their company: as a capital gain or as a dividend. If investors want to
maximize their after-tax income, then what types of investors prefer dividends?
A) A & B
B) C & D
C) E & F
D) A only
E) F only
Answer: A
Explanation: A) Investor types A and B have lower marginal tax rates on dividends than on capital gains
and so will prefer dividends over capital gains.
Diff: 2
Section: 1 Distributions
AACSB: Analytical Thinking
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6)
Refer to the table of marginal tax rates by income bracket. Assume that shareholders can choose the form
in which they receive income from their company: as a capital gain or as a dividend. If investors want to
maximize their after-tax income, then what types of investors prefer capital gains?
A) A & B
B) C & D
C) E & F
D) A only
E) F only
Answer: C
Explanation: C) Investor types E and F have lower marginal tax rates on capital gains than on dividends
and so will prefer capital gains over dividends.
Diff: 2
Section: 1 Distributions
AACSB: Analytical Thinking
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7)
Refer to the table of marginal tax rates by income bracket. Assume that shareholders can choose the form
in which they receive income from their company: as a capital gain or as a dividend. If investors want to
maximize their after-tax income, then what types of investors don't care whether it is dividends or capital
gains?
A) A & B
B) C & D
C) E & F
D) A only
E) F only
Answer: B
Explanation: B) Investor types C and D have the same marginal tax rates on capital gains and dividends
and so will have the same after-tax income regardless of which type of distribution they receive.
Diff: 2
Section: 1 Distributions
AACSB: Analytical Thinking
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8) Last week Lucky Strike Inc. was worth $100M and its shares traded for $10 (there are 10 million shares
outstanding). Lucky is an all equity firm. Yesterday Lucky management announced that the company
won $20 million in the lottery and the stock price rose to $12. Lucky is trying to decide whether to issue a
$2 dividend or repurchase 1.667 million shares for $12 each. You own 100 shares of Lucky Strike. If your
marginal tax rate on dividends is 15% and 25% on capital gains, what do you want the company to do?
Assume that you bought your shares last week and will sell your shares after the dividend or repurchase.
(Hint: Compare your after-tax wealth in each case.)
A) Repurchase stock because after tax wealth is $1,170
B) Issue the dividend because after tax wealth is $1,170
C) Repurchase stock because after tax wealth is $1,190
D) Issue the dividend because after tax wealth is $1,190
Answer: B
Explanation: B) TD = 0.15 and TG = 0.25
After-tax wealth after div:
WA = Div + capital gain + investment - taxes
WA = 100 × $2 + 100 × (PA - PB) + 100 × PB - (100 × $2 × TD - 100 × (PA - PB) × TG)
WA = 100 × $2 × (1 - TD) + 100 × (PA - PB) × (1-TG) + 100 × PB
PA = $10 due to the $2 dividend.
WA = 200 × 0.85 + 100 × 0 × 0.75 + 100 × $10
WA = 170 + 1,000 = $1,170
After-tax wealth after repurchase:
WA = capital gain + investment - taxes
WA = 100 × (PA - PB) + 100 × PB - (100 × (PA - PB) × TG)
WA = 100 × (PA - PB) × (1 - TG) + 100 × PB
PA = $12 after a $12 repurchase.
WA = 100 × ($12 - $10) × 0.75 + 100 × $10
WA = 150 + 1,000 = $1,150
After-tax wealth higher with dividend.
Diff: 3
Section: 1 Distributions
AACSB: Analytical Thinking
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9) Last week Lucky Strike Inc. was worth $100M and its shares traded for $10 (there are 10 million shares
outstanding). Lucky is an all equity firm. Yesterday Lucky management announced that the company
won $20 million in the lottery and the stock price rose to $12. Lucky is trying to decide whether to issue a
$2 dividend or repurchase 1.667 million shares for $12 each. You own 100 shares of Lucky Strike. If your
marginal tax rate on dividends is 25% and 15% on capital gains, what do you want the company to do?
Assume that you bought your shares last week and will sell your shares after the dividend or repurchase.
(Hint: Compare your after-tax wealth in each case.)
A) Repurchase stock because after tax wealth is $1,170
B) Issue the dividend because after tax wealth is $1,170
C) Repurchase stock because after tax wealth is $1,190
D) Issue the dividend because after tax wealth is $1,190
Answer: A
Explanation: A) TD = 0.25 and TG = 0.15
After-tax wealth after div:
WA = Div + capital gain + investment - taxes
WA = 100 × $2 + 100 × (PA - PB) + 100 × PB - (100 × $2 × TD - 100 × (PA - PB) × TG)
WA = 100 × $2 × (1 - TD) + 100 × (PA - PB) × (1-TG) + 100 × PB
PA = $10 due to the $2 dividend.
WA = 200 × 0.75 + 100 × 0 × 0.85 + $10 × 100
WA = 150 + 1,000 = $1,150
After-tax wealth after repurchase:
WA = capital gain + investment - taxes
WA = 100 × (PA - PB) + 100 × PB - (100 × (PA - PB) × TG)
WA = 100 × (PA - PB) × (1 - TG) + 100 × PB
PA = $12 after a $12 repurchase.
WA = 100 × ($12 - $10) × 0.85 + 100 × $10
WA = 170 + 1,000 = $1,170
After-tax wealth higher with repurchase.
Diff: 3
Section: 1 Distributions
AACSB: Analytical Thinking
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LO2: Explain Dividends
1) The cum-dividend day is three days before the date of record, because of the 3-day settlement delay for
stocks.
Answer: TRUE
Explanation: True. Stock transactions are settled in three business days. If a stock is purchased three days
before the day of record, then the buyer will be an owner of record on the day of record and so will
receive the dividend. Thus, the last cum-dividend day is three business days before the day of record.
Diff: 1
Section: 2 Dividends
AACSB: Analytical Thinking
2) If there are no taxes, then dividend policy is irrelevant in the sense that dividends do not affect investor
wealth.
Answer: TRUE
Explanation: True. Modigliani and Modigliani & Miller argue that dividend policy is irrelevant. In
perfect world, dividends have no impact on investor wealth. Investors can create "home made dividends"
by selling off a small part of the stock they own, or undo dividends by reinvesting the dividend cash. To
make the irrelevance argument, M&M assume perfect markets. That is, no taxes, no asymmetric
information, and no transaction costs (no agency problems).
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
3) Modigliani and Miller argued that dividends are irrelevant. According to their argument, dividends
are irrelevant because
A) the stock price is unaffected by a dividend.
B) the value of the company's equity is unaffected by dividends.
C) shareholder wealth is unaffected by dividends.
D) shares outstanding is unaffected by dividends.
Answer: C
Explanation: C) True. Modigliani and Modigliani & Miller argue that dividend policy is irrelevant. In
perfect world, dividends have no impact on investor wealth. Investors can create "home made dividends"
by selling off a small part of the stock they own, or undo dividends by reinvesting the dividend cash.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
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4) Omni Consumer Products just announced a dividend of $0.50 with a day of record on Friday, May 15.
What is the ex-dividend day?
A) May 12
B) May 13
C) May 14
D) May 15
Answer: B
Explanation: B) The ex-dividend day is two business days before the day of record. The day of record is
Friday, so the ex-dividend day is Wednesday, May 13.
Diff: 1
Section: 2 Dividends
AACSB: Analytical Thinking
5) Cyberdyne Systems just announced a dividend of $0.25 with a day of record on Monday Dec 28. What
is the cum-dividend day?
A) Dec 21
B) Dec 22
C) Dec 23
D) Dec 24
Answer: B
Explanation: B) The cum-dividend day is three business days before the day of record. Friday Dec 25 is
Christmas day, a statutory holiday, so the first business day prior is Thursday Dec 24 and the last cum
dividend day is Tuesday Dec 22.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
6) Karkas Cold Cuts Inc. has $20 of cash and analysts expect the company to generate $10 of free cash
flow at the end of the current year. The same amount of free cash is expected annually in perpetuity.
Karkas is all equity financed and stock holders require a return of 10%. There are 200 shares outstanding.
Karkas is considering a cash dividend of $0.10 per share. If it pays the dividend, then what will the stock
price be after the dividend?
A) $0.30
B) $0.40
C) $0.50
D) $0.60
Answer: C
Explanation: C) VA = $10/0.1 = $100
PA = VA /N = $100/200 = $0.5
Diff: 3
Section: 2 Dividends
AACSB: Analytical Thinking
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7) When a company pays a dividend the stock price falls by the amount of the dividend. (Assume perfect
markets and no taxes.)
Answer: TRUE
Explanation: True. The stock price falls on the morning of the ex-dividend day, because the buyer will
not receive the upcoming dividend.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
8) When a company pays a dividend the stock price falls by the amount of the dividend on the morning
of the cum-dividend day.
Answer: FALSE
Explanation: False. The stock price falls on the morning of the ex-dividend day, because the buyer will
not receive the upcoming dividend.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
9) The date on which shareholders are registered to receive an upcoming dividend is called the
A) Ex-Dividend Day.
B) Cum-Dividend Day.
C) Day of Record.
D) Payment Day.
E) Dividend Announcement Day.
Answer: C
Explanation: C) The day on which the list of dividend recipients is created. Registered owners on the
date of record receive the dividend.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
10) You can make a profit (equal to the dividend) by short-selling a stock prior to the ex-dividend day.
Assume that you buy on the ex-dividend day and that there are no taxes.
Answer: FALSE
Explanation: False. The stock price does fall by the amount of the dividend, but the short-seller must pay
the lender of the stock an amount equal to the dividend, so the net profit is zero.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
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11) D Rail Inc. paid a quarterly dividend of $0.365 last quarter on earnings of $0.60. D Rail has a target
payout ratio of 60%. The company uses the Target Payout Model to set its quarterly dividend with an
adjustment factor of 0.006. The CFO of D Rail expects earnings of $0.65 next quarter. What dividend will
it pay?
A) $0.3650
B) $0.3651
C) $0.3652
D) $0.3653
Answer: C
Explanation: C) Dt+1 = Dt + Pay * Lambda * Change in EPS
Dt+1 = 0.365 + 0.6 * (0.006) * (0.65 - 0.6) = 0.36518
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
12) Boren Shaft Inc. is a copper mining company with operations in Indonesia, Mongolia and Chile. Boren
Shaft uses the residual dividend model to set its dividends. Which of the following best describes the
pattern of Boren's dividends over time?
A) Dividends increase slowly and stably over time
B) Dividends fluctuate with copper prices over time
C) Dividends fluctuate with copper prices and new discoveries of copper
D) Dividends are fixed so that no negative signal is sent
Answer: C
Explanation: C) Copper prices would affect net income and so dividends (all else held constant). New
discoveries would require additional capex which would reduce dividends under the residual model.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
13) The policy whereby a firm sets its dividends based on its earnings, its capital budget and its capital
structure is called the
A) the Residual Dividend Policy.
B) the Stable Dividend Policy.
C) the Target-Payout Policy.
D) the Free Cash Flow Dividend Policy.
E) the Lintner Dividend Policy.
Answer: A
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
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14) When a company announces an increase in its dividend, then the stock price typically increases.
Which of the following is (are) a correct reason for the increase?
I. The increase signals that management thinks that future earnings will be higher than the market
previously estimated.
II. The increase reduces free cash flow and so reduces managerial waste.
III. Stockholders prefer companies with greater payouts.
A) I only
B) II only
C) III only
D) I and II
E) II and III
Answer: D
Explanation: D) A is the signaling hypothesis and B is Jensen's free cash flow hypothesis. Both predict an
increase in the stock price following a dividend increase.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
15) Mega Corp. just raised its quarterly dividend from $0.45 per share to $0.475. On the day of the
announcement, the company's stock price rose by $2 from $50 to $52. Which of the following is NOT a
good reason for the stock price increase?
A) Mega's recent earnings had been increasing and the market inferred from the dividend that the
earnings increases would not be reversed.
B) The CEO of Mega is a big spender and the market inferred that the dividend increase would reduce his
wasteful spending by reducing free cash flow.
C) The market inferred that Mega's future sustainable earnings would be higher than it previously
thought.
D) The higher dividends increased the dividend tax shields.
Answer: D
Explanation: D) The first answer is consistent with Koch and Sun, Journal of Finance (2004) who find that
dividend increases signal that past earnings increases will not be reversed in the future. The second is
consistent with Jensens' free cash flow hypothesis. The third is consistent with the dividend signaling
hypothesis (i.e., Miller and Rock, Journal of Finance (1985). The last is incorrect, as dividends are not tax
deductible.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
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16) Which of the following is NOT true about a cash dividend?
A) The cash account may fall
B) Shares outstanding will remain unchanged
C) Retained earnings will be lower than otherwise
D) Net Income will fall
Answer: D
Explanation: D) Net income is not affected by a cash dividend.
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
17) Lazy Lightning Power Corp. manufactures, distributes, and services automotive parts and engines
worldwide. Lazy's income statement for the year just ending is shown below. What was Lazy Lightning's
dividend payout rate?
A) 12.79%
B) 13.07%
C) 14.80%
D) 17.50%
E) 19.55%
Answer: E
Explanation: E) Payout Rate = Total Common Dividends/Net Income
Payout Rate = 290.5/1,456
Payout Rate = 0.1995 or 19.55%
Diff: 1
Section: 2 Dividends
AACSB: Analytical Thinking
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18) Today is January 1 and shares of Lazy Lightning Power Corp. are trading at a price of $88. In its most
recent Management Discussion and Analysis (MD&A) Lazy's management forecast earnings-per-share of
$7.5 for the year-end on Dec 31. If Lazy maintains its 17.62% payout ratio, then what is the dividend yield
(based on forecasted earnings)?
A) 0.88%
B) 1.32%
C) 1.51%
D) 1.76%
E) 2.62%
Answer: C
Explanation: C) Dividend per share = Payout Rate × EPS
Dividend per share = 0.1762 × $7.5
Dividend per share = $1.3215
Dividend Yield = Dividend per share/Stock Price
Dividend Yield = 1.3215/88
Dividend Yield = 0.01507 or 1.51%
Diff: 2
Section: 2 Dividends
AACSB: Analytical Thinking
LO3: Explain Stock Repurchases
1) A repurchase causes the stock price to rise because the number of shares outstanding falls and earnings
per share rises.
Answer: FALSE
Explanation: False: The stock price will rise after a repurchase at a discount (to the pre-announcement
price), or if the repurchase moves the firm closer to its optimal capital structure or if there is an
information effect. The simple reduction in shares outstanding does not, by itself, affect the stock price.
Diff: 3
Section: 3 Stock Repurchases
AACSB: Analytical Thinking
2) Which is the most common type of stock repurchase?
A) Open Market
B) Fixed Price
C) Dutch Auction
D) English Auction
Answer: A
Explanation: A) Open market repurchases are the most common type.
Diff: 1
Section: 3 Stock Repurchases
AACSB: Analytical Thinking
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3) Which type of stock repurchase gives stockholders the highest premium, on average, for their tendered
shares?
A) Open Market
B) Fixed Price
C) Dutch Auction
D) English Auction
Answer: B
Explanation: B) Fixed price repurchases feature the highest premium for repurchased shares.
Diff: 1
Section: 3 Stock Repurchases
AACSB: Analytical Thinking
4) When a company buys back shares at a price above the fair value (P R > PB), then the price rises after
the repurchase is complete. Assume an all equity company and no information effects.
Answer: FALSE
Explanation: False: A premium repurchase causes the stock price to fall after the repurchase.
Diff: 2
Section: 3 Stock Repurchases
AACSB: Analytical Thinking
5) When a company buys back shares at a price equal to fair value (P R = PB), then the price remains
unchanged after the repurchase. Assume an all equity company and no information effects.
Answer: TRUE
Explanation: True: A repurchase at the pre-announcement price leaves the stock price unaffected.
Diff: 2
Section: 3 Stock Repurchases
AACSB: Analytical Thinking
6) When a company buys back shares at a price below the pre-announcement level (PR < PB), then the
price rises after the repurchase is complete and wealth is transferred from those who hold their shares to
those that tender shares. Assume an all equity company and no information effects.
Answer: FALSE
Explanation: False: A discount repurchase causes the stock price to rise after the repurchase, but this
benefits those who hold at the expense of those who sell shares.
Diff: 2
Section: 3 Stock Repurchases
AACSB: Analytical Thinking
7) If your company executes a stock repurchase and you sell the same proportion of shares as the
company buys back (for the same price they pay), then your wealth is unaffected by the repurchase.
Assume an all equity company and no information effects.
Answer: TRUE
Explanation: True: The loss (gain) from a discount (premium) repurchase is offset by equal (and
opposite) change in the value of the remaining shares. Total wealth remains the same.
Diff: 3
Section: 3 Stock Repurchases
AACSB: Analytical Thinking
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LO4: Explain Stock Splits
1) Wayne Enterprises has 300 shares outstanding. It has announced a 3-for-2 split. What is the split ratio
and how many shares will be outstanding after the split?
A) S = 0.5. ShroutA = 100
B) S = 0.67. ShroutA = 200
C) S = 1.5. ShroutA = 450
D) S = 1.33. ShroutA = 400
Answer: C
Explanation: C) S = 450/300 = 3/2 = 1.5
Shares OutAfter = 3/2 × 300 = 450
Diff: 2
Section: 4 Stock Dividends and Splits
AACSB: Analytical Thinking
2) GloboChem has 1,000 shares outstanding. It has announced a 1-for-5 split. How many shares will be
outstanding after the split?
A) 200
B) 1,000
C) 2,000
D) 5,000
Answer: A
Explanation: A) Shares OutAfter = 1/5 × 1,000 = 200
Diff: 2
Section: 4 Stock Dividends and Splits
AACSB: Analytical Thinking
3) Initech Inc. has 100 shares outstanding, which are trading for $90. Initech's CFO believes that the $90
stock price makes the stock too expensive for retail investor, since buying a board lot requires an
investment of $9,000. To lower the price, Initech has announced a 2-for-1 stock split. What is the price
after the split?
A) $45
B) $90
C) $100
D) $180
Answer: A
Explanation: A) S = 2/1 = 2
PA = PB/S = $90/2 = $45
Diff: 2
Section: 4 Stock Dividends and Splits
AACSB: Analytical Thinking
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4) Which of the following will NOT reduce the share price? Assume an all equity firm and no
information, agency or leverage effects.
A) A cash dividend
B) A stock repurchase at a price that is less than the pre-announcement price
C) A 2-1 stock split (Split ratio = 2)
D) A stock dividend
Answer: B
Explanation: B) A repurchase at a discount to the pre-announcement price will cause the stock price to
rise after the repurchase.
Diff: 3
Section: 4 Stock Dividends and Splits
AACSB: Analytical Thinking
5) Berkshire Hathaway B shares are trading for $125. Warren Buffett thinks that this price is too low and
is attracting too many uninformed, short-term investors. What is the best way for Warren to increase the
stock price?
A) A stock repurchase on a day when the price is 10% below its fair value.
B) A cash dividend
C) A stock dividend
D) A 1-for-10 (S = 0.10) reverse split
Answer: D
Explanation: D) A stock repurchase at a price below the pre-announcement price will cause the stock
price to rise (after the repurchase) but only by a small amount. A cash dividend will cause the stock price
to fall. A stock dividend will cause the stock price to fall. A 1-for-10 reverse split will cause the price to
rise tenfold.
Diff: 3
Section: 4 Stock Dividends and Splits
AACSB: Analytical Thinking
6) Cashstrapped Inc. has no cash and no borrowing capacity but it wants to make a distribution to its
shareholders to signal that earnings will be higher in the future. Which of the following is its best choice?
A) A cash dividend
B) An open market stock repurchase
C) A dutch auction stock repurchase
D) A stock dividend
E) An extra dividend
Answer: D
Explanation: D) A stock dividend requires no cash.
Diff: 2
Section: 4 Stock Dividends and Splits
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7) The NASDAQ exchange listing requirements state that a company's stock price must remain above $5
or else the company is considered a Penny Stock. RoadKill Restaurants Inc. is listed on the NASDAQ and
is currently trading for $5.10. What should Roadkill do to raise its price? (Ignore any information
signaling effects of these actions.)
A) A stock split
B) A reverse stock split
C) A cash dividend
D) A stock repurchase
E) A stock dividend
Answer: B
Explanation: B) A reverse stock split will reduce shares outstanding and so increase the stock price.
Diff: 2
Section: 4 Stock Dividends and Splits
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 14 Financial Planning
LO1: Learn How to Forecast Sales
1) There are no questions in this section.
AACSB: Analytical Thinking
LO2: Learn How to Forecast Cash Sources and Uses
1) Windy City Kite Company has prepared sales forecasts for the beginning of Year 3 as shown in the top
row of the table. Half of Windy City's kite sales are cash and the other half are credit. Windy City collects
credit sales the month following the credit sale. What are Windy City's total cash inflows from customers
for January?
Windy City Kite Company
Sales Forecast and Collections Forecast
December
January
Sales Forecast
$1,100
$1,000
Cash Collections
Collections from Sales
last month
Total Cash Inflows
February
$2,000
A) $500
B) $550
C) $1,000
D) $1,050
Answer: D
Explanation: D) Collections in January = 0.5 × December Sales + 0.5 × January Sales
Collections in January = 0.5 × $1,100 + 0.5 × $1,000
453
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Collections in January = $550 + $500 = $1,050
Diff: 2
Section: 2
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2) Windy City Kite Company has prepared sales forecasts for the first quarter of Year 3 as shown in the
top row of the table. Half of Windy City's kite sales are cash and the other half are credit. Windy City
collects credit sales the month following the credit sale. How much of the total January collections from
customers are from January sales?
Windy City Kite Company
Sales Forecast and Collections Forecast
December
January
Sales Forecast
$1,100
$1,000
Cash Collections
Collections from Sales
last month
Total Cash Inflows
February
$2,000
A) $0
B) $500
C) $750
D) $1,000
E) $1,050
Answer: B
Explanation: B) As stated in the question, half of Windy City's monthly sales are cash. Therefore, half of
January's $1,000 in sales would be collected in that month.
Collections from January Sales = $1,000 × 0.5 = $500
Diff: 2
Section: 2
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3) Gyrl Skateboards manufactures skateboard decks. Guy Gyrl, the CEO, is forecasting cash flows for the
next few months. Forecasted sales are shown on the top row of the table. Gyrl's sales are 25% cash and the
rest are credit. It collects two-thirds of the credit sales in the month following the sale, and the remainder
two months later. What are Gyrl's forecasted total cash inflows in December?
Gyrl Skateboards Inc.
Sales Forecast and Collections Forecast ($000s)
October
November
December
Sales Forecast
$2,600
$2,700
$2,950
Cash Sales
Collections from last
month
Collections from 2
months ago
Total Cash Inflows
A) $2,700,000
B) $2,713,000
C) $2,738,000
D) $2,888,000
E) $2,950,000
Answer: C
Explanation: C) Collections in December = 0.25 × Dec. Sales + 0.5 × Nov. Sales + 0.25 × Oct. Sales
Collections in December = 0.25 × $2,950 + 0.5 × $2,700 + 0.25 × $2,600
Collections in December = $738 + $1350 + $650 = $2,738
Diff: 2
Section: 2
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4) Windy City Kite Company has prepared sales forecasts for the first quarter of Year 3 as shown in the
top row of the table. Half of Windy City's kite sales are cash and the other half are credit. Windy City
collects credit sales the month following the credit sale. What are Windy City's ending accounts
receivable in February?
Windy City Kite Company
Sales Forecast and Collections Forecast
December
January
Sales Forecast
$1,100
$1,000
Cash Collections
Collections from Sales
last month
Total Cash Inflows
Beginning accounts
receivable
Ending accounts
receivable
550
February
$2,000
500
$500
A) $500
B) $1,000
C) $1,250
D) $1,500
E) $2,500
Answer: B
Explanation: B) Ending Accounts Receivable in February = Beginning A/R + Sales - Collections
Ending Accounts Receivable in February = $500 + 2000 - $1500 = $1,000
Diff: 2
Section: 2
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5) Giant Koala Stores Inc. has forecasted sales for July and August in the top row of the table. Giant Koala
makes 85% of its sales for cash and the remainder on credit. The credit sales are collected one month after
the sale. What are Giant Koala's forecasted total cash inflows in August?
Sales Forecast and Cash Collections
Giant Koala Stores Inc. ($000,000)
July
August
Sales Forecast
$18.000
$18.000
Cash Sales
15.300
Collections from last
month
Total Cash Inflows
A) $17 million
B) $18 million
C) $19 million
D) $21.15 million
E) $21.4 million
Answer: B
Explanation: B) Collections in August = 0.85 × August Sales + 0.15 × July Sales
Collections in August = 0.85 × $18+ 0.15 × $18 = $18
Diff: 2
Section: 2
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6) Giant Koala Stores Inc. has forecasted sales for July through October in the top row of the table.
Purchases are 65% of sales. All purchases are made one month in advance of the sale. Ten percent (10%)
of suppliers are paid in the month of purchase and the remainder are paid in the following month. What
are Giant Koala's purchases in September?
Sales and Purchase Forecast
Giant Koala Stores Inc. ($000,000)
July
August September
$18.000
$18.000
$22.000
Sales Forecast
Purchases from
Suppliers
Payments to Suppliers
Payments to Suppliers
from last Month
11.700
1.170
October
$21.000
14.300
1.430
12.870
A) $11.7 million
B) $13.7 million
C) $14.3 million
D) $15.4 million
E) $15.5 million
Answer: B
Explanation: B) As stated in the question, all purchases are made one month in advance and are 65% of
sales.
Purchases in September = 0.65 × October Sales
Purchases in September = 0.65 × $21
Purchases in September = $13.65
Diff: 2
Section: 2
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7) Gyrl Skateboards manufactures skateboard decks. Guy Gyrl, the CEO, is forecasting cash flows for the
next few months. Forecasted sales are shown on the top row of the table. Gyrl's cost of goods sold is
81.2% of sales. Gyrl buys its raw materials one month prior to the sale of the finished product. It pays for
half of its raw materials in the same month as the purchase and half in the following month. What are
Gyrl's purchases in January?
Gyrl Skateboards Inc.
Sales and Purchase Forecast ($000s)
November December January
$2,700
$2,950
$2,545
Sales Forecast
Purchases from
Suppliers
Payments to Suppliers
Payments one month
after
February
$2,795
A) $2,067,000
B) $2,150,000
C) $2,225,000
D) $2,270,000
E) $2,395,000
Answer: D
Explanation: D) As stated in the question, all purchases are made one month in advance and are 81.2% of
sales.
Purchases in January = 0.812 × February Sales
Purchases in January = 0.812 × $2,795
Purchases in January = $2,270
Diff: 2
Section: 2
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8) Gyrl Skateboards manufactures skateboard decks. Guy Gyrl, the CEO, is forecasting cash flows for the
next few months. Forecasted sales are shown on the top row of the table. Gyrl's cost of goods sold is
81.2% of sales. Gyrl buys its raw materials one month prior to the sale of the finished product. It pays for
half of its raw materials in the same month as the purchase and half in the following month. What are
Gyrl's total payments to suppliers in January?
Gyrl Skateboards Inc.
Sales and Payments Forecast ($000s)
November December January
$2,700
$2,950
$2,545
Sales Forecast
Purchases from
Suppliers
Payments to Suppliers
Payments one month
after
Total Payments to
Suppliers
February
$2,795
A) $2,050,000
B) $2,168,000
C) $2,270,000
D) $2,568,000
E) $2,757,000
Answer: B
Explanation: B) Payments to suppliers in January = 0.50 × January Purchases + 0.50 × December
Purchases
Purchases in December = 0.812 × January Sales
Purchases in December = 0.812 × $2,545 = $2,067
Purchases in January = 0.812 × February Sales
Purchases in January = 0.812 × $2,795 = $2,270
Payments to suppliers in January = 0.50 × $2,270 + 0.50 × $2,067
Payments to suppliers in January = $1,135 + $1,033 = $2,168
Diff: 2
Section: 2
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9) Gyrl Skateboards manufactures skateboard decks. Guy Gyrl, the CEO, is forecasting cash flows for the
next few months. Forecasted sales are shown on the top row of the table. Forecasted cash inflows and
outflows are also shown in the table. If Gyrl's starts December with $50,000 of cash in the bank, then what
will its cash balance be at the end of January?
Gyrl Skateboards Inc.
Sales Forecast and Cash Budget ($000s)
December
January
Sales forecast
$4,425
$3,818
Total Cash inflows
4,106
4,179
Total Cash Outflows
3,877
3,710
Net cash flow
Beginning Cash
Balance
$50
Plus: Net Cash Flows
Ending Cash Balance
February
$4,193
4,063
4,638
A) $229,000
B) $521,000
C) $469,000
D) $698,000
E) $748,000
Answer: E
Explanation: E) Net Cash Flows = Cash Inflows - Cash Outflows
Net Cash Flows December = 4,106 - 3,877 = $229
Net Cash Flows January = 4,179 - 3,710 = $469
Cash Balance at the End of Dec. = Cash Balance, Start of Dec. + Net Cash Flows for Dec.
Cash Balance at the End of Dec. = $50 + $229
Cash Balance at the End of Dec. = $279
Cash Balance at the End of January = Cash Balance, Start of Jan. + Net Cash Flows for Jan.
Cash Balance at the End of January = $279 + $469
Cash Balance at the End of January = $748 or $748,000
Diff: 2
Section: 2
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10) Giant Koala Stores Inc. has forecasted sales for July through October in the top row of the table.
Purchases are 65% of sales. All purchases are made one month in advance of the sale. Ten percent (10%)
of suppliers are paid in the month of purchase and the remainder are paid in the following month. What
are Giant Koala's payments to suppliers in September?
Sales Forecast, Purchases and Payments to Suppliers
Giant Koala Stores Inc. ($000,000)
July
August September October
Sales Forecast
$18.000
$18.000
$22.000
$21.000
Purchases from
Suppliers
11.700
14.300
Payments to Suppliers
1.170
1.430
Payments to Suppliers
from last Month
12.870
Total Payments to
Suppliers
A) $11.313 million
B) $11.625 million
C) $12.456 million
D) $14.235 million
E) $15.4 million
Answer: D
Explanation: D) Payments to suppliers in September = 0.10 × September Purchases + 0.90 × August
Purchases
Payments to suppliers in September = 0.10 × $13.65 + 0.90 × 14.3
Payments to suppliers in September = $1.365 + $12.87 = $14.235
Diff: 2
Section: 2
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11) Giant Koala Stores Inc. has forecasted sales for July through October in the top row of the table.
Forecasted collections from cash and credit sales as well as forecasted payments to suppliers are also
shown in the table. Wages, general & administrative expenses are 28% of the current month's sales. Giant
Koala starts August with a cash balance of $7.61M. What is the cash balance at the end of September?
Sales Forecast and Cash Budget
Giant Koala Stores Inc. ($000,000)
July
August September
Sales Forecast
$27.000
$27.000
$33.000
Cash Sales
15.300
22.950
28.050
Collections from last
Month
4.050
4.050
Total Cash Inflows
27.000
32.100
Total Payments to
Suppliers
17.940
21.418
Wages, General &
Admin Expenses
7.560
7.560
9.240
Total Disbursements
25.500
30.658
Net Cash Flows
Beginning cash
balance
$7.610
Plus: Net Cash Flows
Ending cash Balance
October
$32.500
27.625
4.950
32.575
A) $7.61 million
B) $8.61 million
C) $9.11 million
D) $10.55 million
E) $11.62 million
Answer: D
Explanation: D) Net Cash Flows = Cash Inflows - Payments to Suppliers - Wages, etc…
Net Cash Flows August = 27 - 17.94 - 7.56 = 1.5
Net Cash Flows September = 32.1 - 21.418 - 9.24 = 1.443
Cash Balance at the End of August = Cash Balance, Start of Aug. + Net Cash Flows for Aug.
Cash Balance at the End of August = $7.61 + $1.5
Cash Balance at the End of August = $9.110
Cash Balance at the End of September = Cash Balance, Start of Sept. + Net Cash Flows for Sept.
Cash Balance at the End of September = $9.110 + $1.443
Cash Balance at the End of September = $10.553
Diff: 2
Section: 2
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12) Dakota Layne is opening up "Layne's Women's Fashions" on April 1. Dakota's sales forecast for the
Spring/Summer is shown in the top row of the table. She is going to purchase her merchandise 2 months
in advance and her cost of goods sold is 70% of sales. What are Dakota Layne's purchases in May?
Sales Forecast
Purchases from
Suppliers
Sales and Purchase Forecast
Layne's Women's Fashions
April
May
June
July
$10,000
$12,000
$15,000
$16,000
August
$18,000
A) $9,000
B) $9,600
C) $10,500
D) $10,800
E) $11,200
Answer: E
Explanation: E) As stated in the question, all purchases are made two months in advance and COGS is
70% of sales.
Purchases in May = July Sales × COGS
Purchases in May = $16,000 × 0.70
Purchases in May = $11,200
Diff: 2
Section: 2
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13) Dakota Layne is opening up "Layne's Women's Fashions" on April 1. Dakota's sales forecast for the
Spring/Summer of Year 1 is shown in the top row of the table. She is going to purchase her merchandise 2
months in advance and her cost of goods sold is 70% of sales. Assume that Dakota has a starting
inventory of $21,700 at the beginning of June. What is Dakota Layne's Ending Inventory Balance in June?
Sales Forecast
Purchases from
Suppliers
Sales and Purchase Forecast
Layne's Women's Fashion
May
June
July
$12,000
$15,000
$16,000
Beginning Inventory
Plus: Additions
Less: Cost of Goods
Sold
Ending Inventory
August
$18,000
$21,700
A) $19,800
B) $22,000
C) $22,400
D) $23,800
E) $25,300
Answer: D
Explanation: D) Ending Inventory in June = Beginning Inv. In June + Purchases - Cost of Goods Sold
Ending Inventory in June = $21,700 + $12,600 - ($15,000 × 0.70)
Ending Inventory in June = $21,700 + $12,600 - $10,500
Ending Inventory in June = $23,800
Diff: 2
Section: 2
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14) The Gadget Company manufactures a wrist watch for spy agencies. The watch has a built-in cell
phone, Geiger counter, compass, magnet and garroting wire. Sales are expected to commence in February
and remain level at 10,000 units per month. The watch sells for $2 per unit. Gadget expects all of its sales
to be on credit, and will collect half of its accounts in the month after the sale and the other half two
months after the sale. What are total cash inflows in April?
Sales and Collections Forecast
The Gadget Company
January
February
March
Sales Forecast
$0
$20,000
$20,000
Collections from last
month
Collections from 2
months ago
Total Cash Inflows
April
$20,000
A) $0
B) $9,800
C) $10,000
D) $20,000
E) $23,700
Answer: D
Explanation: D) Total Cash inflows in April = 0.50 × March Sales + 0.50 × February Sales
Total Cash inflows in April = 0.50 × $20,000 + 0.5 × $20,000
Total Cash inflows in April = $10,000 + $10,000
Total Cash inflows in April = $20,000
Diff: 3
Section: 2
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15) The Gadget Company manufactures a wrist watch for spy agencies. The watch has a built-in cell
phone, Geiger counter, compass, magnet and garroting wire. Sales are expected to commence in February
and remain level at 10,000 units per month. The watch sells for $2 per unit. The raw materials for the
product cost $1 per unit. Raw materials are purchased one month before the expected sales, and suppliers
are paid one month after the purchase. Gadget's overhead expenses are $3,750 per month and
depreciation is $250 per month. What are total cash outflows (disbursements) in May?
Sales and Disbursements Forecast
The Gadget Company
April
May
$20,000
$20,000
Sales Forecast
Purchases from
Suppliers
Payments to Suppliers
General & Admin
Expenses
Depreciation
Total Disbursements
June
$20,000
A) $10,000
B) $12,950
C) $13,750
D) $13,850
E) $20,000
Answer: C
Explanation: C) Total Disbursements in May = Payments to Suppliers May + General & Admin Expenses
Payments to Suppliers May = Purchases in April
Purchases in April = $1 per unit × 10,000 forecasted units
Purchases in April = $10,000
Payments to Suppliers May = $10,000
Total Disbursements in May = $10,000 + $3,750
Total Disbursements in May = $13,750
Diff: 3
Section: 2
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16) The Gadget Company manufactures a wrist watch for spy agencies. The watch has a built-in cell
phone, Geiger counter, compass, magnet and garroting wire. Forecasted sales are shown on the top row
of the table. Forecasted cash inflows and outflows are also shown in the table. The cash balance at the end
of May is $30,000. What is the cash balance at the end of June?
Sales Forecast Cash Budget
The Gadget Company
April
May
Sales forecast
$30,000
$30,000
Total Cash inflows
$30,000
$30,000
Total Cash Outflows
$13,750
$13,750
Net cash flow
Beginning Cash Balance
Plus: Net Cash Flows
Ending Cash Balance
$30,000
June
$30,000
$30,000
$13,750
A) $36,750
B) $42,250
C) $46,250
D) $46,750
E) $50,000
Answer: C
Explanation: C) Ending Cash Balance in June = Beginning Cash Balance in June + Net Cash Flows for
June
Net Cash Flows = Cash Inflows - Cash Outflows
Net Cash Flows June = 30,000 - 13,750 = $16,250
Ending Cash Balance in June = $30,000 + $16,250
Ending Cash Balance in June = $46,250
Diff: 2
Section: 2
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17) The Snow Globe Emporium sells snow globes. The forecasted first quarter sales volume for the
Emporium is shown in the top row of the table. The Emporium buys the snow globes from a distributor
for $5 and sells them for $8. All purchases are made on credit one month in advance of sales and are paid
for the month following the purchase. What are the Snow Globe Emporium's purchases (in dollars) for
March?
Sales and Purchase Forecast
The Snow Globe Emporium
January
February
March
Sales Forecast (units)
2,000
3,000
3,800
Purchases from
Suppliers ($)
April
4,700
Payments to Suppliers
A) $19,000
B) $22,800
C) $23,500
D) $24,000
E) $30,400
Answer: C
Explanation: C) As stated in the question, all purchases are made one month in advance at a cost of $5
per unit.
Purchases for March = $5 × April Sales (Units)
Purchases for March = $5 × 4700 units
Purchases for March = $23,500
Diff: 2
Section: 2
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18) The Snow Globe Emporium sells snow globes. The forecasted first quarter sales volume for the
Emporium is shown in the top row of the table. The Emporium buys the snow globes from a distributor
for $5 and sells them for $8. All purchases are made on credit one month in advance of sales and are paid
for the month following the purchase. What are the Snow Globe Emporium's payments in March?
Sales and Purchase Forecast
The Snow Globe Emporium
January
February
March
Sales Forecast (units)
2,000
3,000
3,800
Purchases from
Suppliers ($)
Payments to Suppliers
Beginning Accounts
Payable
Ending Accounts
Payable
April
4,700
$15,000
$15
A) $15,000
B) $19,000
C) $23,500
D) $24,000
E) $30,400
Answer: B
Explanation: B) As stated in the question, all payments are made the month following the purchase.
Payments in March = Purchases in February
Payments in March = $19,000
Diff: 2
Section: 2
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19) The Snow Globe Emporium sells snow globes. The forecasted first quarter sales for The Snow Globe
Emporium is shown in the top row of the table. The Snow Globe Emporium buys the snow globes from a
distributor for $5 and sells them for $8. All purchases are made on credit one month in advance of sales
and are paid for the month following the purchase. Assume that The Snow Globe Emporium has a
starting accounts payable balance of $15,000 at the beginning of February. What are the Snow Globe
Emporium's Ending Accounts Payable in February?
Sales and Purchase Forecast
The Snow Globe Emporium
January
February
March
$32,000
$48,000
$60,800
Sales Forecast
Purchases from
Suppliers ($)
Payments to Suppliers
Beginning Accounts
Payable
Plus: Purchases
Less: Payments
Ending Accounts
Payable
April
$75,200
$15,000
$15,000
A) $15,000
B) $23,000
C) $23,500
D) $24,000
E) $26,500
Answer: B
Explanation: B) Ending Accounts Payable in Feb. = Beginning A/P + Purchases - Payments
Ending Accounts Payable in Feb. = $15,000 + $38,000 - $30,000
Ending Accounts Payable in Feb. = $23,000
Diff: 2
Section: 2
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20) The Blatz Brewing Company produces 25 million hectolitres of beer each year. To put this in
perspective, California consumed that much beer last year. A sales forecast for Blatz is provided in the
top row of the table. Blatz sells its beer at a wholesale price of US$85 per hectoliter. All sales are on
account and 75% of receivables are collected after 1 month, while 25% are collected after 2 months. What
are Blatz' cash collections in March?
Sales and Cash Inflow Forecast
Blatz Brewing Company
January
February
Sales Forecast - millions of
hectoliters
1
1
Sales Forecast - millions of
dollars
$85
$85
Collections from last month
Collections from 2 months ago
Total Cash Inflows
March
1.5
$128
A) $21
B) $26
C) $64
D) $73
E) $85
Answer: E
Explanation: E) Collections in March = 0.75 × February Sales + 0.25 × January Sales
Collections in March = 0.75 × $85 + 0.25 × $85
Collections in March = $63.75 + $21.25 = $85
Diff: 2
Section: 2
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21) The Blatz Brewing Company produces 25 million hectolitres of beer each year. To put this in
perspective, California consumed that much beer last year. A sales forecast for Blatz is provided in the
top row of the table. Blatz sells its beer at a wholesale price of US$85 per hectoliter. Blatz buys barley,
hops and yeast one month before the sale. Raw materials cost are 15% of the wholesale price of the beer.
Blatz purchases its raw materials on account and pays its suppliers one month after the purchase. What
are Blatz' payments to suppliers in April?
Sales and Payments Forecast
Blatz Brewing Company
January
February
March
Sales Forecast - millions
of hectoliters
1
1
1.5
Sales Forecast millions of dollars
$85
$85
$128
Purchases from
Suppliers
Payments to Suppliers
April
2
$170
A) $19.1
B) $23.5
C) $25.5
D) $31.9
E) $32.5
Answer: C
Explanation: C) As stated in the question, raw materials cost 15% of the wholesale price of the beer. Blatz
pays its suppliers one month after the purchase.
Payments to suppliers in April = Purchases in March
Purchases in March = 0.15 × April Sales
Purchases in March = 0.15 × (2 hectolitres × US$85 per hectolitre)
Purchases in March = 0.15 × $170
Purchases in March = $25.5
Payments to suppliers in April = $25.5
Diff: 2
Section: 2
AACSB: Analytical Thinking
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22) The Blatz Brewing Company produces 25 million hectolitres of beer each year. To put this in
perspective, California consumed that much beer last year. A sales forecast for Blatz is provided in the
top row of the table. Blatz sells its beer at a wholesale price of US$85 per hectoliter. All sales are on
account and 75% of receivables are collected after 1 month, while 25% are collected after 2 months. Blatz
buys barley, hops and yeast one month before the sale. Raw materials cost 15% of the wholesale price of
the beer. Blatz purchases its raw materials on account and pays its suppliers one month after the
purchase.
Average monthly overhead expenses are $35M (wages, salaries, heat, water, electricity, selling, general
and administration). What are Blatz' net cash flows in March?
Sales Forecast and Cash Budget
Blatz Brewing Company
January
February
March
Sales Forecast - millions
of hectoliters
1
1
1.5
Sales Forecast millions of dollars
$85
$85
$128
Collections from last
month
Collections from 2
months ago
Total Cash Inflows
Purchases from
Suppliers
Payments to Suppliers
Overhead Expenses
Total Disbursements
35
35
35
April
2
$170
35
Net Cash Flow
A) $11
B) $31
C) $38
D) $64
E) $68
Answer: B
Explanation: B) As stated in the question, Blatz pays its suppliers one month after the purchase.
Net Cash Flows in March = Cash Inflows - Cash Outflows
Net Cash Flows in March = (0.75 × February Sales + 0.25 × January Sales) - (Payments to Suppliers +
Overhead)
Net Cash Flows in March = (0.75 × $85 + 0.25 × $85) - ($19 + $35)
Net Cash Flows in March = ($63.75 + 21.75) - ($54)
Net Cash Flows in March = $85 - $54
Net Cash Flows in March = $31
Diff: 3
Section: 2
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AACSB: Analytical Thinking
Gerald's Produce provides quality fruits and vegetables to upscale restaurants in the tri-cities area. A
sales forecast for Gerald's is shown on the top row of the table. Gerald makes 100% of his sales on credit.
Gerald collects 50% of sales in the month following the sale, and the remaining 50% two months later.
Gerald buys his produce in the same month as the sales. The cost of the fruits and vegetables is half of
sales. Suppliers require Gerald to pay cash for his purchases. Gerald makes lease payments on his van of
$500 per month, and gas costs him $100 per month. Gerald's Produce has a cash balance of $1,000 at the
beginning of January.
Sales Forecast and Cash Budget
Gerald's Produce
Nov
Dec
Jan
Feb
Sales Forecast
$20,000 $15,000 $5,000 $15,000
Collections from last
month
Collections from 2
months ago
Total Cash Inflows
Purchases From
Suppliers
Payments to
Suppliers
Van Lease Payments
Gas
Total disbursements
$500
$100
$500
$100
$500
$100
$500
$100
March
$20,000
$500
$100
Net Cash Flow
Beginning cash
balance
Plus: Net Cash Flows
Ending Cash balance
1,000
1,000
23) What are Gerald's purchases expected to be in February?
A) $2,500
B) $5,000
C) $7,500
D) $10,000
E) $15,000
Answer: C
Explanation: C) As stated in the question, purchases are 50% of sales.
Purchases in February = 0.5 × February Sales
Purchases in February = 0.5 × $15,000
Purchases in February = $7,500
Diff: 2
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Section: 2
AACSB: Analytical Thinking
24) Referring to Gerald's Produce, what are Gerald's collections from customers expected to be in March?
A) $2,500
B) $5,000
C) $7,500
D) $10,000
E) $20,000
Answer: D
Explanation: D) Collections in March = 0.5 × January Sales + 0.5 × February Sales
Collections in March = 0.5 × $5,000 + 0.5 × $15,000
Collections in March = $2,500 + $7,500
Collections in March = $10,000
Diff: 2
Section: 2
AACSB: Analytical Thinking
25) Referring to Gerald's Produce, what are Gerald's total cash outflows (disbursements) in February?
A) $2,500
B) $3,100
C) $7,500
D) $8,100
E) $10,600
Answer: D
Explanation: D) Total outflows in February = Total Payments to Suppliers + Van Lease Payments + Gas
Total outflows in February = February Purchases + $500 + $100
Total outflows in February = $7,500 + $500 + $100
Total outflows in February = $8,100
Diff: 2
Section: 2
AACSB: Analytical Thinking
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26) Referring to Gerald's Produce, what is Gerald's ending cash balance expected to be in March?
A) $15,400
B) $16,700
C) $17,000
D) $17,700
E) $18,200
Answer: B
Explanation: B) Ending Cash Balance in March = Beginning Cash Balance + Net Cash Flows in March
Ending Cash Balance in March = $17, 300 + (-$600)
Ending Cash Balance in March = $16,700
Sales Forecast and Cash Budget
Gerald's Produce
Nov
Dec
Jan
Feb
Sales Forecast
$20,000 $15,000 $5,000 $15,000
Collections from last
month
7,500
2,500
Collections from 2
months ago
10,000
7,500
Total Cash Inflows
17,500
10,000
Purchases From
Suppliers
Payments to
Suppliers
Van Lease Payments
Gas
Total disbursements
March
$20,000
7,500
2,500
10,000
10,000
7,500
2,500
7,500
10,000
10,000
$500
$100
10,600
7,500
$500
$100
8,100
2,500
$500
$100
3,100
7,500
$500
$100
8,100
10,000
$500
$100
10,600
Net Cash Flow
14,400
1,900
-600
Beginning cash
balance
Plus: Net Cash Flows
Ending Cash balance
1,000
14,400
$15,400
15,400
1,900
$17,300
17,300
-600
$16,700
$1,000
Diff: 2
Section: 2
AACSB: Analytical Thinking
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Cool Looks imports and distributes sunglasses in Southern California. The company's peak selling season
has just passed and forecasted sales for the next few months is shown in the top row of the table. 40% of
sales are cash and are collected in the month of the sale. 60% of sales are on credit, and are collected in the
month following the sale. Cool Looks purchases merchandise one month in advance of sales and the cost
of goods sold is 70% of sales. Cool Looks' suppliers are paid one month after the purchase. General and
administrative expenses are $6,750 a month. Interest payments are $200 per month. Cool Looks will begin
September with a cash balance of $10,000.
Cool Looks
Sales Forecast and Cash Budget
Aug
Sept
Oct
Nov
$50,000 $20,000 $10,000 $30,000
Sales Forecast
Cash Sales
Collections from last
month
Total Cash Inflows
Purchases From
Suppliers
Payments to
Suppliers
General & Admin
Expenses
Interest
Total disbursements
6,750
200
6,750
200
Dec
$30,000
6,750
200
Net Cash Flow
Beginning cash
balance
Plus: Net Cash Flows
Ending Cash balance $10,000
$10,000
27) Referring to Cool Looks, what are total cash inflows in September?
A) $18,000
B) $20,000
C) $30,000
D) $38,000
E) $50,000
Answer: D
Explanation: D) Total Cash inflows in September = 0.40 × Sept Sales + 0.60 × August Sales
Total Cash inflows in September = 0.40 × $20,000 + 0.60 × $50,000
Total Cash inflows in September = $8,000 + $30,000
Total Cash inflows in September = $38,000
Diff: 2
Section: 2
AACSB: Analytical Thinking
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28) Referring to Cool Looks, what are Cool Looks purchases in October?
A) $14,000
B) $16,000
C) $18,000
D) $19,000
E) $21,000
Answer: E
Explanation: E) Purchases in October = 0.70 × November sales
Purchases in October = 0.70 × $30,000
Purchases in October = $21,000
Diff: 2
Section: 2
AACSB: Analytical Thinking
29) Referring to Cool Looks, what are total cash disbursements in October?
A) $13,950
B) $17,050
C) $20,950
D) $27,950
E) $28,950
Answer: A
Explanation: A) Total Disbursements in October = Total Payments to Suppliers + General & Admin
Expenses + Interest
Total Disbursements in October = September Purchases + $6,750 + $200
Total Disbursements in October = $7,000+ $6,750 + $200
Total Disbursements in October = $13,950
Diff: 2
Section: 2
AACSB: Analytical Thinking
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30) Referring to Cool Looks, what is the cash balance at the end of November?
A) $17,150
B) $19,150
C) $19,750
D) $21,250
E) $22,000
Answer: B
Explanation: B) Ending Cash Balance in June = Beginning Cash Balance. + Net Cash Flows for June
Ending Cash Balance in June = $29,100 + (- $9,950)
Ending Cash Balance in June = $19,150
Cool Looks
Sales Forecast and Cash Budget
Aug
Sept
Oct
Nov
Sales Forecast
$50,000 $20,000 $10,000 $30,000
Cash Sales
20,000
8,000
4,000
12,000
Collections from last
month
30,000
12,000
6,000
Total Cash Inflows
38,000
16,000
18,000
Purchases From
Suppliers
Payments to
Suppliers
General & Admin
Expenses
Interest
Total disbursements
14,000
7,000
21,000
21,000
14,000
7,000
21,000
6,750
200
20,950
6,750
200
13,950
6,750
200
27,950
Net Cash Flow
17,050
2,050
-9,950
Beginning cash
balance
Plus: Net Cash Flows
Ending Cash balance $10,000
$10,000
17,050
$27,050
$27,050
2,050
$29,100
$29,100
-9,950
$19,150
Dec
$30,000
12,000
18,000
Diff: 2
Section: 2
AACSB: Analytical Thinking
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Schwety Confectionery Co.
Sales Forecast and Cash Budget
($000,000s)
Nov
Dec
Jan
Feb
$13.2 $13.6 $12.8 $11.3
Sales Forecast
Cash Sales
Collections from last
month
Collections from 2
months ago
Total Cash Inflows
Purchases From
Suppliers
Payments to
Suppliers
General & Admin
Expenses
Taxes
Total disbursements
3.50
2.00
3.50
2.00
March April
$11.6 $10.1
3.50
2.00
Net Cash Flow
Beginning cash
balance
Plus: Net Cash Flows
Ending Cash balance
$6.00
$6.00
31) Referring to Schwety, what are total cash inflows in January?
A) $11.30
B) $11.72
C) $12.44
D) $12.80
E) $13.28
Answer: E
Explanation: E) Total Cash inflows in January = 0.20 × Jan Sales + 0.40 × Dec Sales + 0.40 × Nov Sales
Total Cash inflows in January = 0.20 × $12.8 + 0.40 × $13.6 + 0.40 × $13.2
Total Cash inflows in January = $2.56 + $5.44 + $5.28
Total Cash inflows in January = $13.28
Diff: 2
Section: 2
AACSB: Analytical Thinking
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32) Referring to Schwety, what are Schwety's raw materials purchases in January?
A) $5.09
B) $5.22
C) $5.76
D) $6.12
E) $6.50
Answer: A
Explanation: A) As stated in the question, Schwety purchases raw materials one month in advance and
cost of goods sold is 45% of expected sales.
Purchases in January = 0.45 × February Sales
Purchases in January = 0.45 × $11.3
Purchases in January = $5.09
Diff: 2
Section: 2
AACSB: Analytical Thinking
33) Referring to Schwety, what are total cash disbursements in February?
A) $7.09
B) $8.59
C) $9.75
D) $10.59
E) $11.25
Answer: D
Explanation: D) Total Disbursements in February = Total Payments to Suppliers + G & A Expenses +
Taxes
Total Disbursements in February = January Purchases + G & A Expenses + Taxes
Total Disbursements in February = $5.09 + $3.50 + $2.00
Total Disbursements in February = $10.59
Diff: 2
Section: 2
AACSB: Analytical Thinking
34) Referring to Schwety, what is the cash balance at the end of March?
A) $10.90
B) $11.50
C) $12.70
D) $13.00
E) $13.70
Answer: B
Explanation: B) Ending Cash Balance in March = Beginning Cash Balance. + Net Cash Flows for June
Ending Cash Balance in March = $10.26 + $1.24
Ending Cash Balance in March = $11.50
Diff: 2
Section: 2
AACSB: Analytical Thinking
483
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LO3: Learn How to Forecast Financial Statements
1) Q9 Networks is a leading provider of outsourced data centre infrastructure such as web-servers and
data storage. Forecast the financial statements for Q9 Networks for Year 6. Use the percent of sales
method based on Year 5 and the assumptions listed below. Please note the ratios to sales provided in the
table which are useful for making the forecast. Forecast the financial statements for Q9. What is the
change in the cash account from Year 5 to Year 6?
Sales growth of 20%. The cost of debt is 4%. The Tax rate is 35%. The depreciation rate is 5%. CAPEX is
$4,000,000. Cash is the plug account. The following accounts are held constant: Long-term debt and
Common Stock. No dividends are paid in Year 6.
Q9 Networks
Income Statement and Balance Sheet
As of December 31, Year 5 ($ 000's)
Year 5
Ratios
Revenue
$37,829
COGS
25,840
0.683074
SG&A
11,163
Dep. Exp.
535
EBIT
291
Int. Exp.
136
EBT
155
Provision for Income Taxes
55
Net Income
100
Assets
Year 5
Cash
71,301
Other Current Assets
5,046
0.133390
Total Current Assets
76,347
PP&E
36,757
Total Assets
113,104
Liabilities & Stockholders'
Equity
Total Current Liabilities
7,688
0.203230
Long-Term Debt
4,091
Total Liabilities
11,779
Shareholders' Equity
Common Stock
178,328
Retained Earnings
-77,003
Total Owners Equity
101,325
Total Liabilities and Owners
Equity
113,104
Year 6
$45,395
Year 6
4,091
178,328
A) $2.292 million
B) $1.301 million
C) -$2.220 million
D) -$6.702 million
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E) -$7.081 million
Answer: C
Explanation: C)
Revenue
COGS
SG&A
Dep. Exp.
EBIT
Int. Exp.
EBT
Provision for Income Taxes
Net Income
Assets
Cash
Other Current Assets
Total Current Assets
PP&E
Total Assets
Liabilities & Stockholders'
Equity
Total Current Liabilities
Long-Term Debt
Total Liabilities
Shareholders' Equity
Common Stock
Retained Earnings
Total Owners Equity
Total Liabilities and Owners
Equity
Year 5
$37,829
25,840
11,163
535
291
136
155
55
100
Year 5
71,301
5,046
76,347
36,757
113,104
7,688
4,091
11,779
Ratios
0.683074
0.133390
0.203230
Forecast
$45,395
31,008
13,396
2,038
-1,047
164
-1,210
-424
-787
Forecast
69,081
6,055
75,136
38,719
113,855
9,226
4,091
13,317
178,328
-77,003
101,325
178,328
-77,789
100,539
113,104
113,855
Change in cash = Cash6 - Cash5
Change in cash = 69,081 - 71,301
Change in Cash = -$2,220
Q9 Networks will need additional funds of $2.220 million.
Diff: 4
Section: 3
AACSB: Analytical Thinking
485
Copyright © 2015 Pearson Canada, Inc.
2) Outlaws is a general goods retail chain in the High Plains region. Forecast the financial statements for
Outlaws for Year 7. Use the percent of sales method based on Year 6 and the assumptions listed below.
Please note the ratios provided in the table which are useful for making the forecast.
Sales growth of 5.5%. The cost of debt is 6.25%. The tax rate is 35%. The depreciation rate is 6%. CAPEX is
$300 Million. The following accounts are constant: Goodwill and common stock. Long term debt is the
PLUG variable. No dividends.
Forecast the financial statements for Outlaws. What are the additional funds needed (AFN) in Year 7? The
AFN is the change in the plug account from Year 6 to Year 7.
Revenue
COGS
SG&A
Dep. Exp.
EBIT
Int. Exp.
EBT
Inc. Taxes
Net Income
ASSETS
Total Current Assets
PP&E
Goodwill
Total Assets
LIABILITIES AND
OWNER'S EQUITY
Total Current Liabilities
Long Term Debt
Total Liabilities
Owner's Equity
Common Stock
Retained Earnings
Total Owner's Equity
Total Liabilities & Owner's
Equity
Year 6
$29,210
22,152
5,245
621
1,192
277
915
288
$627
Year 6
$4,385
9,637
678
$14,700
3,651
4,208
$7,859
Ratios
Forecast
$30,817
0.758370
0.179562
Ratios
0.150120
Forecast
678
0.124991
1,192
5,089
6,281
1,192
$14,700
A) -$381 million
B) -$290 million
C) -$91 million
D) $127 million
E) $189 million
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Answer: A
Explanation: A) AFN = Long-term Debt7 - Long-term Debt6
AFN = $3,827 - $4,208
AFN = -$381
Outlaws will generate a surplus of $381 million.
Revenue
COGS
SG&A
Dep. Exp.
EBIT
Int. Exp.
EBT
Inc. Taxes
Net Income
ASSETS
Total Current Assets
PP&E
Goodwill
Total Assets
LIABILITIES AND
OWNER'S EQUITY
Total Current Liabilities
Long Term Debt
Total Liabilities
Owner's Equity
Common Stock
Retained Earnings
Total Owner's Equity
Total Liabilities & Owner's
Equity
Year 6
$29,210
22,152
5,245
621
1,192
277
915
288
$627
Year 6
$4,385
9,637
678
$14,700
3,651
4,208
$8,419
Ratios
0.758370
0.179562
Ratios
0.150120
0.124991
Forecast
$30,817
23,370
5,533
596
1,316
263
1,053
369
$685
Forecast
$4,626
9,341
678
$14,645
3,852
3,827
$7,679
1,192
5,089
6,281
1,192
5,774
6,966
$14,700
$14,645
Diff: 4
Section: 3
AACSB: Analytical Thinking
487
Copyright © 2015 Pearson Canada, Inc.
3) CN Railways is North America's fifth largest railway. Forecast the financial statements for CN for Year
11. Use the percent of sales method based on Year 10 and the assumptions listed below. Please note the
ratios to sales provided in the table which are useful for making the forecast.
Sales growth of 10%. The cost of debt is 4.59%. The tax rate is 31.943%. The depreciation rate is 3%.
CAPEX is $1,600 Million. The following accounts are constant: Intangible assets, Deferred taxes, and
Common Stock. Long term debt is the PLUG variable. No dividends.
Forecast the financial statements for CN. What are the additional funds needed (AFN) in Year 11? The
AFN is the change in the plug account from Year 10 to Year 11.
CN Railway Company
Income Statement and Balance Sheet
As of December 31, Year 10 ($ 000,000's)
Year 10
Ratios
Revenue
$6,110
COGS
2,550
0.417349
Dep. Exp.
499
SG&A
1,945
0.318331
EBIT
1,116
Int. Exp.
277
Income before Taxes
839
Income Taxes
268
Net income
$571
ASSETS
Year 10
Ratios
Total Current Assets
1,163
0.190344
PP&E
16,898
Intangible assets
863
Total assets
$18,924
Total Current liabilities
2,134
0.349264
Deferred Taxes
5,160
Long-term debt
5,003
Common Stock
3,558
Retained earnings
2,762
Total Owners Equity
6,627
Total liabilities and Owners
equity
18,924
Forecast
$6,721
Forecast
863
5,160
3,558
A) $64 million
B) $165 million
C) $342 million
D) $580 million
E) $965 million
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Answer: D
Explanation: D) AFN = Long-term Debt11 - Long-term Debt10
AFN = $5,583 - $5,003
AFN = $580
CN Railways will require additional funds of $580 million.
CN Railway Company
Income Statement and Balance Sheet
As of December 31, Year 10 ($ 000,000's)
Year 10
Ratios
Revenue
$6,110
COGS
2,550
0.417349
Dep. Exp.
499
SG&A
1,945
0.318331
EBIT
1,116
Int. Exp.
277
Income before Taxes
839
Income Taxes
268
Net income
$ 571
ASSETS
Year 10
Ratios
Total Current Assets
1,163
0.190344
PP&E
16,898
Intangible assets
863
Total assets
$18,924
Total Current liabilities
2,134
0.349264
Deferred Taxes
5,160
Long-term debt
5,003
Common Stock
3,558
Retained earnings
2,762
Total Owners Equity
6,320
Total liabilities and
Owners equity
18,924
Forecast
$6,721
2,805
555
2,140
1,222
230
992
317
$ 675
Forecast
1,279
17,943
863
$20,085
2,347
5,160
5,583
3,558
3,437
6,995
20,085
Diff: 4
Section: 3
AACSB: Analytical Thinking
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Copyright © 2015 Pearson Canada, Inc.
4) Blockbuster is a North American video and DVD sales and rental chain. Forecast the financial
statements for Blockbuster for Year 3. Use the percent of sales method based on Year 2 and the
assumptions listed below. Please note the ratios to sales provided in the table which are useful for making
the forecast. In the event that taxable income is negative, calculate taxes in the usual way. Negative taxes
can be interpreted as a tax refund.
Sales growth of 10%. The cost of debt is 7.5%. The tax rate is 35%. The depreciation rate is 25%. CAPEX is
$200M. The following accounts are held constant: Goodwill and Common Stock. Long Term Debt is the
PLUG account. No dividends.
Blockbuster Inc.
Income Statement and Balance Sheet
As of December 31, Year 2 ($000's)
Year 2
Ratios
Revenue
$5,157,600
COGS
2,420,700
0.469346
SG&A
2,708,500
0.525147
Dep. Exp.
246,600
EBIT
-218,200
Int. Exp.
78,200
Income Before Tax
-296,400
Income Taxes
-56,100
Net Income
-$240,300
ASSETS
Total Current Assets
716,400
0.138902
PP&E
909,000
Goodwill
6,127,000
Total Assets
$7,752,400
LIABILITIES AND
OWNERS EQUITY
Total Current Liabilities
1,268,800
0.246006
Long Term Debt
734,900
Total Liabilities
$2,003,700
Owners Equity
Common Stock
6,075,800
Retained Earnings
-327,100
Total Stockholder Equity
5,748,700
Total Liabilities and
Owners Equity
7,752,400
Forecast
$5,673,360
6,127,000
6,075,800
What are the additional funds needed in Year 3?
A) -$225.363 million
B) $63.243 million
C) $125.363 million
D) $189.900 million
E) $299.990 million
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Answer: B
Explanation: B) AFN = Long-term Debt3 - Long-term Debt2
AFN = $798,143 - $734,900
AFN = $63,243
Blockbuster will require additional funds of $63.243 million.
Blockbuster Inc.
Income Statement and Balance Sheet
As of December 31, Year 2 ($000's)
Year 2
Ratios
Revenue
$5,157,600
COGS
2,420,700
0.469346
SG&A
2,708,500
0.525147
Dep. Exp.
246,600
EBIT
-218,200
Int. Exp.
78,200
Income Before Tax
-296,400
Income Taxes
-56,100
Net Income
-$240,300
ASSETS
Total Current Assets
716,400
0.138902
PP&E
909,000
Goodwill
6,127,000
Total Assets
$7,752,400
LIABILITIES AND
OWNERS EQUITY
Total Current Liabilities
1,268,800
0.246006
Long Term Debt
734,900
Total Liabilities
$2,003,700
Owners Equity
Common Stock
6,075,800
Retained Earnings
-327,100
Total Stockholder Equity
5,748,700
Total Liabilities and
Owners Equity
$7,752,400
Forecast
$5,673,360
2,662,770
2,979,350
277,250
-246,010
55,118
-301,128
-105,395
-$195,733
788,040
831,750
6,127,000
$7,746,790
1,395,680
798,143
$2,193,823
6,075,800
-522,833
5,552,967
$7,746,790
Diff: 4
Section: 3
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5) Polaris Industries produces a wide range of outdoor leisure vehicles including all-terrain vehicles
(ATV's), motorcycles, and snowmobiles. Forecast the financial statements for Polaris for Year 6. Use the
percent of sales method based on Year 5 and the assumptions listed below. Please note the ratios to sales
provided in the table which are useful for making the forecast.
Sales decline by 5.5%. The cost of debt is 11.76%. The tax rate is 31%. The depreciation rate is 12%. CAPEX
is $28,360. The following accounts are held constant: Goodwill, Long-term debt, and Common Stock.
Cash is the PLUG account. No dividends.
Forecast the financial statements for Polaris. What is the change in the cash account from Year 5 to Year
6?
Polaris Industries Inc.
Income Statement and Balance Sheet
As of December 31, Year 5 ($000's)
Year 5
Ratios
Revenue
$1,908,459
COGS
1,454,374
0.762067
SG&A
213,114
0.111668
Dep. Exp.
28,632
EBIT
212,339
Int. Exp.
4,713
Income Before Tax
207,626
Income Taxes
64,348
Net Income
$143,278
ASSETS
Cash
$19,675
Accounts Receivable
354,313
0.185654
Total current assets
373,988
PP&E
222,336
Goodwill
172,632
Total Assets
$768,956
LIABILITIES AND OWNERS
EQUITY
Total Current Liabilities
381,299
0.199794
Long Term Debt
18,000
Total Liabilities
$399,299
Owners Equity
Common Stock
417
Retained Earnings
369,240
Total Owners Equity
369,657
Total Liabilities and
Owners Equity
$768,956
Forecast
$1,803,494
172,632
18,000
417
A) -$132.146 million
B) $135.146 million
C) $139.157 million
D) $146.187 million
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E) $154.821 million
Answer: B
Explanation: B) Change in Cash = Cash6 - Cash5
Change in Cash = $154,821 - $19,675
Change in Cash = $135,146
Polaris will generate a surplus of $135,146,000.
Polaris Industries Inc.
Income Statement and Balance Sheet
As of December 31, Year 5 ($000's)
Year 5
Ratios
Revenue
$1,908,459
COGS
1,454,374
0.762067
SG&A
213,114
0.111668
Dep. Exp.
28,632
EBIT
212,339
Int. Exp.
4,713
Income Before Tax
207,626
Income Taxes
64,348
Net Income
$143,278
ASSETS
Cash
$19,675
Accounts Receivable
354,313
0.185654
Total current assets
373,988
PP&E
222,336
Goodwill
172,632
Total Assets
$768,956
LIABILITIES AND
OWNERS EQUITY
Total Current Liabilities
381,299
0.199794
Long Term Debt
18,000
Total Liabilities
$399,299
Owners Equity
Common Stock
417
Retained Earnings
369,240
Total Owners Equity
369,657
Total Liabilities and
Owners Equity
$768,956
Forecast
$1,803,494
1,374,383
201,393
30,084
197,634
2,117
195,517
60,610
$134,907
$154,821
334,826
489,647
220,612
172,632
$882,891
360,328
18,000
$378,328
417
504,147
504,564
$882,891
Diff: 4
Section: 3
AACSB: Analytical Thinking
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6) Blockbuster is a video rental and retail chain. Blockbuster is forecasting its financial statements for Year
3. Selected financial information for Year 2 is provided in the table. What is Retained Earnings for Year 3?
Selected Financial Information
Blockbuster Inc. ($ '000)
Ratios
Year 2
(to Sales)
Revenue
$5,157,600
COGS
2,420,700
0.469346
SG&A
2,532,400
0.491004
R&D
176,100
0.034144
Dep. Exp.
246,600
EBIT
-218,200
Int. Exp.
78,200
EBT
-296,400
Provision for Income
Taxes
-56,100
0.19*
Net Income
$ -240,300
Dividends
Retained Earnings
$ -327,100
Owner's Equity
$ -427,100
*Tax rate is a proportion of Earnings before Taxes.
Forecast
Year 3
$5,673,360
300,000
78,000
$0
A) $-46,224
B) $-47,279
C) $-329,300
D) $-607,976
E) $-707,976
Answer: D
Explanation: D) Retained Earnings3 = Retained Earnings2 + Net Income3 - Dividends3
Net Income = (Revenues - COGS - SG&A - Depreciation - R&D - Interest + Taxes)
Net Income = (5,673,360 - 2,662,770 -2,785,640 - 193,710, - 300,000 -78,000 + 65,884)
Net Income = $-280,876
Retained Earnings3 = $-327,100 -$280,876 - $0 = $-607,976
Diff: 2
Section: 3
AACSB: Analytical Thinking
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7) Blockbuster is a video rental and retail chain. Blockbuster is forecasting its financial statements for Year
7. Selected financial information for Year 6 is provided in the table. What is long term debt (the plug
variable) for the forecasted year? To forecast current liabilities payable use the percentage of sales method
based on Year 6 figures. Assume that no dividends are paid in Year 7.
Selected Financial Information
Blockbuster Inc. ($ '000)
Year 6
Forecast
Revenue
$5,157,600
$5,673,360
Net Income
-240,300
-195,733
TOTAL ASSETS
LIABILITIES AND
STOCKHOLDERS'
EQUITY
Total Current Liabilities
Long Term Debt
Shareholders' Equity
Common Stock
Retained Earnings
Total Shareholders'
Equity
Total Liabilities &
Shareholders' Equity
$7,752,400
$7,746,790
1,268,800
734,900
6,075,800
-327,100
6,075,800
5,748,700
$7,752,400
A) $707,803
B) $743,168
C) $793,168
D) $798,143
E) $798,988
Answer: D
Explanation: D) Calculate Current Liabilities as % of sales from Year 6 : 24.6006%
Current Liabilities = (5,673,360) × (0.246006) = 1,395,680
Long Term Debt7 = Total Assets - Total Shareholders' Equity - Total Current Liabilities
Total Shareholder's Equity7 = Common Stock7 + Retained Earnings7
Retained Earnings7 = Retained Earning6 + Net Income7 - Dividends7
Retained Earnings7 = -327,100 + (-195,733) - 0 = $-522,833
Total Shareholder's Equity7 = 6,075,800 + (-522,833) = 5,552,967
Long Term Debt7 = $7,746,790 - $5,552,967 - $1,395,680 = $798,143
Diff: 3
Section: 3
AACSB: Analytical Thinking
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8) Outlaws is a general goods retail chain in the High Plains region. Outlaws is forecasting its financial
statements for Year 3. Selected financial information for Years 1 and 2 is provided in the table. In Year 3
Outlaws is planning to invest $300 million in CAPEX. The average depreciation rate is 6%. What is the
forecasted depreciation expense in Year 3?
Selected Financial Information
Outlaws Inc. ($ millions)
Year 1
Year 2
PP&E
9,372
9,637
Depreciation
621
CAPEX
886
A) $531
B) $560
C) $578
D) $596
E) $655
Answer: D
Explanation: D) Depreciation Expense3 = Dep. rate × (PPE2 + CAPEX)
Depreciation Expense3 = 0.06 × ($9,637 + $300)
Depreciation Expense3 = $596
Diff: 2
Section: 3
AACSB: Analytical Thinking
9) Cadbury plc is a global confectionery company. Cadbury is forecasting its financial statements for Year
9. Selected financial information for Years 7 and 8 is provided in the table. In Year 8 Cadbury is planning
to invest £300 million in CAPEX. The average depreciation rate is 10%. What is the forecasted
depreciation expense in Year 9?
Selected Financial Information
Cadbury Inc. (£ millions)
Year 7
Year 8
PP&E
1,904
1,761
Depreciation
196
CAPEX
53
A) £176
B) £206
C) £286
D) £300
E) £322
Answer: B
Explanation: B) Depreciation Expense9 = Dep. Rate (PP&E8 + CAPEX)
Depreciation Expense9 = 0.10 × (£1,761 + £300) = £206
Diff: 2
Section: 3
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AACSB: Analytical Thinking
10) The Film Shoppe is a video rental and retail chain. The Shoppe is forecasting its financial statements
for Year 2. Selected financial information for Years 1 and 2 is provided in the table. In Year 2 The Shoppe
is planning to invest $600 million in CAPEX and forecasted depreciation is $903 million. What is Net
Property, Plant and Equipment in Year 2?
Selected Financial Information
The Film Shoppe Inc. ($ millions)
Year 1
Year 2
PP&E
$15,622
Depreciation
884
903
CAPEX
1,343
600
A) $15,116
B) $15,319
C) $15,419
D) $15,519
E) $16,222
Answer: B
Explanation: B) Net PPE2 = Net PPE1 + CAPEX2 - Dep. Exp2
Net PPE2 = $15,622 + $600 - $903 = $15,319
Diff: 2
Section: 3
AACSB: Analytical Thinking
11) Outlaws is a general goods retail chain in the High Plains region. Outlaws is forecasting its financial
statements for Year 3. Selected financial information for Years 1 and 2 is provided in the table. What is the
interest expense for Outlaws in Year 3? (Assume that Outlaws average cost of debt is 6.25%.)
Selected Financial Information
Outlaws Inc. ($ millions)
Year 1
Year 2
Short Term Debt
627
715
Long Term Debt
4,194
4,208
Interest Expense
277
A) $209
B) $243
C) $263
D) $295
E) $308
Answer: E
Explanation: E) Interest Expense3 = kd × (Short-term Debt2 + Long-term Debt2)
Interest Expense3 = 0.0625 × ($715 + $4,208)
Interest Expense3 = $308
Diff: 2
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Section: 3
AACSB: Analytical Thinking
12) Blockbuster is a video rental and retail chain. Blockbuster is forecasting its financial statements for
Year 3. Selected financial information for Years 1 and 2 is provided in the table. What is the interest
expense for Blockbuster in Year 3? (Assume that Blockbuster's average cost of debt is 7.50%.)
Selected Financial Information
Blockbuster Inc. ($ '000)
Year 1
Short Term Debt
31,890
Long Term Debt
1,137,256
Interest Expense
Year 2
162,430
798,300
87,686
A) $70,341
B) $72,054
C) $80,667
D) $87,686
E) $135,166
Answer: B
Explanation: B) Interest Expense3 = kd × (Short-term Debt2 + Long-term Debt2)
Interest Expense3 = 0.075 × ($162,430 + $798,300) = $72,054
Diff: 2
Section: 3
AACSB: Analytical Thinking
13) Cadbury plc is a global confectionery company. Cadbury is forecasting its financial statements for
Year 9. Selected financial information for Years 7 and 8 is provided in the table. What is the interest
expense for Year 9? (Assume that Cadbury's average cost of debt is 3%.)
Selected Financial Information
Cadbury Inc. (£ millions)
Year 7
Year 8
Short Term Debt
£2,562
£1,189
Long Term Debt
2,551
1,973
Interest Expense
153
A) £36
B) £59
C) £63
D) £95
E) £110
Answer: D
Explanation: D) Interest Expense9 = kd × (Short-term Debt8 + Long-term Debt8)
Interest Expense9 = 0.03 × (£1,189 + £1,973) = £95
Diff: 2
Section: 3
AACSB: Analytical Thinking
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14) Polaris Industries is forecasting its financial statements for Year 6. Selected financial information for
Year 5 is provided in the table. What is the interest expense for Polaris Industries in Year 6? (Assume that
Polaris Industries average cost of debt is 11.76%.)
Selected Financial Information
Polaris Industries Inc. ($ '000)
Year 5
Long Term Debt
18,000
Interest Expense
1,350
A) $2,117
B) $2,347
C) $3,114
D) $4,139
E) $4,234
Answer: A
Explanation: A) Interest Expense6 = kd × Long-term Debt5
Interest Expense6 = 0.1176 × $18,000 = $2,117
Diff: 2
Section: 3
AACSB: Analytical Thinking
15) Save-a-lot is a grocery store chain. Save-a-lot is forecasting its financial statements for Year 3. Selected
financial information for Years 2 and 3 is provided in the table. In Year 3 Save-a-lot is planning to invest
$600 million in CAPEX and forecasted depreciation is $903 million. What is Net PP&E (Property, Plant
and Equipment) at the end of Year 3?
Selected Financial Information
Save-a-lot Inc.
Dec 31, Year 2 and Year 3 ($ millions)
Year 2
Year 3
PP&E
$14,456
Depreciation
923
903
CAPEX
1,329
600
A) $14,153
B) $14,250
C) $14,382
D) $14,456
E) $14,577
Answer: A
Explanation: A) Net PPE3 = Net PPE2 + CAPEX - Dep. Exp.
Net PPE3 = $14,456 + $600 - $903 = $14,153
Diff: 2
Section: 3
AACSB: Analytical Thinking
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16) Polaris Industries is forecasting its financial statements for Year 6. Selected financial information for
Years 5 and 6 is provided in the table. What is the forecasted Cost of Goods Sold in Year 3?
Selected Financial Information
Polaris Industries Inc. ($000s)
Year 5
Forecast Year 6
Sales
$1,908,459
$1,803,493
COGS
1,454,374
A) $1,368,500
B) $1,367,500
C) $1,369,350
D) $1,374,383
E) $1,375,450
Answer: D
Explanation: D)
=
= 0.762067
COGS6 = 0.762067 × $1,803,493 = $1,374,383
Diff: 2
Section: 3
AACSB: Analytical Thinking
17) Scrumptious Confections plc is a United Kingdom confectionery company. Scrumptious Inc. is
forecasting its financial statements for Year 2. Selected financial information for Years 1 and 2 is provided
in the table. In Year 2 Scrumptious is planning to invest £53 million in CAPEX and forecasted
depreciation is £196 million. What is Property, Plant and Equipment (Net) in Year 2?
Selected Financial Information
Scrumptious Inc. (£ millions)
Year 1
Year 2
PP&E
£1,904
Depreciation
212
196
CAPEX
45
53
A) £831
B) £861
C) £1,411
D) £1,441
E) £1,761
Answer: E
Explanation: E) Net PP&E2 = Net PP&E1 + CAPEX - Depreciation Expense
Net PP&E2 = £1,904+ £53 - £196 = £1,761
Diff: 2
Section: 3
AACSB: Analytical Thinking
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18) Polaris Industries is forecasting its financial statements for Year 6. Selected financial information for
Year 5 is provided in the table. In Year 6 Polaris Industries is planning to invest $50 million in CAPEX.
The average depreciation rate is 12%. What is the forecasted depreciation expense in Year 6?
Selected Financial Information
Polaris Industries Inc. ($000s)
Year 5
PP&E
222,336
Depreciation
28,632
CAPEX
30,000
A) $26,844
B) $26,824
C) $30,280
D) $31,624
E) $32,680
Answer: E
Explanation: E) Depreciation Expense6 = Dep. Rate (PP&E5 + CAPEX)
Depreciation Expense6 = 0.12 × (222,336 + 50,000) = $32,680
Diff: 2
Section: 3
AACSB: Analytical Thinking
19) Sona is forecasting its financial statements for Year 2. Selected financial information for Years 1 and 2
is provided in the table. In Year 2 Sona is planning to invest $50 million in CAPEX and forecasted
depreciation is $16 million. What is the Net Property, Plant and Equipment balance in Year 2?
Selected Financial Information
Sona Inc. ($ millions)
Year 1
Year 2
PP&E
$150
Depreciation
20
16
CAPEX
30
50
A) $184
B) $194
C) $203
D) $209
E) $211
Answer: A
Explanation: A) Net PP&E2 = Net PP&E1 + CAPEX2 - Depreciation Expense2
Net PP&E2 = $150 + 50 - 16 = $184
Diff: 2
Section: 3
AACSB: Analytical Thinking
501
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20) Outlaws is a general goods retail chain in the High Plains region. Outlaws is forecasting its financial
statements for Year 3. Selected financial information for Years 1 and 2 is provided in the table. What is
Retained Earnings for Year 3?
Selected Financial Information
Outlaws Inc. ($ millions)
Ratios
Year 2
(to sales)
Revenue
$29,210
COGS
22,152
0.758370
SG&A
5,245
0.179562
Dep. Exp.
621
EBIT
1,192
Int. Exp.
277
EBT
915
Provision for Income
Taxes
288
0.35*
Net Income
$627
Dividends
Retained Earnings
$5,089
Owner's Equity
$6,281
*The tax rate is a percentage of Earnings Before Tax.
Forecast
Year 3
$30,817
621
277
$225
A) $5,524
B) $5,745
C) $5,762
D) $7,610
E) $7,385
Answer: A
Explanation: A) Retained Earnings3 = Retained Earnings2 + Net Income3 - Dividends3
Net Income = (Revenues - COGS - SG&A - Depreciation - Interest) × (1 - T)
Net Income = (30,817 - 23,370 - 5,533 - 621 - 277) × (1 - 0.35) = $660
Retained Earnings3 = $5,089 + $660 - $225 = $5,524
Diff: 2
Section: 3
AACSB: Analytical Thinking
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21) CN is North America's fifth largest railroad. CN is forecasting its financial statements for Year 3.
Selected financial information for Year 2 is provided in the table. What is Retained Earnings for Year 3?
Selected Financial Information
CN Railway Company ($000'000s)
Ratios
Year 2
(to sales)
Revenue
$6,110
COGS
2,550
0.417349
Dep. Exp.
499
Other Expenses
1,945
0.318331
EBIT
1,116
Int. Exp.
277
EBT
839
Provision for Income
Taxes
268
0.31943*
Net Income
$571
Retained Earnings
$2,762
Owner's Equity
$6,627
*The tax rate is a percentage of Earnings Before Tax.
Forecast
Year 3
$6,721
555
259
A) $2,762
B) $3,128
C) $3,293
D) $3,417
E) $3,630
Answer: D
Explanation: D) Retained Earnings3 = Retained Earnings2 + Net Income3 - Dividends3
Net Income = (Revenues - COGS - Depreciation - Other - Interest + Taxes)
Net Income = (6,721 - 2,805 - 555 - 2,140 - 259 - 307) = $655
Retained Earnings3 = $2,762 + 655 = $3,417
Diff: 2
Section: 3
AACSB: Analytical Thinking
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22) Polaris Industries is forecasting its financial statements for Year 6. Selected financial information for
Year 5 is provided in the table. What is Retained Earnings for Year 6?
Selected Financial Information
Polaris Industries Inc. ($000s)
Ratios
Year 5
(to Sales)
Revenue
$1,908,459
COGS
1,454,374
0.762067
SG&A
213,114
0.111668
Dep. Exp.
28,632
EBIT
212,339
Int. Exp.
4,713
EBT
207,626
Provision for Income
taxes
64,348
31%*
Net Income
$143,278
Dividends
Retained Earnings
$369,240
*Tax rate is a proportion of Earnings before Taxes.
Forecast
Year 6
$1,803,494
30,084
2,117
$700
A) $ 503,447
B) $ 504,147
C) $ 534,137
D) $ 534,837
E) $ 607,556
Answer: A
Explanation: A) Retained Earnings6 = Retained Earnings5 + Net Income6 - Dividends6
Net Income = (Revenues - COGS - SG&A - Depreciation - Interest) × (1 - T)
Net Income = (1,803,494 - 1,374,383 - 201,393 - 30,084 - 2,177) × (1 - 0.31)
Net Income = $134,907
Retained Earnings6 = 369,240 + 134,907 - 700 = $503,447
Diff: 2
Section: 3
AACSB: Analytical Thinking
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23) Cadbury plc is a global confectionery company. Cadbury is forecasting its financial statements for
Year 9. Selected financial information for Years 7 and 8 is provided in the table. What is Retained
Earnings for Year 9?
Selected Financial Information
Cadbury plc (£ millions)
Ratios
Year 8
(to Sales)
Revenue
£5,802
COGS
3,300
0.568769
SG&A
1,490
0.256808
Dep. Exp.
196
EBIT
816
Int. Exp.
153
EBT
663
Provision for Income
taxes
30
0.045*
Net Income
£633
Dividends
Retained Earnings
£2,498
Shareholder's Equity
£3,534
*Tax rate is a proportion of Earnings before Taxes.
Forecast
£6,962
312
77
£315
A) £2,917
B) £3,268
C) £4,007
D) £5,307
E) £5,885
Answer: A
Explanation: A) Retained Earnings9 = Retained Earnings8 + Net Income9 - Dividends9
Net Income = (Revenues - COGS - SG&A - Depreciation - Interest) × (1 - T)
Net Income = (6,962 - 3,960 - 1,788 - 312 - 77) × (1 - 0.045) = $788
Retained Earnings9 = £2,498 + £788 - £315 = £2,971
Diff: 2
Section: 3
AACSB: Analytical Thinking
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24) Outlaws is a general goods retail chain in the High Plains region. Outlaws is forecasting its financial
statements for Year 7. Selected financial information for Year 6 is provided in the table. What is long term
debt, the plug variable, for the forecasted year? To calculate forecasted current liabilities use the
percentage of sales method based on Year 6 figures. Assume that no dividends are paid in Year 7.
Selected Financial Information
Outlaws Inc. ($ millions)
Year 6
Revenue
$29,210
Net Income
$627
TOTAL ASSETS
LIABILITIES AND
STOCKHOLDERS' EQUITY
Total Current Liabilities
Long Term Debt
Shareholders' Equity
Common Stock
Retained Earnings
Total Shareholders' Equity
Total Liabilities &
Shareholders' Equity
Forecast
$30,817
$685
$14,700
$14,645
3,651
4,208
1,192
5,089
6,281
1,192
14,700
A) $3,859
B) $3,336
C) $3,827
D) $6,397
E) $10,236
Answer: C
Explanation: C) Calculate Total Current Liabilities: % of sales from Year 6: 12.4991%
A/P: Sales (30,817) × (0.124991) = $3,852
Long Term Debt7 = Total Assets - Total Shareholders' Equity - Total Current Liabilities
Total Shareholder's Equity7 = Common Stock7 + Retained Earnings7
Retained Earnings7 = Retained Earnings6 + Net Income7 - Dividends7
Retained Earnings7 = 5,089 + 685 - 0 = $5,774
Total Shareholder's Equity7 = 1,192 + 5,774 = $6,966
Long Term Debt7 = $14,645 - $6,966 - $3,852 = $3,827
Diff: 3
Section: 3
AACSB: Analytical Thinking
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25) CN is North America's fifth largest railroad. CN is forecasting its financial statements for Year 7.
Selected financial information for Year 6 is provided in the table. What is long term debt (the plug
variable) for the forecasted year? To forecast current liabilities payable use the percentage of sales method
based on Year 6 figures. Assume that no dividends are paid in Year 7.
Selected Financial Information
CN Railway Company ($000'000s)
Year 6
Revenue
$6,110
Net Income
571
TOTAL ASSETS
LIABILITIES AND
STOCKHOLDERS' EQUITY
Total Current Liabilities
Long Term Debt
Shareholders' Equity
Common Stock
Retained Earnings
Total Shareholders' Equity
Total Liabilities & Shareholders'
Equity
Forecast
$6,721
655
$18,924
$20,086
2,134
10,163
3,558
2,762
6,320
3,558
$18,924
A) $10,764
B) $10,955
C) $11,179
D) $11,483
E) $11,798
Answer: A
Explanation: A) Calculate Current Liabilities as % of sales from Year 6: 34.9264%
Current Liabilities = (6,721) × (0.349264) = $2,283
Long Term Debt7 = Total Assets - Total Shareholders' Equity - Total Current Liabilities
Total Shareholder's Equity7 = Common Stock7 + Retained Earnings7
Retained Earnings7 = Retained Earnings6 + Net Income7 - Dividends7
Retained Earnings7 = $2,762 + 655 = $3,417
Total Shareholder's Equity7 = 3,558 + 3,417 = $6,975
Long Term Debt7 = $20,086 - $6,975 - $2,347 = $10,764
Diff: 3
Section: 3
AACSB: Analytical Thinking
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26) Polaris Industries is forecasting its financial statements for Year 10. Selected financial information for
Year 9 is provided in the table. What is the forecasted balance of cash in Year 10? (Cash is the plug
account.) Use the percentage of sales method to calculate accounts receivable for year 10 (based on the
Year 9 values).
Selected Financial Information
Polaris Industries Inc. ($000s)
Year 9
Revenue
$2,084,194
Current Assets
Cash
Accounts Receivable
Total current assets
Net property and equipment
Goodwill
Total Assets
LIABILITIES & OWNERS'
EQUITY
Total Liabilities
Total owners' equity
Total Liabilities & Owners'
Equity
$ 19,675
354,313
373,988
300,000
172,632
$846,620
Forecast
$2,292,614
300,000
172,632
$446,053
400,567
$494,047
455,337
$846,620
$949,384
A) $80,300
B) $85,343
C) $87,008
D) $89,078
E) $90,731
Answer: C
Explanation: C) Calculate Accounts Receivable % of sales from Year 4 = 17%
A/R = (2,292,614) × (0.17) = $389,744
Cash10 = Total Liabilities & Owner's Equity - A/R - PP&E - Goodwill
Cash10 = 949,384 - 389,744 - 300,000 - 172,632 = $87,008
Diff: 3
Section: 3
AACSB: Analytical Thinking
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27) Cadbury plc is a global confectionery company. Cadbury is forecasting its financial statements for
Year 5. Selected financial information for Year 4 is provided in the table. What is the long term debt, the
plug variable, amount for the forecasted year? To forecast accounts payable use the percentage of sales
method based on Year 4 figures. Assume that no dividends are paid in Year 5.
Selected Financial Information
Cadbury plc Year 4 (£ millions)
Year 4
Revenue
£4,022
Net Income
£393
TOTAL ASSETS
LIABILITIES AND
STOCKHOLDERS' EQUITY
Short Term Debt
Accounts payable
Total Current Liabilities
Long Term Debt
Other Liabilities
Total Liabilities
Shareholders' Equity
Common Stock
Retained Earnings
Total Shareholders' Equity
Total Liabilities & Shareholders'
Equity
8,895
Forecast
£5,802
£528
10,275
1,189
1,551
2,740
1,973
648
5,361
1,036
2,498
3,534
1,189
648
1,036
8,895
A) £1,259
B) £1,397
C) £1,530
D) £2,027
E) £2,138
Answer: E
Explanation: E) Calculate Accounts Payable % of sales from Year 4: 38.56%
A/P = (5,802) × (0.3856) = $2,237
Long Term Debt5 = Total Assets - Total Shareholders' Equity - Total Current Liabilities - Other Liabilities
Total Shareholders' Equity5 = Common Stock5 + Retained Earnings5
Retained Earnings5 = Retained Earnings4 + Net Income5 - Dividends5
Retained Earnings5 = 2,498 + 528 - 0 = $3,026
Total Shareholders' Equity5 = 1,036 + 3,026 = $4,062
Long Term Debt5 = £10,275 - 4,062 - £3,426 - £648 = £2,138
Diff: 3
Section: 3
AACSB: Analytical Thinking
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28) Blockbuster is a video rental and retail chain. Blockbuster is forecasting its financial statements for
Year 3. Selected financial information for Years 1 and 2 is provided in the table. In Year 3 Blockbuster is
planning to invest $400,000 thousand in CAPEX. The average depreciation rate is 25%. What is the
forecasted depreciation expense in Year 3?
Selected Financial Information
Blockbuster Inc. ($ '000)
Year 1
Year 2
PP&E
$1,009,300
$919,000
Depreciation
252,325
CAPEX
162,025
A) $207,175
B) $270,256
C) $329,750
D) $314,526
E) $455,300
Answer: C
Explanation: C) Depreciation Expense3 = Dep. rate × (PPE2 + CAPEX)
Depreciation Expense3 = 0.25 × ($919,000 + 400,000) = $329,750
Diff: 2
Section: 3
AACSB: Analytical Thinking
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LO4: Learn How to Manage Additional Funds Needed
1) Q9 Networks is a leading provider of outsourced data centre infrastructure such as web-servers and
data storage. Use the equation approach and the financial data in the table to calculate additional funds
needed (AFN) in Year 6.
Selected Financial Statement Values and Ratios
Q9 Networks As of December 31, Year 5 ($ 000's)
Total Assets
$113,104
Fixed Assets
36,757
Assets that Change with Sales
41,803
Total Revenues (Year 5)
37,829
Total Revenues (Year 6)
45,395
Change in Revenues
7,566
Total Liabilities
11,779
Liabilities that Change with Sales
7,688
Profit Margin
0.27%
Dividend Payout Ratio
0%
A) -$2,292
B) -$1,301
C) $2,220
D) $6,702
E) $7,081
Answer: D
Explanation: D) AFN =
AFN =
A* =
St =
ΔS =
L* =
PM =
St+1 =
ΔS - [PM × St × (1 - d)]
Additional Funds Needed
5,046 + 36,757 = 41,803
37,829
45,395 - 37,829 = 7,566
7,688
0.0027
45,395
0
d=
AFN =
ΔS -
× 7,566 -
× 7,566 - [0.0027 × 45,395 × (1 - 0)]
AFN = $6,702
Diff: 2
Section: 4
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2) Q9 Networks is a leading provider of outsourced data centre infrastructure such as web-servers and
data storage. Use the financial information in the table to calculate Q9's maximum internal growth rate.
Selected Ratios
Q9 Networks Year 5
ROE
0.10%
ROA
0.09%
Net Profit
Margin
0.27%
Total Asset
Turnover
0.33
Dividend
Payout Rate
0%
A) 0.09%
B) 0.10%
C) 0.13%
D) 0.16%
E) 0.20%
Answer: A
Explanation: A) MIGR =
MIGR =
= 0.09%
Diff: 2
Section: 4
AACSB: Analytical Thinking
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3) Q9 Networks is a leading provider of outsourced data centre infrastructure such as web-servers and
data storage. Use the financial information in the table to calculate Q9's maximum sustainable growth
rate.
Selected Ratios
Q9 Networks Year 5
ROE
0.10%
ROA
0.09%
Net Profit
Margin
0.27%
Total Asset
Turnover
0.33
Dividend
Payout Rate
0%
A) 0.09%
B) 0.10%
C) 0.11%
D) 0.12%
E) 0.13%
Answer: B
Explanation: B) MSGR =
MSGR =
= 0.10%
Diff: 2
Section: 4
AACSB: Analytical Thinking
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4) Outlaws is a general goods retail chain in the High Plains region. Use the equation approach and
Outlaws financial information for Year 6 to calculate additional funds needed (AFN) in Year 7.
Selected Financial Statement Values and Ratios
Outlaws Inc. As of December 31, Year 6 ($ millions)
Total Assets
$14,700
Fixed Assets
9,637
Assets that Change with Sales
14,022
Total Revenues (Year 6)
29,210
Total Revenues (Year 7)
30,817
Change in Revenues
1,607
Total Liabilities
8,419
Liabilities that Change with Sales
3,651
Profit Margin
2.15%
Dividend Payout Ratio
0%
A) -$381 million
B) -$290 million
C) -$91 million
D) $127 million
E) $189 million
Answer: C
Explanation: C) AFN =
AFN =
A* =
St =
ΔS =
L* =
PM =
St+1 =
ΔS - [PM × St+1 × (1 - d)]
Additional Funds Needed
4,385 + 9,637 = 14,022
29,210
30,817 - 29,210 = 1,607
3,651
0.0215
30,817
0
d=
AFN =
ΔS -
× 1,607 -
× 1,607 - [0.0215 × 30,817 × (1 - 0)]
AFN = -$91
Outlaws will generate a surplus of $91 million.
Diff: 3
Section: 4
AACSB: Analytical Thinking
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5) CN Railways is North America's fifth largest railway. Use the equation approach and CN's financial
information for Year 10 to calculate additional funds needed (AFN) in Year 11.
Selected Financial Statement Values and Ratios
CN Railway Company
As of December 31, Year 10 ($ millions)
Total Assets
$18,924
Fixed Assets
16,898
Assets that Change with Sales
18,061
Total Revenues (Year 10)
6,110
Total Revenues (Year 11)
6,721
Change in Revenues
611
Total Liabilities
12,297
Liabilities that Change with Sales
2,134
Profit Margin
9.35%
Dividend Payout Ratio
0%
A) $64 million
B) $165 million
C) $342 million
D) $580 million
E) $965 million
Answer: E
Explanation: E) AFN =
AFN =
A* =
St =
ΔS -
Additional Funds Needed
1,163 + 16,898 = 18,061
6,110
6,721 - 6,110 = 611
2,134
0.0935
ΔS =
L* =
PM =
St+1 =
6,721
0
d=
AFN =
ΔS - [PM × St+1 × (1 - d)]
× 611 -
× 611 - [0.0935 × 6,721 × (1 - 0)]
AFN = $965
CN Railways will require additional funds of $965 million.
Diff: 3
Section: 4
AACSB: Analytical Thinking
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6) Outlaws is a general goods retail chain in the High Plains region. Use the financial information in the
table to calculate Outlaws maximum internal growth rate.
Selected Ratios
Outlaws Inc. Year 5
ROE
9.98%
ROA
4.27%
Net Profit
Margin
2.15%
Total Asset
Turnover
1.99
Dividend
Payout Rate
0%
A) 1.5%
B) 2.5%
C) 3.5%
D) 4.5%
E) 5.5%
Answer: D
Explanation: D) MIGR =
MIGR =
= 4.46%
Diff: 2
Section: 4
AACSB: Analytical Thinking
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7) Outlaws is a general goods retail chain in the High Plains region. Use the financial information in the
table to calculate Outlaws maximum sustainable growth rate.
Selected Ratios
Outlaws Inc. Year 5
ROE
9.98%
ROA
4.27%
Net Profit
Margin
2.15%
Total Asset
Turnover
1.99
Dividend
Payout Rate
0%
A) 11.0%
B) 11.1%
C) 11.2%
D) 11.3%
E) 11.4%
Answer: B
Explanation: B) MSGR =
MSGR =
= 11.09%
Diff: 2
Section: 4
AACSB: Analytical Thinking
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8) CN Railways is North America's fifth largest railway. Use the financial information in the table to
calculate CN's maximum internal growth rate.
CN Railway Company
As of December 31, Year 10
ROE
8.62%
ROA
3.02%
Net Profit
Margin
9.35%
Total Asset
Turnover
0.32
Dividend
Payout Rate
30%
A) 2.2%
B) 3.1%
C) 6.4%
D) 7.0%
E) 9.4%
Answer: A
Explanation: A) MIGR =
MIGR =
= 2.16% or 2.2%
Diff: 2
Section: 4
AACSB: Analytical Thinking
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9) Blockbuster is a North American video and DVD sales and rental chain. Use the financial information
in the table to calculate Blockbuster's maximum internal growth rate.
Selected Ratios
Blockbuster Inc.
As of December 31, Year 2
ROE
-4.18%
ROA
-3.10%
Net Profit
Margin
-4.66%
Total Asset
Turnover
0.67
Dividend
Payout Rate
0%
A) -3.0%
B) 0%
C) 1.0%
D) 2.0%
E) 3.0%
Answer: B
Explanation: B) MIGR =
MIGR =
= -0.0301 or -3.01%
ROA is negative and so is MIGR. A negative MIGR means that the firm cannot grow with internal funds
because it isn't generating internal funds. Thus, MIGR = 0%.
Diff: 2
Section: 4
AACSB: Analytical Thinking
519
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10) CN Railways is North America's fifth largest railway. Use the financial information in the table to
calculate CN's maximum sustainable growth rate.
CN Railway Company
As of December 31, Year 10
ROE
8.62%
ROA
3.02%
Net Profit
Margin
9.35%
Total Asset
Turnover
0.32
Dividend
Payout Rate
30%
A) 2.2%
B) 3.1%
C) 6.4%
D) 7.0%
E) 9.4%
Answer: C
Explanation: C) MSGR =
MSGR =
= 6.42%
Diff: 2
Section: 4
AACSB: Analytical Thinking
520
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11) Blockbuster is a North American video and DVD sales and rental chain. Use the financial information
in the table to calculate Blockbuster's maximum sustainable growth rate.
Selected Ratios Blockbuster Inc.
As of December 31, Year 2
ROE
-4.18%
ROA
-3.10%
Net Profit
Margin
-4.66%
Total Asset
Turnover
0.67
Dividend
Payout Rate
0%
A) -4.0%
B) 0%
C) 4.2%
D) 4.3%
E) 4.4%
Answer: B
Explanation: B) MSGR =
MSGR =
= -0.0401 or -4.01%
ROE is negative and so is MSGR. A negative MSGR means that the firm cannot grow with internal equity
because it isn't generating internal equity. Thus, MSGR = 0%.
Diff: 2
Section: 4
AACSB: Analytical Thinking
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12) Blockbuster is a North American video and DVD sales and rental chain. Use the equation approach
and Blockbuster's financial statement for Year 2 to calculate additional funds needed (AFN) in Year 3.
Assume that sales in Year 3 will be $5.67336 billion. Assume a 0% dividend payout rate.
Blockbuster Inc.
Income Statement and Balance Sheet
As of December 31, Year 2 ($000's)
Revenue
$ 5,157,600
COGS
2,420,700
SG&A
2,708,500
Dep. Exp.
246,600
EBIT
-218,200
Int. Exp.
78,200
Income Before Tax
-296,400
Income Taxes
-56,100
Net Income
-$ 240,300
ASSETS
Total Current Assets
716,400
PP&E
909,000
Goodwill
6,127,000
Total Assets
$ 7,752,400
LIABILITIES AND
OWNERS EQUITY
Total Current Liabilities
1,268,800
Long Term Debt
734,900
Total Liabilities
$ 2,003,700
Owners Equity
Common Stock
6,075,800
Retained Earnings
-327,100
Total Stockholder Equity
5,748,700
Total Liabilities and
Owners Equity
$ 7,752,400
A) -$225.363 million
B) $63.243 million
C) $125.363 million
D) $189.900 million
E) $299.990 million
Answer: E
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Explanation: E) AFN =
AFN =
A* =
St =
ΔS =
L* =
PM =
St+1 =
ΔS -
Additional Funds Needed
716,400 + 909,000 = 1,625,400
5,157,600
5,673,360 - 5,157,600 = 515,760
1,268,800
-0.0466
5,673,360
0
d=
AFN =
ΔS - [PM × St+1 × (1 - d)]
× 515,760 -
× 515,760 - [-0.0466 × 5,673,360 × (1 - 0)]
AFN = $299.990 million
Diff: 3
Section: 4
AACSB: Analytical Thinking
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13) Polaris Industries produces a wide range of outdoor leisure vehicles including all-terrain vehicles
(ATV's), motorcycles, and snowmobiles. Use the equation approach and Polaris' financial statement for
Year 5 to calculate additional funds needed (AFN) in Year 6. Assume that sales in Year 6 will be $1.803494
billion. Assume a 0% dividend payout rate.
Polaris Industries Inc.
Income Statement and Balance Sheet
As of December 31, Year 5 ($000's)
Revenue
$1,908,459
COGS
1,454,374
SG&A
213,114
Dep. Exp.
28,632
EBIT
212,339
Int. Exp.
4,713
Income Before Tax
207,626
Income Taxes
64,348
Net Income
$143,278
ASSETS
Cash
$ 19,675
Accounts Receivable
354,313
Total current assets
373,988
PP&E
222,336
Goodwill
172,632
Total Assets
$768,956
LIABILITIES AND
OWNERS EQUITY
Total Current Liabilities
381,299
Long Term Debt
18,000
Total Liabilities
$399,299
Owners Equity
Common Stock
417
Retained Earnings
369,240
Total Owners Equity
369,657
Total Liabilities and
Owners Equity
$768,956
A) -$135 million
B) -$139 million
C) -$146 million
D) -$155 million
E) $132 million
Answer: C
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Explanation: C) AFN =
AFN =
A* =
St =
ΔS =
L* =
PM =
St+1 =
ΔS -
Additional Funds Needed
768,956 - 19,675 - 172,632 = 576,649
1,908,459
1,803,494 - 1,908,459 = -104,965
381,299
0.0751
1,803,494
0
d=
AFN =
ΔS - [PM × St+1 × (1 - d)]
× -104,965 -
AFN = -$146,142 AFN =
AFN =
A* =
St =
ΔS =
L* =
PM =
St+1 =
ΔS -
ΔS - [PM × St+1 × (1 - d)]
Additional Funds Needed
768,956 - 19,675 - 172,632 = 576,649
1,908,459
1,803,494 - 1,908,459 = -104,965
381,299
0.0751
1,803,494
0
d=
AFN =
× -104,965 - [0.0751 × 1,803,494 × (1 - 0)]
× -104,965 -
× -104,965 - [0.0751 × 1,803,494 × (1 - 0)]
AFN = -$146,142
Diff: 3
Section: 4
AACSB: Analytical Thinking
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14) Polaris Industries produces a wide range of outdoor leisure vehicles including all-terrain vehicles
(ATV's), motorcycles, and snowmobiles. Use the financial information in the table to calculate Polaris'
maximum internal growth rate.
Selected Ratios
Polaris Industries Inc.
As of December 31, Year 5
ROE
38.76%
ROA
18.63%
Net Profit
Margin
7.51%
Total Asset
Turnover
2.48
Dividend
Payout Rate
20%
A) 8.1%
B) 17.5%
C) 22.9%
D) 44.9%
E) 63.3%
Answer: B
Explanation: B) MIGR =
MIGR =
= 0.175 or 17.5%
Diff: 2
Section: 4
AACSB: Analytical Thinking
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15) Polaris Industries produces a wide range of outdoor leisure vehicles including all-terrain vehicles
(ATV's), motorcycles, and snowmobiles. Use the financial information in the table to calculate Polaris'
maximum sustainable growth rate.
Selected Ratios
Polaris Industries Inc.
As of December 31, Year 5
ROE
38.76%
ROA
18.63%
Net Profit
Margin
7.51%
Total Asset
Turnover
2.48
Dividend
Payout Rate
20%
A) 8.1%
B) 17.5%
C) 22.9%
D) 44.9%
E) 63.3%
Answer: D
Explanation: D) MSGR =
MSGR =
= 0.449 or 44.90%
Diff: 3
Section: 4
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 15 The Management of Working Capital
LO1: Compute Optimal Inventory Level
1) The ________ is the time it takes to acquire and sell the inventory.
A) collection period
B) turnover
C) inventory period
D) operating period
Answer: C
Explanation: C) The inventory period is the time it takes to acquire and sell the inventory.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
2) The cash conversion cycle is found within the
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A) operating period.
B) accounts payable period.
C) average collection period.
D) holding period.
Answer: A
Explanation: A) Within the operating period is the cash conversion cycle.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
3) The collection period is
A) the time it takes to acquire and sell inventory.
B) the time from the sale of the product until funds are actually received.
C) the time creditors give to pay.
D) the time between ordering inventory and having a full inventory.
Answer: B
Explanation: B) The collection period is the time from the sale of the product until funds are actually
received.
Diff: 1
Section: 1.1
AACSB: Analytical Thinking
4) What is the equation for the cash conversion cycle?
A) Operating Period + Accounts Payable
B) Operating Period × Accounts Payable
C) Operating Period - Accounts Payable
D) Operating Period / Accounts Payable
Answer: C
Explanation: C) Cash Conversion Cycle = Operating Period - Accounts Payable Period.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
5) The time the vendor gives us to pay is
A) cash conversion cycle.
B) receivables turnover.
C) accounts payable period.
D) operating period.
Answer: C
Explanation: C) The accounts payable period is the time the vendor is us to pay.
Diff: 1
Section: 1.2
AACSB: Analytical Thinking
6) A company has an accounts payable period of 58 days, a collection period of 28 days, and a cash
conversion cycle of 43 days. Calculate the operating period.
A) 15
B) 101
C) 86
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D) 30
E) 28
Answer: B
Explanation: B) Operating period = Accounts payable period + cash conversion cycle
Operating period = 58 + 43 = 101
Diff: 2
Section: 1.2
AACSB: Analytical Thinking
7) Frank's Franks posted a cost of goods sold of $5,000 and had an average payables of $125. Calculate the
Accounts Payable Period.
A) 10.2
B) 9.125
C) 13.41
D) 7.65
E) 8.54
Answer: B
Explanation: B) Step 1 - Compute the Payables Turnover.
Payables turnover =
Payables turnover =
= 40
Step 2 - Use the Payables Turnover to compute the Accounts Payables Period.
Accounts payables period =
Accounts payables period =
= 9.125
Diff: 3
Section: 1.3
AACSB: Analytical Thinking
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8) Wayne's Wax World has an inventory turnover of 16 times per year and a cost of goods sold of $1,600.
Calculate the average inventory turnover.
A) 22.81
B) 1,000
C) 4.38
D) 13.92
E) 14.25
Answer: A
Explanation: A) Average inventory turnover =
Average inventory turnover =
= 22.81
Diff: 2
Section: 1.3
AACSB: Analytical Thinking
9) Firm X has an accounts payable period of 38 and a costs of goods sold of $7,500. Calculate the Average
payables.
A) 780.44
B) 197.37
C) 835.64
D) 217.26
E) 694.61
Answer: A
Explanation: A) Step 1 - Compute the Payables Turnover by using the Accounts Payables Period
formula.
Accounts payables period =
38 =
Payables turnover =
= 9.61
Step 2 - Use the Payables Turnover formula to compute the Average Payables.
Payables turnover =
9.61 =
Average payables =
= 780.44
Diff: 3
Section: 1.3
AACSB: Analytical Thinking
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10) 365 / Receivables Turnover =
A) Payment Period.
B) Collection Period.
C) Operating Period.
D) Receivables Period.
E) Payables Period.
Answer: B
Explanation: B) Collection period = 365/Receivables Turnover
Diff: 1
Section: 1.3
AACSB: Analytical Thinking
11) A company has a receivables turnover of 16, a cost of goods sold of $8,000, and an average payables of
$1,200. Calculate the collection period.
A) 22.81
B) 54.75
C) 31.25
D) 43.16
E) 25.64
Answer: A
Explanation: A) Collection period =
Collection period =
= 22.81
Diff: 2
Section: 1.3
AACSB: Analytical Thinking
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12) A company has a collection period of 37.5 days, an inventory period of 93.4 days, and a payables
turnover of 48.12. Calculate the cash conversion cycle.
A) 82.78
B) 130.9
C) 123.31
D) 85.62
E) 120.31
Answer: C
Explanation: C) Step 1 - Compute the Operating Period.
Operating period = Inventory period + Collection period
Operating period = 93.4 + 37.5 = 130.90
Step 2 - Compute the Accounts Payable Period.
Accounts Payable Period =
Accounts Payable Period =
= 7.59
Step 3 - Use the Operating Period and Account Payable Period to compute the Cash Conversion Cycle.
Cash conversion cycle = Operating period - Accounts payable period
Cash conversion cycle = 130.90 - 7.59 = 123.31
Diff: 3
Section: 1.3
AACSB: Analytical Thinking
13) All of the following will increase the cash conversion cycle EXCEPT
A) an increase in accounts receivable.
B) an increase in inventory.
C) an increase in costs of goods sold.
D) an increase in accounts payable.
Answer: D
Explanation: D) An increase in accounts payable decreases the cash conversion cycle.
Diff: 1
Section: 1.4
AACSB: Analytical Thinking
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Copyright © 2015 Pearson Canada, Inc.
LO2: Use the Economic Order Quantity Method to Compute Optimal Inventory Level
1) Shortage costs can be enormous.
Answer: TRUE
Explanation: Shortage costs can be enormous.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
2) At least how much of a typical manufacturing firms assets are tied up in inventory?
A) 15%
B) 25%
C) 10%
D) 30%
E) 35%
Answer: A
Explanation: A) Typical manufacturing firms have at least 15% of assets tied up in inventory.
Diff: 1
Section: 2
AACSB: Analytical Thinking
3) Which of the following is not a type of manufacturing inventory?
A) Work in process
B) Raw materials
C) Intangible
D) Finished goods
Answer: C
Explanation: C) The three types of inventory are raw materials, work in process, and finished goods.
Diff: 1
Section: 2.1
AACSB: Analytical Thinking
4) Which of the following is a cost of holding inventory?
A) Workers comp
B) Reordering costs
C) Conversion costs
D) Insurance costs
Answer: D
Explanation: D) The costs associated with holding inventory include opportunity costs of tied up funds,
storage costs, insurance costs, and costs of obsolescence, damage, and theft.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
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5) The combined costs of holding inventory are called
A) opportunity costs.
B) storage costs.
C) carrying costs.
D) stocking charges.
E) maintenance costs.
Answer: C
Explanation: C) The combined costs of holding inventory are called carrying costs.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
6) ________ costs fall when larger inventory levels are maintained.
A) Insurance
B) Reorder
C) Storage
D) Carrying
E) Opportunity
Answer: B
Explanation: B) As the size of average inventory order increases, reorder costs fall.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
7) ________ are costs associated with the consequences of running out of inventory.
A) Reorder costs
B) Opportunity costs
C) Storage costs
D) Shortage costs
E) Carrying costs
Answer: D
Explanation: D) Shortage costs are associated with the consequences of running out of inventory.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
8) Inventory carrying costs include all of the following EXCEPT
A) storage costs.
B) the cost of financing the inventory investment.
C) the cost of taking trade discounts.
D) insurance.
E) damage and theft costs.
Answer: C
Explanation: C) The costs associated with holding inventory include opportunity costs of tied up funds,
storage costs, insurance costs, and costs of obsolescence, damage, and theft.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
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9) The cost of obsolescence, damage, and theft is considered part of
A) Shortage Costs.
B) Opportunity Costs.
C) Carrying Costs.
D) Insurance Costs.
Answer: C
Explanation: C) The cost of obsolescence, damage, theft is part of carrying costs.
Diff: 1
Section: 2.2
AACSB: Analytical Thinking
10) Car-Quake Stereo plans to sell 500 bass boosters this year. If the carrying cost per unit is $1 and the
cost per order is $25, what is the optimal number of units per order?
A) 150
B) 168
C) 125
D) 173
E) 158
Answer: E
Explanation: E) Q* =
Q* =
Q* = 158.11
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
11) The optimal ordering quantity for a company is 350. If the carrying cost per item is $2.50 and the cost
per order is $18, what is the number of total sales expected for the year?
A) 7,516
B) 5,314
C) 10,305
D) 8,507
E) 6,924
Answer: D
Explanation: D) Q* =
350 =
122,500 =
306,250 = 36 × S
S = 8,506.94
Diff: 3
Section: 2.3
AACSB: Analytical Thinking
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12) Carrying costs per unit are $3.00. An average order contains 200 units. According to the economic
order quantity model, what are total carrying costs?
A) $300
B) $67
C) $600
D) $400
E) $565
Answer: A
Explanation: A) Total carrying cost = CC ×
Total carrying cost = $3 ×
= $300
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
13) ABC Co. has an average inventory of 750. The carrying cost per item is 1.25, the ordering cost is $18
per order, and they make 28 orders per year. What is the total carrying cost for ABC Co?
A) $504
B) $937.50
C) $1,166.67
D) $844.50
E) $492.65
Answer: B
Explanation: B) Total carrying cost = CC ×
Total carrying cost = $1.25 × 750 = $937.50
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
536
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14) Approximately how often should Jed's Supermarket order 20 oz. cans of Splat Spiced Possum if it
expects to sell 5,000 cases per year, the ordering cost is $0.50 per order, and the carrying cost is $0.75/case?
A) 45.29 times per year
B) 61.24 times per year
C) 63.67 times per year
D) 24.56 times per year
E) 55.36 times per year
Answer: B
Explanation: B) Step 1 - Compute the optimal number of units per order.
Q* =
Q* =
Q* = 81.65
Step 2 - Use the optimal number of units per order to compute how often they should order.
=
= 61.24
Diff: 3
Section: 2.3
AACSB: Analytical Thinking
15) The order cost per order is $10. Expected sales are 500,000 units and 20,000 units are in each order.
What is the total order cost?
A) $20,000
B) $500,000
C) $250
D) $200,000
E) $2,000
Answer: C
Explanation: C) Step 1 - Compute the number of times they order.
=
= 25
Total order cost is the number of times they order multiplied times the cost of each order:
25 × $10 = $250
Diff: 2
Section: 2.3
AACSB: Analytical Thinking
537
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16) If a firm uses the EOQ model to manage its inventory and its managers decide to hold safety stock, its
A) reorder costs will fall.
B) processing costs will fall.
C) orders will be less frequent.
D) shortage costs will rise.
E) first order is increased to include the extra number of units sold.
Answer: E
Explanation: E) EOQ assumes inventor will hit 0 before re-ordering. Adding safety stock will increase
the first order.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
17) As the number of units per order ________, total carrying costs ________.
A) increases; stay the same
B) increases; increase
C) decreases; increase
D) decreases; stay the same
E) increases; decrease
Answer: B
Explanation: B) Total carrying cost = CC ×
Therefore, as Q increases, total carrying costs increase.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
18) The minimum level of inventory a firm keeps on hand.
A) EOQ
B) Safety Stock
C) Reorder Point
D) Optimum Inventory Level
Answer: B
Explanation: B) Safety stock is a minimum level of inventory a firm keeps on hand.
Diff: 1
Section: 2.3
AACSB: Analytical Thinking
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19) A company has predicted annual sales of 2500 units, an ordering cost of $35, and a carrying cost of
$1.75 per unit. How many orders should they make this year?
A) 71.43
B) 12.65
C) 7.91
D) 23.46
E) 15.64
Answer: C
Explanation: C) Step 1 - Compute the optimal number of units per order.
Q* =
Q* =
Q* = 316.23
Step 2 - Use the optimal number of units per order to compute how often they should order.
=
= 7.91
Diff: 3
Section: 2.3
AACSB: Analytical Thinking
20) Which type of firm would benefit the most from a "basket" type of inventory management system?
A) "Category-killer" office supply stores
B) Aircraft manufacturers
C) Defence contractors
D) Public accounting firms
E) Automotive manufacturers
Answer: D
Explanation: D) The basket approach may be appropriate for low value inventory items or when
inventory represents a very small part of the firm's assets.
Diff: 1
Section: 2.4
AACSB: Analytical Thinking
21) The inventory method that relies on deliveries coming right before they are needed is
A) Just-in-Time.
B) Basket.
C) LIFO.
D) FIFO.
Answer: A
Explanation: A) The idea behind the just-in-time inventory is that parts and supplies are delivered just as
firms need them.
Diff: 1
Section: 2.4
AACSB: Analytical Thinking
539
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LO3: Evaluate the Nature of Float and How It Affects a Firm's Cash Requirements
1) Each of the following is a decision that can be avoided if a firm refuses to offer credit EXCEPT
A) collection period.
B) discounts to give fast payers.
C) accounts payable.
D) who to extend credit to.
Answer: C
Explanation: C) Firm managers must decide how aggressive collection efforts should be, who should
receive credit, and what discounts the firm will give to customers who pay promptly. All of these
problems can be avoided if the firm simply refuses to offer credit.
Diff: 1
Section: 3
AACSB: Analytical Thinking
2) The primary reason for offering customers credit is to
A) increase the predictability of cash flows.
B) stimulate sales.
C) smooth billing cycles.
D) reduce the risk of nonpayment.
E) speed cash flows.
Answer: B
Explanation: B) The primary reason for offering credit is to stimulate sales.
Diff: 1
Section: 3.1
AACSB: Analytical Thinking
3) Many industries offer trade credit so frequently, that failing to do so would result in failure. What is
the real credit decision for companies in such industries?
A) What terms to offer
B) Which collection company to use
C) How to obtain credit for purchases
D) Maximum credit to extend
Answer: A
Explanation: A) The real decision for industries that offer trade credit frequently is what terms to offer.
Diff: 1
Section: 3.1
AACSB: Analytical Thinking
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4) If credit terms are 2/30, net 60, what is the effective annual rate for a customer's loan when the
customer pays the invoice in 60 days?
A) 44%
B) 16%
C) 59%
D) 11%
E) 28%
Answer: E
Explanation: E) Step 1 - Compute the number of periods in a year.
60 - 30 = 30 days.
= 12.167
Step 2 - Compute the percentage holding cost per period.
= 0.02041
Step 3 - Compute the EIR.
EIR =
-1
EIR = (1 + 0.02041)12.167 - 1
EIR = 0.2787 or 28%
Diff: 3
Section: 3.2
AACSB: Analytical Thinking
5) Optimal credit policy is one in which the
A) increased cash flow from sales equals the carrying cost of accounts receivable.
B) sales of a firm are maximized.
C) increased profit from sales equals the costs of carrying and administering accounts receivable.
D) customers pay their bills on time, without exception.
E) costs of taking a trade discount equal its benefits.
Answer: C
Explanation: C) The optimal amount of credit is where cost of receivables = revenues from increased
sales.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
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6) All of the following are costs of credit EXCEPT
A) bad debt losses.
B) credit analysis expenses.
C) lost revenues when customers do not take advantage of trade discounts.
D) the increased investment in accounts receivable.
Answer: C
Explanation: C) The three factors of cost of credit include cost of holding increased accounts receivable,
bad debt losses, and the cost of administering the accounts receivable which includes credit analysis.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
7) All of the following are part of the five "Cs" of credit analysis EXCEPT
A) currency.
B) capital.
C) collateral.
D) conditions.
E) capacity.
Answer: A
Explanation: A) The 5 C's include character, capacity, capital, conditions, and collateral.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
8) The best source of information about a customer's credit is/are
A) the firm's experience with the customer.
B) Dun and Bradstreet.
C) information from the customer's bank.
D) data from financial markets.
E) credit references supplied by the customer.
Answer: A
Explanation: A) The best information may be from the firm's own prior experience with the customer.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
9) An accounts receivable aging schedule is used to
A) decide whether to extend credit.
B) determine whether legal action should be taken against a customer with a past due account.
C) provide information about whether the firm's prices are too low.
D) monitor accounts receivable.
E) make decisions regarding the length of time a firm should take before paying suppliers.
Answer: D
Explanation: D) Aging schedule is a list of amounts due, organized by due dates.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
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10) What stipulates how a firm will handle each phase of the credit decision?
A) Credit Policy
B) Credit Period
C) Trade Credit
D) Cash Discount
Answer: A
Explanation: A) A firm's credit policy stipulates how it will handle each phase of the credit decision.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
11) The length of time it takes a buyer to acquire, process, and sell the inventory is the
A) Receivables Cycle.
B) Receivables Period.
C) Inventory Cycle.
D) Inventory Period.
Answer: D
Explanation: D) The inventory period is the length of time it takes a buyer to acquire process and sell the
inventory.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
12) What is a widely used method to speed up the collection of accounts receivable?
A) Zero Rate
B) Cash Discounts
C) LIFO
D) Late Penalties
Answer: B
Explanation: B) Cash discounts are widely used as a method to speed up the collection of accounts
receivable.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
13) A company is offering a discount with terms 3/15 net 40. What is the discount rate associated with this
offer?
A) 3%
B) 15%
C) 40%
D) 20%
E) 5%
Answer: A
Explanation: A) 2/10 net 30 means a 2% discount will be available if the customer pays in 10 days,
otherwise the full bill will be due in 30 days.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
543
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14) The annualized interest rate that is realized when not taking advantage of a possible cash discount is
known as
A) high cost financing.
B) low cost financing.
C) the effective interest rate.
D) the flat rate.
Answer: C
Explanation: C) The effective interest rate for a discount is the cost of not paying early and taking the
discount.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
15) A company has the possibility to pay off a line of credit early for a 2% discount rate if paid off in 25
days. There are 24.333 discount periods for the year for this money if the discount is not taken. What are
the terms for this cash discount?
A) 2/25 net 50
B) 2/25 net 40
C) 2/25 net 60
D) 2/25 net 70
E) 2/25 net 30
Answer: B
Explanation: B)
= 24.33
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
16) Calculate the APR for an invoice that has the terms 1/20 net 45.
A) 14.75%
B) 18.80%
C) 12.25%
D) 15.65%
E) 10.35%
Answer: A
Explanation: A) APR = Periodic rate × number of periods
Periodic rate =
= .0101
number of periods =
= 14.6
APR = .0101 × 14.6 = 14.75%
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
544
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17) What is the percentage holding cost per period for a credit with the terms of 2/30 net 60?
A) .0101
B) .2787
C) .0667
D) .0204
E) .0352
Answer: D
Explanation: D)
= .020408
Diff: 2
Section: 3.2
AACSB: Analytical Thinking
18) What is a usual default rate when looking at bad debt losses?
A) 2%
B) 3%
C) 4%
D) 5%
E) 6%
Answer: A
Explanation: A) Default rates of 1 or 2% are not unusual.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
19) Which of the following is not considered a cost for administering the accounts receivable?
A) analyzing credit
B) increased holdings
C) sending out bills
D) collecting past due accounts
Answer: B
Explanation: B) Increased holdings is not considered a cost for administering accounts receivable.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
20) ________ can be found where cost of receivables is equal to the revenues from increased sales.
A) Accounts payable
B) Accounts receivable
C) Optimal amount of credit
D) Cost of extending credit
Answer: C
Explanation: C) The optimal amount of credit is found where the cost of receivables is equal to the
revenues from increased sales.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
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21) As the amount of credit extended increases, the ________ decreases.
A) Optimal amount of credit
B) Net cost of receivables
C) Cost of receivables
D) Revenues from increased sales
Answer: D
Explanation: D) Additional revenues from increased sales decrease as the amount of credit increases.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
22) In the 5 C's of credit analysis, ________ is the ability of the borrower to pay.
A) Capacity
B) Capital
C) Character
D) Collateral
E) Collections
Answer: A
Explanation: A) Capacity is the ability of the borrower to pay.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
23) ________ is the willingness of the borrower to pay obligations owed.
A) Capital
B) Character
C) Conditions
D) Capacity
E) Collections
Answer: B
Explanation: B) Character is the willingness of the borrower to pay obligations owed.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
24) If a company has not had prior experience with a client, where might they obtain the credit
information?
A) Rating Companies
B) 5 C's
C) Complex Programs
D) Friends and family
Answer: A
Explanation: A) When prior experience is not available, the manager can obtain the information from
credit rating companies.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
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25) What would help track the use of discounts offered as well as delinquency occurrence?
A) Debt Table
B) Aging Schedule
C) Invoice Tracker
D) Average Collection Period
Answer: B
Explanation: B) An aging schedule would be useful to track how many customers are taking advantage
of the discount and how many are truly delinquent.
Diff: 1
Section: 3.2
AACSB: Analytical Thinking
LO4: Recognize the Real Cost of Using Trade Credit
1) In one sense, holding cash is a waste of resources.
Answer: TRUE
Explanation: In one sense, holding cash is a waste of resources.
Diff: 1
Section: 4
AACSB: Analytical Thinking
2) Which of the following does not relate to "float"?
A) Stock-outs
B) Cheque-processing delays
C) Electronic funds transfer (EFT)
D) Concentration banking
Answer: A
Explanation: A) Float occurs because of delays in the banking system.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
3) ________ float occurs when there is a delay between when a firm issues a cheque and when the funds
are removed from the chequing account balance.
A) Net
B) Book balance
C) Disbursement
D) Collection
E) Electronic funds transfer (EFT)
Answer: C
Explanation: C) Disbursement float occurs when there is a delay between the firm issues a cheque and
when the funds are removed from the chequing account balance.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
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4) ________ float can be calculated by subtracting a firm's book balance from the firm's available balance.
A) Net
B) Collection
C) Electronic funds transfer (EFT)
D) Compensating
E) Disbursement
Answer: A
Explanation: A) We calculate net float as the difference between the firm's available balance and the
firm's book balance.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
5) Net float equals
A) disbursement float + collection float.
B) the available balance − the firm's book balance.
C) disbursement float − collection float − the firm's book balance.
D) disbursement float − collection float.
E) disbursement float + collection float − the firm's available balance.
Answer: B
Explanation: B) Net Float = Available Balance - Book Balance.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
6) The delay between when you receive payment and when the bank gives you credit is called
A) Disbursement Float.
B) Net Float.
C) Clearing Float.
D) Collection Float.
Answer: D
Explanation: D) Collection float occurs when there's a delay between when you receive payment and
when the bank gives you credit.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
7) A(n) ________ is an annotation put on a chequing account preventing funds on deposit that can be
spent.
A) Hold
B) Stop
C) Float
D) ETF
Answer: A
Explanation: A) A hold is an annotation put on a chequing account preventing funds on deposit that can
be spent.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
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8) Why might a bank put a hold on a small personal cheque?
A) Not wanting to disburse funds they have not yet received
B) Requested by the payee
C) Uncertain the cheque is good
D) Prevent fraud
Answer: C
Explanation: C) Smaller personal cheques may have holds placed by the bank if the bank is uncertain
whether the cheque is good.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
9) What is a reason the government prefers electronic banking over paper banking?
A) Increased transaction costs
B) Decreased float
C) Decreased electronic use
D) Decreased banking fraud
Answer: B
Explanation: B) In addition to savings in processing cost, float is reduced to virtually zero.
Diff: 1
Section: 4.1
AACSB: Analytical Thinking
10) The ________ motive for holding cash is the need to pay debts that arise as a regular consequence of
doing business.
A) Transactional
B) Precautionary
C) Speculative
D) Intuitive
Answer: A
Explanation: A) The transactional motive for holding cash is the need to pay debts that arise as a regular
consequence of doing business.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
11) The ________ motive for holding cash is to take advantage of bargain purchases or opportunities that
might arise.
A) Transactional
B) Precautionary
C) Intuitive
D) Speculative
Answer: D
Explanation: D) The speculative motive for holding cash is to take advantage of bargain purchases or
opportunities that might arise.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
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550
Copyright © 2015 Pearson Canada, Inc.
12) The ________ motive for holding cash is the need for a safety supply to act as a financial reserve
against unexpected events.
A) Transactional
B) Precautionary
C) Speculative
D) Intuitive
Answer: B
Explanation: B) The precautionary motive for holding cash is the need for a safety supply to act as a
financial reserve against unexpected events.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
13) The three motives for holding cash are
A) float reduction, precautionary, and speculative.
B) buffer stock, speculative, and transactional.
C) speculative, transactional, and precautionary.
D) float reduction, buffer stock, and transactional.
E) convenience, transactional, and precautionary.
Answer: C
Explanation: C) There are three reasons for holding cash — transactional, precautionary, and speculative.
Diff: 1
Section: 4.2
AACSB: Analytical Thinking
551
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LO5: Evaluate the Tradeoff Between Different Credit Policies
1) What is a danger in using only short term borrowing?
A) Higher rates than long term borrowing
B) Lower fee per loan
C) Cost of borrowing can increase
D) Less flexibility
Answer: C
Explanation: C) The risk from using short term money in that the cost of borrowing can rise if interest
rates increase.
Diff: 1
Section: 5
AACSB: Analytical Thinking
2) What is an advantage of short term lending for banks?
A) New fees every loan
B) More flexibility
C) Locked in rates
D) Increased clients
Answer: A
Explanation: A) The advantage of short term lending to banks is that they can charge fees every time a
new loan is made.
Diff: 1
Section: 5
AACSB: Analytical Thinking
3) What does a self-liquidating bank loan mean?
A) The loan pays of itself.
B) The loan is received in cash only.
C) The loan is used to purchase assets that are worth more than the loan.
D) The loan is used to finance an asset that will pay off the loans.
Answer: D
Explanation: D) Short-term bank loans are often self-liquidating, meaning the loan is made to finance an
asset that will pay off the loans.
Diff: 1
Section: 5
AACSB: Analytical Thinking
4) All of the following are forms of short term financing EXCEPT
A) receivable financing.
B) inventory financing.
C) lines of credit.
D) self-liquidating loans.
Answer: C
Explanation: C) Short term financing includes self-liquidating loans, receivables financing, and inventory
financing; Line of credit is the total amount that can be borrowed.
Diff: 1
Section: 5
AACSB: Analytical Thinking
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5) The total amount that can be borrowed is the firm's
A) line of credit.
B) max credit.
C) line limit.
D) credit limit.
Answer: A
Explanation: A) The total amount that can be borrowed is the firm's line of credit.
Diff: 1
Section: 5
AACSB: Analytical Thinking
6) A bank will typically lend the firm no more than ________% of the book value of receivables.
A) 70
B) 80
C) 60
D) 50
E) 40
Answer: B
Explanation: B) The bank will typically lend the firm no more than 80% of the book value of receivables.
Diff: 1
Section: 5
AACSB: Analytical Thinking
7) The firm borrows a portion of the value of its inventory and pays off the loan from the proceeds
generated by selling the inventory. This is known as
A) inventory financing.
B) receivable financing.
C) sales financing.
D) liquidation financing.
Answer: A
Explanation: A) Inventory financing is when firm borrows a portion of the value of its inventory and
pays off the loan from the proceeds generated by selling inventory.
Diff: 1
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AACSB: Analytical Thinking
8) This kind of financing requires the firm to pledge its accounts receivables to the bank as collateral for
the loan.
A) Inventory financing
B) Sales financing
C) Receivable financing
D) Liquidation financing
Answer: C
Explanation: C) Receivables financing usually requires the firm to pledge its accounts receivables to the
bank as collateral for the loan.
Diff: 1
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Chapter 16 International Finance
LO1: Explain the Basics of Exchange Rates
1) ________ is the price of one country's money quoted in terms of another country's money.
A) Arbitrage
B) PPP
C) Exchange rate
D) Direct rate
Answer: C
Explanation: C) The exchange rate is the price of one country's money quoted in terms of another
country's money.
Diff: 1
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2) ________ risk is the risk of loss due to exchange rates moving over time.
A) Exchange rate
B) Interest rate
C) Political
D) Reinvestment rate
E) Systematic
Answer: A
Explanation: A) Exchange rate risk is the risk of loss due to exchange rates moving over time.
Diff: 1
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3) Why are exchange rates important?
A) They affect the relative price of domestic and foreign products
B) They show how much stronger one country is than the other
C) They allow you to buy products cheaper in foreign markets
D) They provide important information about current the economic status
Answer: A
Explanation: A) Exchange rates are important because they affect the relative price of domestic and
foreign products.
Diff: 1
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4) If the exchange rate makes foreign goods ________ expensive, demand will increase and imports are
likely to ________.
A) less; fall
B) less: rise
C) more; fall
D) more; rise
Answer: B
Explanation: B) If the exchange rate makes foreign goods less expensive, demand will increase and
exports are likely to rise.
Diff: 1
Section: 1
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5) The Canadian dollar equivalent of 1 unit of a foreign currency is called the
A) base rate.
B) counter rate.
C) indirect rate.
D) direct rate.
Answer: D
Explanation: D) The Canadian dollar equivalent of 1 unit of foreign currency is called the direct rate.
Diff: 1
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6) There is an indirect rate of 0.74 between the American dollar and the Canadian dollar. How many
American dollars could you buy for 5,000 Canadian dollars?
A) 3,700
B) 7,430
C) 6,760
D) 5,420
Answer: C
Explanation: C) Indirect rate shows the amount of foreign currency $1 will buy; 5000/.74 = 6756.76
Diff: 2
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7) Exchange rates are reported as fractions with the ________ in the denominator and the ________ in the
numerator.
A) counter rate; base rate
B) base rate; counter rate
C) foreign currency; domestic currency
D) domestic currency; foreign currency
Answer: B
Explanation: B) Exchange rates are reported as fractions, with the base rate as the denominator and the
counter rate as the numerator. The foreign and domestic rate switches depending on if it is a direct or
indirect rate.
Diff: 1
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8) The amount of foreign currency 1 Canadian dollar will buy is called the
A) base rate.
B) counter rate.
C) indirect rate.
D) direct rate.
Answer: C
Explanation: C) The amount of foreign currency 1 Canadian dollar will buy is called the indirect rate.
Diff: 1
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9) You see the Greek drachma (GRD) quoted at $0.003635. Yesterday, it was quoted at $0.003521. The
drachma ________ by ________.
A) depreciated; 1.14%
B) appreciated; 3.05%
C) depreciated; 3.05%
D) appreciated; 3.24%
E) depreciated; 3.24%
Answer: D
Explanation: D) 0.003635 - 0.003521 = 0.000114; 0.00114 / 0.003521 =0.0324. It appreciated since it now
takes fewer drachma to buy one $.
Diff: 3
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10) Carol plans to visit Japan next week and wishes to convert $1,000 Canadian into yen to cover her
travel expenses. If her travel agent quotes her an exchange rate of 115¥/$, how many yen will she obtain?
A) 115,000
B) 110,000
C) 150,000
D) 5.0
E) 8.7
Answer: A
Explanation: A) 1,000 × 115 = 115,000
Diff: 1
Section: 1
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11) What is the percentage change in price for an Canadian importer of Indian sitar music cassettes if the
Indian rupee/Canadian dollar exchange rate goes from 12 rps./$ to 14rps./$ and the price of a cassette is
50 rupees?
A) -16.7%
B) -14.4%
C) +20.2%
D) +16.5%
E) +14.2%
Answer: B
Explanation: B) 50 / 12 = 4.17; 50 / 14 = 3.57 ; 3.57 - 4.17 = -0.60 ; -0.60 / 4.17 = -0.144
Diff: 3
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12) Assume $1 buys .685 pounds and that $1 buys 78.342 Yen. Calculate the cross rate.
A) 114.37¥/£
B) .01¥/£
C) 53.66¥/£
D) 98.25¥/£
Answer: A
Explanation: A) 1C$/.685L = 1.46; 1.46C$/L × 78.342Y/C$ = 114.37Y/L
Diff: 3
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AACSB: Analytical Thinking
13) If you have the exchange rates for converting Canadian dollars to Yen and Canadian dollars to the
Euro, you could convert from Yen to Euro by using a
A) spot rate.
B) indirect rate.
C) counter rate.
D) cross rate.
Answer: D
Explanation: D) A cross rate is computed using the exchange rates between the Canadian dollar and 2
other currencies.
Diff: 1
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14) When buying foreign currency, you can expect to receive the rates quoted on the internet.
Answer: FALSE
Explanation: Because retail exchange rates allow for a profit to the dealer, you'll receive less foreign
currency than indicated by the exchange rates quoted on the internet.
Diff: 1
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15) The foreign exchange market is ________ and functions much like a ________ market.
A) noncompetitive; decentralized
B) competitive; centralized
C) noncompetitive; centralized
D) competitive; decentralized
Answer: B
Explanation: B) Because of the rapid flow of information among traders, the foreign exchange market is
very competitive and functions like a centralized market.
Diff: 1
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16) ________ exchange rates apply to exchanges of funds that occur at the present time.
A) Forward
B) Current
C) Spot
D) Foreign
Answer: C
Explanation: C) Spot exchange rates apply to exchanges of funds that occur at the present time.
Diff: 1
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17) By using a forward transaction, ________ has been transferred from the firm to a speculator in the
exchange rate market.
A) Exchange rate risk
B) Political risk
C) Foreign risk
D) Market risk
Answer: A
Explanation: A) By using a forward transaction, exchange rate risk has been transferred from the firm to
a speculator in the exchange rate market.
Diff: 1
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18) Exchange rates
A) help increase a nation's productivity level.
B) are a minor consideration for foreign investors.
C) are volatile and introduce a source of risk in international transactions.
D) are currently fixed for the world's major currencies.
E) have little effect on the prices of imports and exports.
Answer: C
Explanation: C) Exchange rates regularly fluctuate over time.
Diff: 2
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19) Foreign currency trading
A) takes place on organized exchanges.
B) mostly entails small transactions.
C) volume averages less than $1 billion per day.
D) is conducted in less-than-competitive markets.
E) takes place in markets similar to OTC stock markets.
Answer: E
Explanation: E) The foreign exchange market is organized much like the over-the-counter stock market.
Diff: 1
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20) Forward transactions
A) seldom benefit manufacturing firms.
B) typically only enable the buyer of the forward contract to benefit from favorable exchange rate
changes, but not the seller.
C) are widely used to reduce exchange rate risk.
D) are processed by dealers, but seldom by money-center banks.
E) are executed in spot markets.
Answer: C
Explanation: C) Forward transactions are used by businesses that want to reduce exchange rate risk.
Diff: 1
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21) If the dollar appreciates against the Irish punt,
A) the Canadian price of Irish goods will rise.
B) the Canadian exports to Ireland will fall.
C) then the punt also appreciates against the Canadian dollar.
D) the Canadian inflation rate will have a tendency to rise.
E) the Irish exports to the Canadian should decline.
Answer: B
Explanation: B) If the dollar appreciates, the price of the Canadian goods would rise overseas causing
demand to fall.
Diff: 2
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LO2: Explain How Exchange Rates Are Established
1) Each of the following is a factor that affects exchange rates EXCEPT
A) Domestic economy
B) Supply and demand of currency
C) Relative price of goods
D) Returns on international investments in securities
Answer: A
Explanation: A) Many issues affect exchange rates including supply and demand for each country's
currency, the relative price of goods, and the returns that can be earned on international investments in
securities. Exchange rates directly affect domestic economy.
Diff: 1
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2) As long the flow of currencies is ________, the exchange rate can remain ________.
A) out of balance; constant
B) equal; in flux
C) there is no relationship between the two
D) equal; constant
Answer: D
Explanation: D) As long as the flow of currencies between countries is equal, the exchange rate can
remain constant.
Diff: 1
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3) Governments become very concerned with their exchange rates because they directly affect the
A) Foreign economy
B) Demand of currency
C) Domestic economy
D) Supply of currency
Answer: C
Explanation: C) Governments become very concerned with exchange rates because they directly affect
domestic economy.
Diff: 1
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4) ________ exports can be caused by a(n) ________ currency, which can cause slower growth.
A) Decreasing; appreciating
B) Decreasing; depreciating
C) Increasing; appreciating
D) Increasing; depreciating
Answer: A
Explanation: A) When exports decrease because of an appreciating currency, domestic firms will have
slower growth and reduce profits, and will employ fewer workers.
Diff: 2
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5) If the Canadian dollar currently buys more Brazilian goods than the Brazilian real buys Canadian
goods,
A) purchasing power parity holds at this moment.
B) the real should appreciate.
C) the dollar should appreciate.
D) Brazilian prices should fall.
E) U.S. prices should rise.
Answer: B
Explanation: B) The increased supply of Canadian dollars in Brazil makes it more difficult to convert,
decreasing the value of the dollar in comparison to the real.
Diff: 2
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AACSB: Analytical Thinking
6) Two homogeneous products from Germany and Brazil are being purchased by an Canadian trader.
The product from Germany is cheaper than the product from Brazil. According to ________, the trader
will purchase the products from Germany until the increased demand for the German product equalizes
the price.
A) Arbitrage
B) Purchasing power parity
C) Law of one price
D) Exchange rate arbitrage
Answer: C
Diff: 1
Section: 2
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7) The ________ states that two identical products produced in two different countries should cost the
same to traders in any other country.
A) Law of one price
B) Relative purchasing power parity
C) Absolute purchasing power parity
D) Arbitrage
Answer: A
Explanation: A) Law of one price says that two identical products produced in two different countries
should cost the same to traders in any other country.
Diff: 1
Section: 2
AACSB: Analytical Thinking
8) Low ________ for homogeneous commodities, such as oil, lets traders take advantage of price
differences that may emerge.
A) Exchange rates
B) Arbitrage
C) PPP
D) Transportation costs
Answer: D
Explanation: D) Oil is a homogeneous commodity and cheaply transported so traders can take advantage
of price differences that may emerge.
Diff: 1
Section: 2
AACSB: Analytical Thinking
9) According to the theory of purchasing power parity, if the price of haircuts in Canada is lower than
those in Mexico,
A) Canadian exports should increase.
B) there would be little effect in both currency and services markets.
C) the value of the peso should fall by a large amount.
D) the value of the dollar should rise by a large amount.
E) Mexican imports should rise.
Answer: B
Explanation: B) If you learn that haircuts cost less in France than in England, there's little you can do to
earn a profit with this opportunity.
Diff: 1
Section: 2
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10) The idea behind ________ is that exchange rates must adjust over time to maintain the law of one
price.
A) Arbitrage
B) Purchasing power arbitrage
C) Purchasing power parity
D) Exchange rate risk
Answer: C
Explanation: C) The idea behind purchasing power parity is that exchange rates must adjust over time to
maintain the law of one price.
Diff: 1
Section: 2
AACSB: Analytical Thinking
11) If ________ didn't hold, the price of goods would change because merchants would buy cheap goods
and avoid the expensive ones.
A) Purchasing power parity
B) Arbitrage
C) Exchange rates
D) Law of one price
Answer: A
Explanation: A) If purchasing power parity didn't hold, the price of goods would change because
merchants would buy the cheap goods and avoid the expensive ones.
Diff: 1
Section: 2
AACSB: Analytical Thinking
12) ________ is the act of trading to profit from a violation of the law of one price.
A) Relative purchasing power parity
B) Arbitrage
C) Absolute purchasing power parity
D) Purchasing power arbitrage
Answer: D
Explanation: D) Purchasing power arbitrage is the act of trading to profit from a violation of the law of
one price.
Diff: 1
Section: 2
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13) Traders take advantage of deviations from purchasing power parity by buying cheap goods and
selling expensive ones. This trading causes the price of goods to ________ and exchange rates to
________.
A) fall; fall
B) rise; rise
C) fall; rise
D) rise; fall
Answer: B
Explanation: B) PPP depends on traders taking advantage of deviations from PPP by buying low and
selling high. This trading causes both the price of the goods and the exchange rates to rise.
Diff: 1
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14) PPP won't hold if the goods aren't transportable or
A) close substitutes.
B) unique.
C) expensive.
D) cheap.
Answer: A
Explanation: A) PPP won't hold if the goods aren't transportable or close substitutes.
Diff: 1
Section: 2
AACSB: Analytical Thinking
15) 1 year ago $1 would buy 6.5 pesos. Today $1 buys 7.5 pesos. If Canada had an inflation rate of 3%,
calculate Mexico's inflation rate.
A) 3.1%
B) 6.1%
C) 4.2%
D) 7.8%
Answer: B
Explanation: B) 6.7 = 6.5 × [ 1 + ( X - .03) ]; 6.7/6.5 = 1 + (X - .03) ; 1.031 - 1 = X - .03; X = .061
Diff: 3
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16) The ________ represents a best guess as to what the spot rate will be in the future.
A) PPP
B) Arbitrage
C) Exchange rate
D) Forward rate
Answer: D
Explanation: D) The forward rate represents a best guess as to what the spot rate will be in the future.
Diff: 1
Section: 2
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17) In the short run, relative purchasing power parity does not explain changes in exchange rates well.
Answer: TRUE
Explanation: Studies show that in the short run, relative purchasing power parity doesn't explain
changes in exchange rates well.
Diff: 1
Section: 2
AACSB: Analytical Thinking
18) Strict PPP requires a good that has ________ transportation costs and is ________ substitutable.
A) zero; perfectly
B) zero; not
C) high; perfectly
D) high; not
Answer: A
Explanation: A) Strict PPP requires a good that has zero transportation costs and is perfectly
substitutable.
Diff: 1
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19) For the law of one price to hold, all of the following are necessary EXCEPT
A) transportation costs must be negligible.
B) exchange rates must be fixed.
C) tariffs must not be levied by any country.
D) all goods and services must be tradable.
E) traded goods must be homogeneous.
Answer: B
Explanation: B) Exchange rates must adjust over time to maintain the law of one price.
Diff: 1
Section: 2
AACSB: Analytical Thinking
20) If the price of wheat is $25/bushel in the U.S. and $20/bushel in Canada, all of the following would
tend to equalize prices EXCEPT
A) when the U.S. imposes a tariff on Canadian wheat.
B) the Canadian dollar will appreciate.
C) when the domestic price of U.S. wheat falls.
D) the U.S. dollar will depreciate.
E) when the domestic price of Canadian wheat rises.
Answer: A
Explanation: A) Strict PPP requires a good that has 0 transportation cost, including tariff.
Diff: 1
Section: 2
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21) A theory stating that changes in inflation rates between two countries cause exchange rates to adjust
is
A) interest rate parity.
B) exchange rate parity.
C) relative purchasing power parity.
D) absolute purchasing power parity.
E) None of the above
Answer: C
Explanation: C) Relative purchasing power parity - changes in inflation rates cause exchange rates to
adjust.
Diff: 1
Section: 2
AACSB: Analytical Thinking
22) According to relative purchasing power parity, if Belgian prices are increasing 10% faster than
Japanese prices,
A) the yen should fall 10% versus the Belgian franc.
B) the yen should rise 10% versus the Belgian franc.
C) prices in Belgium should fall 10%.
D) prices in Japan should rise 10%.
E) prices in Japan will rise 5% and the yen will rise 5%.
Answer: B
Explanation: B) If inflation in one country is 10% higher than another, the cost of buying currency from
the country with lower inflation will increase 10%.
Diff: 2
Section: 2
AACSB: Analytical Thinking
23) According to relative purchasing power parity, if the inflation rate in Italy was 8% and the inflation
rate in Israel was 6%,
A) the Italian lira should fall 6%.
B) the Italian lira should fall 8%.
C) the Italian lira should fall 2%.
D) the Italian lira should rise 2%.
E) the Italian lira should rise 8%.
Answer: C
Explanation: C) If there is a difference in inflation, the exchange rate would have to compensate. Pit =
(6% - 8%) = -2%
Diff: 2
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24) The theory of relative purchasing power parity
A) can be used to explain differences in real interest rates among countries.
B) holds extremely well in the short run.
C) does not hold well in the long run.
D) is used to explain the difference between U.S. and foreign treasury security yields.
E) seeks to explain changes in purchasing power parity over time.
Answer: E
Explanation: E) Relative purchasing power parity shows changes in purchasing power parity.
Diff: 1
Section: 2
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25) If the inflation rate in the Canada is expected to average 4% in the future and the inflation rate in
Denmark is expected to average 7%, what spot rate is expected to be in effect in three years? Assume the
Danish kroner per Canadian dollar exchange rate is now $0.20.
A) $0.245
B) $0.219
C) $0.177
D) $0.192
E) $0.206
Answer: B
Explanation: B) So = 0.2 ; 0.2 × [ 1 + ( .07 - .04) ]^3 = 0.2 × [ 1.03 ]^3 = 0.2 × 1.093 = 0.219
Diff: 3
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26) Which of the following is not true with respect to interest rate arbitrage?
A) Interest rate arbitrage maintains the interest rate parity relationship.
B) To arbitrage, you buy and sell something so that you have a positive investment and then earn a return
on the transaction.
C) It is rare that similar risk investments in one country earn more than another country after converting
money to and from the foreign currency using spot and forward exchange rates.
D) Arbitrageurs help exchange rates adjust to their correct levels rapidly and accurately.
E) All of the above are true.
Answer: B
Explanation: B) To arbitrage, you buy and sell equal amounts of a good so that you have zero net
investment.
Diff: 1
Section: 2
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27) Assume that you have $900,000 to invest. The current spot rate of the Australian dollar is $0.62, and
the 180-day forward rate of the Australian dollar is $0.64. Furthermore, the 180-day interest rate in
Canada is 3.5% and the 180-day interest rate in Australia is 3.0%. What is the net income you will have
realized after 180 days if you conduct interest rate arbitrage?
A) $61,548.39
B) $56,903.23
C) $27,000.00
D) $31,500.00
Answer: B
Explanation: B) 900,000 / 0.62 = 1,451,612.90 AUS; 1,451,612.90 × 1.03% = 1,495,161.29;
1,495,161.29 × 0.62 = 956,903.23; Profit = 56,903.23
Diff: 3
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28) All of the following are necessary for arbitrage to take place EXCEPT
A) no transactions costs.
B) no sales or transfer taxes.
C) the means to execute trades quickly.
D) a willingness to undertake a substantial net investment.
E) different prices in different locations.
Answer: D
Explanation: D) To arbitrage you buy and sell equal amounts of good so you have zero
net investment.
Diff: 1
Section: 2
AACSB: Analytical Thinking
29) What is the maximum net profit to a speculator with $1 million if interest rates on 1-year Treasuries
are 6% in France, 4% in Canada and the exchange rate is expected to change from today's rate of 2Fr/$ to
2.1Fr/$ in 1 year?
A) $1,060,000
B) $1,005,683
C) $1,040,000
D) $1,050,000
E) $1,009,524
Answer: C
Explanation: C) 1,000,000 × 1.04 = 1,040,000
Diff: 3
Section: 2
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30) The theory that exchange rates must adjust so that there is no reason for funds to flow from one
country just to take advantage of better returns in another is part of
A) purchasing power parity.
B) purchasing power arbitrage.
C) interest rate parity.
D) interest rate arbitrage.
Answer: C
Explanation: C) Exchange rates must adjust so that there is no reason for funds to flow from one country
just to take advantage of better returns in another. This is a part of interest rate parity.
Diff: 1
Section: 2
AACSB: Analytical Thinking
31) Understanding interest rate parity requires that we first understand
A) purchasing power parity.
B) interest rate arbitrage.
C) spot rates.
D) purchasing power arbitrage.
Answer: B
Explanation: B) Understanding interest rate parity requires that we first understand interest rate
arbitrage.
Diff: 1
Section: 2
AACSB: Analytical Thinking
32) All of the following are reasons money will adhere to PPP accurately EXCEPT
A) electronic transfers.
B) universal value.
C) easily determined price.
D) not substitutable.
Answer: D
Explanation: D) Money can be transferred from one country to another electronically, has universal
value, and has an easy to determine price.
Diff: 1
Section: 2
AACSB: Analytical Thinking
33) You have equal amounts of money invested in a risk-free dollar-denominated investment and
borrowed at the rate paid on the British pound. If you can earn a return during this, you have shown
A) interest rate arbitrage.
B) interest rate parity.
C) purchasing power arbitrage.
D) purchasing power parity.
Answer: A
Explanation: A) If you can invest $1 in a risk-free dollar-denominated investment while simultaneously
borrowing $1 at the rate paid on British pounds, you have zero net investment. If you earn a return, you
have an arbitrage opportunity.
Diff: 1
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34) You can borrow $25,000 at 1% interest for 1 year. The exchange rate for Australia is 1.25AUS/1C. The
Australian Treasury is offering 2.5% risk free investments. What is the total profit you can make in 1
year?
A) $625
B) $450
C) $250
D) $375
Answer: D
Explanation: D) $25,000 × 1.25 = 31,250 AUS; 31,250 × 1.025 = 32,031.25 AUS;
32,031.25 AUS / 1.25 = $25,625; $25,000 × 1.01 = $25,250; $25,625 - $25,250 = $375.
Diff: 3
Section: 2
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35) The main conclusion drawn from the theory of interest rate parity is that
A) a single currency will increase economic welfare.
B) arbitrage opportunities may persist for long periods of time.
C) investors can seldom earn higher returns from foreign investments than from domestic ones.
D) exchange rates adjust slowly to their proper levels.
Answer: C
Explanation: C) It's rare that similar risk investments in one country earn more than in another country.
Diff: 1
Section: 2
AACSB: Analytical Thinking
LO3: Define International Finance Risk
1) Which of the following is a risk unique to businesses practicing business internationally?
A) Financial risk
B) Investment risk
C) Political risk
D) Compliance risk
Answer: C
Explanation: C) Firms investing in foreign countries are also subject to politic risk.
Diff: 1
Section: 3
AACSB: Analytical Thinking
2) Insisting the contracts be denominated in the US dollar can help avoid
A) exchange rate risk.
B) arbitrage.
C) political risk.
D) PPP
Answer: A
Explanation: A) Another way to avoid exchange rate risk is to insist the contracts be denominated in the
US dollar.
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3) The ________ is as close to a worldwide currency as there is.
A) British pound
B) US Dollar
C) Euro
D) Canadian Dollar
Answer: B
Explanation: B) The US dollar is as close to a worldwide currency as there is.
Diff: 1
Section: 3
AACSB: Analytical Thinking
4) Futures contracts may help firms hedge against exchange rate risk by
A) enabling the hedger to offset foreign currency losses by profiting from the sale of the futures contract.
B) giving the owner of the contract the right to swap one currency for another at a later date.
C) giving the holder of the contract the ability to purchase foreign currencies at a predetermined
exchange rate at a future date.
D) providing riskless arbitrage opportunities.
E) paying the holder of the contract in the event of a loss, much like an insurance policy.
Answer: A
Explanation: A) The concept behind a hedge is if a drop in the exchange rate will cost a firm money, a
futures contract is sold so that the same drop will cause the value of the hedge to increase by exactly the
amount of the loss.
Diff: 1
Section: 3
AACSB: Analytical Thinking
5) It is more difficult to deal with political risk than exchange rate risk.
Answer: TRUE
Explanation: It is more difficult to deal with political risk than exchange rate risk.
Diff: 1
Section: 3
AACSB: Analytical Thinking
6) XY Corp has a plant in a small country with a friendly, though unstable government. A new
government takes over before XY Corp is able to move any assets out of the country. The new
government chooses to not recognize XY's ownership takes control of the company's assets. This is an
example of
A) arbitrage.
B) exchange rate risk.
C) nationalization.
D) hostile takeover.
Answer: C
Explanation: C) Nationalization is the process of a government taking control of business assets.
Diff: 1
Section: 3
AACSB: Analytical Thinking
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7) Which of the following is not a possible political risk when practicing business internationally?
A) Loss of using own specialized labor
B) Fewer opportunities for growth
C) Limited ability to convert currency
D) Additional taxes
Answer: B
Explanation: B) The local government in a foreign country may impose tariffs that may make the
operation of a firm from another country unprofitable.
Diff: 2
Section: 3
AACSB: Analytical Thinking
8) Tariffs imposed by a foreign government are an example of
A) exchange rate risk.
B) foreign risk.
C) policy risk.
D) political risk.
Answer: D
Explanation: D) Tariffs imposed by the local government of a foreign nation in which a company is
operating may make the operation unprofitable.
Diff: 1
Section: 3
AACSB: Analytical Thinking
9) What can companies use to lock in exchange rates to set up a risk-free arbitrage for interest rates?
A) Expropriation
B) Forward markets
C) Counter rates
D) Futures contracts
Answer: D
Explanation: D) Companies can use futures contracts to lock in an exchange rate when setting up a riskfree arbitrage for interest rates.
Diff: 1
Section: 3
AACSB: Analytical Thinking
10) Expropriation is another name for
A) arbitrage.
B) hedging.
C) parity.
D) nationalization.
Answer: D
Explanation: D) Nationalization is also called expropriation.
Diff: 1
Section: 3
AACSB: Analytical Thinking
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11) The seizure of a firm's assets by a foreign government is called
A) misappropriation.
B) rationalization.
C) expropriation.
D) extortion.
E) confiscation.
Answer: C
Explanation: C) The taking of a firm's assets is called nationalization or expropriation.
Diff: 1
Section: 3
AACSB: Analytical Thinking
12) All of the following are sources of political risk EXCEPT
A) tax holidays.
B) change in government
C) tariff increases.
D) labor law changes.
Answer: A
Explanation: A) Tariff increases, change in government, and labor laws are all sources of political risk.
Diff: 1
Section: 3
AACSB: Analytical Thinking
13) Political risk may be hedged with
A) higher operating leverage.
B) lower breakeven points.
C) forward contracts.
D) futures contracts.
E) alliances developed with foreign governments.
Answer: E
Explanation: E) Large companies may form allegiances with foreign governments to reduce political risk.
Diff: 1
Section: 3
AACSB: Analytical Thinking
14) The increased risk of doing business in a foreign country can be offset by
A) growth opportunities.
B) arbitrage.
C) diversification.
D) expropriation.
Answer: C
Explanation: C) Offsetting the increased risk of doing business in a foreign nation are the benefits
realized from increased diversification.
Diff: 1
Section: 3
AACSB: Analytical Thinking
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15) It is possible to reduce risk of the portfolio by adding a ________ risk investment if it ________
correlated.
A) high; negatively
B) low; negatively
C) high; positively
D) low; positively
Answer: A
Explanation: A) It is possible to reduce the risk of a portfolio by adding a high risk investment if it is
negatively correlated with others.
Diff: 1
Section: 3
AACSB: Analytical Thinking
16) Large companies may reduce political risk through
A) nationalization.
B) expropriation.
C) joint ventures.
D) tariffs.
Answer: C
Explanation: C) Large companies may form allegiances with foreign governments to reduce political risk.
Diff: 1
Section: 3
AACSB: Analytical Thinking
LO4: Assess How to Make Foreign Investments
1) Evaluating foreign investment opportunities involves different principles use to evaluate domestic
projects.
Answer: FALSE
Explanation: Evaluating these opportunities involves the same principle used to evaluate any
investment-maximizing value of the firm by accepting positive net present value projects.
Diff: 1
Section: 4
AACSB: Analytical Thinking
2) All of the following of are possible complicating factors for evaluating foreign investments accept
A) estimating foreign cash flows.
B) little of experience to draw on.
C) lack of comparable firms.
D) new methods to learn.
Answer: D
Explanation: D) The process of evaluating foreign investments has additional complicating factors:
estimating foreign cash flows, lack of experience to draw on for evaluation, possible lack of firms.
Diff: 1
Section: 4
AACSB: Analytical Thinking
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3) The increased risk of foreign investments is most often incorporated in capital budgeting models by
A) international diversification.
B) hedging with financial derivatives.
C) reducing market risk.
D) calculating certainty equivalents.
E) adjusting the discount rate.
Answer: E
Explanation: E) The usual method for adjusting a project's cash flow for increased risk is to increase the
discount rate.
Diff: 1
Section: 4
AACSB: Analytical Thinking
4) The interest rate on Eurodollar loans tends to be based on
A) eurobonds.
B) forward rates.
C) spot rates.
D) LIBOR.
Answer: D
Explanation: D) The interest rate on Eurodollar loans tends to be based on the London Interbank Offered
Rate (LIBOR).
Diff: 1
Section: 4
AACSB: Analytical Thinking
5) The usual sources of capital for investing projects include all of the following EXCEPT
A) LIBOR.
B) retained earnings.
C) bank loans.
D) domestically marketed stocks and bonds.
Answer: A
Explanation: A) International firms may finance their international investments with the usual sources of
capital, such as retained earnings, bank loans, or domestically marketed bonds and stocks.
Diff: 1
Section: 4
AACSB: Analytical Thinking
6) Eurodollars are
A) currencies that will disappear once the euro is adopted.
B) funds created by the International Monetary Fund to be transferred among the world's central banks.
C) dollar-denominated deposits held in European banks
D) European currencies deposited in U.S. banks.
E) dollar-denominated deposits held in foreign banks
Answer: E
Explanation: E) Eurodollars are dollar-denominated deposits held in foreign banks.
Diff: 1
Section: 4
AACSB: Analytical Thinking
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7) Eurobonds
A) may be denominated in dollars or in the currency of another country.
B) are always denominated in U.S. dollars.
C) are always denominated in the foreign currency.
D) may not be split so that part of it is denominated in one currency and the balance is in another.
Answer: A
Explanation: A) Eurobonds may be in dollars in the currency of another country Eurobonds.
Diff: 1
Section: 4
AACSB: Analytical Thinking
8) The primary advantage of Eurobonds is
A) the fact that LIBOR is set in competitive markets and enables firms to borrow funds at lower interest
rates.
B) more favorable tax treatment of earnings compared with the U.S.
C) the relative lack of regulation compared with similar markets in the U.S.
D) that they are subject to the same regulation as similar markets in the U.S.
E) their greater degree of acceptability worldwide.
Answer: C
Explanation: C) The primary advantage of Eurobonds is that they're not subject to US Securities and
Exchange Commission registration and disclosure rules.
Diff: 1
Section: 4
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 17 Corporate Valuation
LO1: Perform Advanced Financial Statement Forecasting
1)
What is total CAPEX for Hairy Noodles Inc. in Year 3?
A) 3,922,635
B) 16,662,155
C) 2,732,110
D) 3,701,110
E) 2,968,945
Answer: A
Explanation: A) Use the fixed asset identity:
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Nett = Nett-1 + CAPEXt - Deprt → where Nett is the net fixed assets (PP&E) in year t
CAPEXt = Nett - Nett-1 + Deprt
CAPEXt = 16,662,155 - 13,930,045 + 1,190,525
CAPEXt = 3,922,635
Diff: 1
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
577
Copyright © 2015 Pearson Canada, Inc.
2)
What is the depreciation rate for Harry's Heavy Equipment in Year 3?
A) 6.67%
B) 7.15%
C) 14.8%
D) 6.50%
E) 30.73%
Answer: A
Explanation: A) dr = Depreciationt / (Nett + Depreciationt)
dr = 1,190,525/ (16,662,155 + 1,190,525)
dr = 0.0667 or 6.67%
Diff: 1
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
3)
What is maintenance CAPEX for Hairy Textiles in Year 3? The depreciation rate is 16.79%.
A) 7,948
B) 8,505
C) 10,412
D) 11,141
Answer: C
Explanation: C) mCAPEX = Nett-1 * [dr / (1 - dr)]
mCAPEX = 51,603 * 0.1679 / (1 - 0.1679)
mCAPEX = 10,412
Diff: 1
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
578
Copyright © 2015 Pearson Canada, Inc.
4)
What is maintenance CAPEX for Happy Harry in Year 3?
A) 6,887,716
B) 7,056,922
C) 7,122,309
D) 7,348,217
E) 7,550,907
Answer: B
Explanation: B) dr = Depreciationt / (Nett + Depreciationt)
dr = 7,550,907/ (48,226,904 + 7,550,907)
dr = 0.1354 or 13.54%
mCAPEX = Nett-1 * [dr / (1 - dr)]
mCAPEX = 45,071,873 * 0.1354 / (1 - 0.1354)
mCAPEX = 7,056,922
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
579
Copyright © 2015 Pearson Canada, Inc.
5)
What is growth CAPEX for Harry's in Year 3?
A) 1,711,350
B) 2,732,110
C) 3,106,381
D) 3,932,264
Answer: D
Explanation: D) gCAPEX = Total CAPEX - mCAPEX
gCAPEX = 11,880,567 - 7,948,303
gCAPEX = 3,932,264
Diff: 1
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
580
Copyright © 2015 Pearson Canada, Inc.
6)
What is the ratio of growth CAPEX to the change in sales for Harry's Hoodies in Year 3?
A) 1.71
B) 1.60
C) 0.63
D) 0.77
E) 0.58
Answer: A
Explanation: A) gCAPEX = Total CAPEX - mCAPEX
gCAPEX = 3,922,635 - 995,313
gCAPEX = 2,927,322
ΔSales = Salest - Salest-1
ΔSales = 5,120,500 - 3,409,150
ΔSales = 1,711,350
Answer = gCAPEX / ΔSales
Answer = 2,927,322 / 1,711,350
Answer = 1.71
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
581
Copyright © 2015 Pearson Canada, Inc.
7)
What is the ratio of growth CAPEX to the change in sales for Happy Harry in Year 3?
A) 0.153
B) 0.168
C) 0.181
D) 0.197
Answer: A
Explanation: A) Step 1: Calculate depreciation rate
Step 2: Calculate maintenance CAPEX
Step 3: Calculate growth CAPEX
Step 4: Calculate change in sales
Step 5: Calculate ratio.
dr = Depreciationt / (Nett + Depreciationt)
dr = 13,057/ (59,080 + 13,057)
dr = 0.1810 or 18.10%
mCAPEX = Nett-1 * [dr / (1 - dr)]
mCAPEX = 55,215 * 0.1810 / (1 - 0.1810)
mCAPEX = 12,203
gCAPEX = Total CAPEX - mCAPEX
gCAPEX = 16,922 - 12,203
gCAPEX = 4,719
ΔSales = Salest - Salest-1
ΔSales = (148,346 - 117,688)
ΔSales = 30,658
Answer = gCAPEX / ΔSales
Answer = 4,719/ 30,658
Answer = 0.1539
Diff: 3
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
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Copyright © 2015 Pearson Canada, Inc.
8)
What is the depreciation rate for Heath Robinson in Year 2?
A) 6%
B) 34%
C) 39%
D) 11%
E) 51%
Answer: B
Explanation: B) dr = Depreciationt / (Nett + Depreciationt)
dr = 62,405 / (123,400 + 62,405)
dr = 0.3359 or 33.59%
Diff: 1
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
583
Copyright © 2015 Pearson Canada, Inc.
9)
What is maintenance CAPEX for Goldberg Machines in Year 3?
A) 14,812
B) 15,458
C) 16,495
D) 17,025
Answer: B
Explanation: B) dr = Depreciationt / (Nett + Depreciationt)
dr = 17,592 / (89,973 + 17,592)
dr = 0.1466 or 14.66%
mCAPEX = Nett-1 * [dr / (1 - dr)]
mCAPEX = 75,815 * 0.1466 / (1 - 0.1466)
mCAPEX = 15,458
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
584
Copyright © 2015 Pearson Canada, Inc.
10)
What is growth CAPEX for Newfangled Gadgets Inc in Year 3?
A) 2,610
B) 5,461
C) 14,518
D) 14,948
Answer: A
Explanation: A) Step 1: Calculate total CAPEX
Step 2: Calculate depreciation rate
Step 3: Calculate maintenance CAPEX
Step 4: Calculate growth CAPEX.
Nett = Nett-1 + CAPEXt - Depr.t
CAPEXt = Nett - Nett-1 + Depr.t
CAPEXt = 75,815 - 73,635 + 14,948
CAPEXt = 17,128
dr = Depreciationt / (Nett + Depreciationt)
dr = 14,948/ (75,815 + 14,948)
dr = 0.1647 or 16.47%
mCAPEX = Nett-1 * [dr / (1 - dr)]
mCAPEX = 73,635 * 0.1647 / (1 - 0.1647)
mCAPEX = 14,518
gCAPEX = Total CAPEX - mCAPEX
gCAPEX = 17,128 - 14,518
gCAPEX = 2,610
Diff: 3
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
585
Copyright © 2015 Pearson Canada, Inc.
11)
What is the ratio of growth CAPEX to the change in sales for Pic 'N Save in Year 3?
A) 5.5%
B) 6.0%
C) 6.5%
D) 7.0%
E) 7.5%
Answer: B
Explanation: B) Step 1: Calculate total CAPEX
Step 2: Calculate maintenance CAPEX
Step 3: Calculate growth CAPEX
Step 4: Calculate change in sales
Step 5: Calculate ratio.
Nett = Nett-1 + CAPEXt - Depr.t
CAPEXt = Nett - Nett-1 + Depr.t
CAPEXt = 126,995- 123,400 + 65,900
CAPEXt = 69,495
mCAPEX = Nett-1 * [dr / (1 - dr)]
mCAPEX = 123,400 * 0.3416 / (1 - 0.3416)
mCAPEX = 64,024
gCAPEX = Total CAPEX - mCAPEX
gCAPEX = 69,495 - 64,024
gCAPEX = 5,471
ΔSales = Salest - Salest-1
ΔSales = 1,200,490 - 1,109,043
ΔSales = 91,447
Answer = gCAPEX / ΔSales
Answer = 5,471 / 91,447
Answer = 0.060
Diff: 3
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
586
Copyright © 2015 Pearson Canada, Inc.
12)
Soporific Games is expecting revenues of $563,613 next year. Last year, net property plant and equipment
was $84,029 and debt was $11,168. Assume a depreciation rate of 34.10%, CAPEX of $6,199, and a cost of
debt of 8%. Forecast Soporific's net income for next year.
A) $1,572
B) $1,768
C) $2,196
D) $2,253
E) $3,048
Answer: A
Explanation: A) Depreciationt = dr × [Nett-1 + CAPEXt]
Depreciationt = 0.3410 × [84,029 + 6,199]
Depreciationt = 30,768
Interestt = i × Debtt-1
Interestt = 0.08 × 11,168
Interestt = 893
Tax rate, T = Income Taxes/Pre-Tax Income
= 2,422/8,016
= 0.3021
587
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Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
588
Copyright © 2015 Pearson Canada, Inc.
13)
Soporific Games is expecting revenues of $464,651 next year. Last year, net property plant and equipment
was $45,460 and debt was $3,425. Assume a depreciation rate of 28.7%, CAPEX of $9,586, and a cost of
debt of 10%. Forecast Soporific's net income for next year.
A) $2,043
B) $4,784
C) $5,425
D) $6,043
E) $8,719
Answer: D
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Explanation: D) Depreciationt = dr × [Nett-1 + CAPEXt]
Depreciationt = 0.2870 × [45,460 + 9,586]
Depreciationt = 15,798
Interestt = i × Debtt-1
Interestt = 0.10 × 3,425
Interestt = 343
Tax rate, T = Income Taxes/Pre-Tax Income
= 337/1,098
= 0.3069
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
590
Copyright © 2015 Pearson Canada, Inc.
14)
Soporific Games has forecasted sales of $450,728 next year. Given the data in the table above, calculate
maintenance CAPEX for next year.
A) $19,872
B) $22,798
C) $24,460
D) $27,487
E) $29,838
Answer: E
Explanation: E) Maintenance CAPEXt = Nett-1 × dr/(1-dr)
mCAPEXt = 59,497 × 0.334/(1-0.334)
mCAPEXt = 29,838
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
15)
Soporific Games is expecting sales of $464,651 next year. Given the data in the table, calculate
maintenance CAPEX for next year.
A) $13,047
B) $15,791
C) $18,299
D) $28,700
E) $32,413
Answer: C
Explanation: C) Maintenance CAPEXt = Nett-1 × dr/(1 - dr)
mCAPEXt = 45,460 × 0.287/(1- 0.287)
mCAPEXt = 18,299
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
591
Copyright © 2015 Pearson Canada, Inc.
16)
Soporific Games has forecast sales of $563,613 next year. Given the data in the table, what will growth
CAPEX be next year?
A) $7,223
B) $13,709
C) $15,497
D) $26,199
E) $38,042
Answer: B
Explanation: B) Growth CAPEXt = ΔSalest × [Growth CAPEX/ ΔSales]
gCAPEXt = ΔSalest × (gx)
gCAPEXt = (563,613-450,728) × 0.1214
gCAPEXt = 13,704
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
592
Copyright © 2015 Pearson Canada, Inc.
17)
Soporific Games has forecast sales of $2,001,313 next year. Given the data in the table, what will growth
CAPEX be next year?
A) $1,807
B) $2,695
C) $4,028
D) $5,078
E) $6,023
Answer: E
Explanation: E) Growth CAPEXt = ΔSalest × [Growth CAPEX/ ΔSales]
gCAPEXt = ΔSalest × (gx)
gCAPEXt = (464,651 - 450,728) × 0.4326
gCAPEXt = 6,023
Diff: 2
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
593
Copyright © 2015 Pearson Canada, Inc.
18)
Soporific Games is predicting sales of $563,613 for next year. Soporific's ratio of growth CAPEX to new
sales is 12%. Given the data provided, what are total assets next year?
A) $198,275
B) $230,821
C) $242,779
D) $258,122
E) $267,546
Answer: B
Explanation: B) Depreciation rate = dr = Depreciationt/ [Nett + Depreciationt]
dr = 22,779 /(22,779 + 45,460)
dr = 0.3338
Maintenance CAPEXt = Nett-1 × dr/(1 - dr)
mCAPEXt = 45,460 × 0.3338/(1 - 0.3338)
mCAPEXt = 22,779.00
Growth CAPEXt = ΔSalest × [Growth CAPEX/ ΔSales]
gCAPEXt = ΔSalest × (gx)
gCAPEXt = (563,613 - 450,728) × 0.12
gCAPEXt = 13,546.20
Total CAPEX = mCAPEX + gCAPEX
Total CAPEX = 22,779 + 13,546.20 = 36,325.20
Depreciationt = dr × [Nett-1 + CAPEXt]
Depreciationt = 0.3338 × [45,460 + 36,325]
Depreciationt = 27,300.88
Nett = Nett-1 + CAPEXt - Depreciationt
Nett = 45,460 + 36,325 - 27,300
Nett = 54,484.32
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Diff: 3
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
595
Copyright © 2015 Pearson Canada, Inc.
19)
Soporific Games has forecast sales of $810,115 for next year. Soporific's ratio of growth CAPEX to new
sales is 14.5%. Given the data provided, what are total assets next year?
A) $360,110
B) $374,932
C) $395,098
D) $405,647
E) $432,009
Answer: C
Explanation: C) Depreciation rate = dr = Depreciationt/ [Nett + Depreciationt]
dr = 29,737/(29,737+ 84,029)
dr = 0.2614
Maintenance CAPEXt = Nett-1 × dr/(1 - dr)
mCAPEXt = 84,029 × 0.2614/(1 - 0.2614)
mCAPEXt = 29,737
Growth CAPEXt = ΔSalest × [Growth CAPEX/ ΔSales]
gCAPEXt = ΔSalest × (gx)
gCAPEXt = (810,115 - 621,568) × 0.145
gCAPEXt = 27,339.32
Total CAPEX = mCAPEX + gCAPEX
Total CAPEX = 29,737 + 27,339
Total CAPEX = 57,076.32
Depreciationt = dr × [Nett-1 + CAPEXt]
Depreciationt = 0.2614 × [84,029 + 57,076]
Depreciationt = 36,883.15
Nett = Nett-1 + CAPEXt - Depreciationt
Nett = 84,029 + 57,076.32 - 36,883.15
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Nett = 104,222.16
Diff: 3
Section: 1 Advanced Financial Statements Forecasting
AACSB: Analytical Thinking
597
Copyright © 2015 Pearson Canada, Inc.
LO2: Calculate Free Cash Flow
1)
Calculate operating cash flow for the B&O Railroad.
A) $855,482
B) $1,116,000
C) $1,258,518
D) $1,347,000
E) $1,615,000
Answer: C
Explanation: C) Operating Cash Flow = Sales - COGS - SG&A - Taxes
Operating Cash Flow = EBIT*(1 - T) + Depreciation
T = Taxes/Income Before Taxes
T = 268,000/839,000 = 0.3194
Operating Cash Flow = 1,116,000 * (1 - 0.3194) + 499,000
Operating Cash Flow = 1,258,518.474
Diff: 2
Section: 2 Free Cash Flow
AACSB: Analytical Thinking
598
Copyright © 2015 Pearson Canada, Inc.
2)
Calculate B&O Railroad's change in Net Working Capital for Year 10.
A) -$349,000
B) -$118,000
C) -$86,000
D) $64,700
E) $86,000
Answer: C
Explanation: C) NWC = (Current Assets - Cash) - (Current Liabilities - Short Term Debt)
NWC10 = (1,163,000 - 25,000) - (2,134,000 - 647,000) = -349,000
NWC09 = (1,164,000 - 53,000) - (1,638,000 - 264,000) = -263,000
Change in NWC = NWC10 - NWC09 = -349,000 - (-263,000) = -$86,000
Diff: 2
Section: 2 Free Cash Flow
AACSB: Analytical Thinking
599
Copyright © 2015 Pearson Canada, Inc.
3)
Calculate B&O Railroad's Capital Expenditures for Year 10.
A) $175,000
B) $363,000
C) $499,000
D) $577,000
E) $674,000
Answer: E
Explanation: E) Capital Expenditures = Net Fixed Assets 10 - Net Fixed Assets09 + Depreciation10
Capital Expenditures10 = 16,898,000 - 16,723,000 + 499,000 = $674,000
Diff: 2
Section: 2 Free Cash Flow
AACSB: Analytical Thinking
600
Copyright © 2015 Pearson Canada, Inc.
4)
Calculate Free Cash Flow for B&O Railroad Inc. for Year 10.
A) $528,000
B) $584,518
C) $623,000
D) $670,518
E) $1,027,000
Answer: D
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Explanation: D) Free Cash Flow = Operating Cash Flow - Change in NWC - Capital Expenditures
Operating Cash Flow = Sales - COGS - SG&A - Taxes
Operating Cash Flow = EBIT*(1 - T) + Depreciation
T = Taxes/Income Before Taxes
T = 268,000/839,000 = 0.3194
Operating Cash Flow = 1,116,000 * (1-0.3194) + 499,000
Operating Cash Flow = 1,258,518.474
NWC = (Current Assets - Cash) - (Current Liabilities - Short Term Debt)
NWC10 = (1,163,000 - 25,000) - (2,134,000 - 647,000) = -349,000
NWC09 = (1,164,000 - 53,000) - (1,638,000 - 264,000) = -263,000
Change in NWC = NWC10 - NWC09 = -349,000 - (-263,000) = -$86,000
Capital Expenditures = Net Fixed Assets10 - Net Fixed Assets09 + Depreciation10
Capital Expenditures10 = 16,898,000 - 16,723,000 + 499,000 = $674,000
Free Cash Flow = Operating Cash Flow - Change in NWC - Capital Expenditures
Free Cash Flow = 1,258,518.474 - (-86,000) - 674,000 = $670,518.474
Diff: 4
Section: 2 Free Cash Flow
AACSB: Analytical Thinking
602
Copyright © 2015 Pearson Canada, Inc.
5)
Calculate Sanitary Supermarket's operating cash flow for Year 6.
A) $817
B) $996
C) $1,192
D) $1,438
E) $1,525
Answer: D
Explanation: D) Operating Cash Flow = Sales - COGS - SG&A - Taxes
Operating Cash Flow = EBIT * (1 - T) + Depreciation
T = Taxes/Income Before Taxes
T = 288/915 = 0.3148
Operating Cash Flow06 = 1,192 * (1 - 0.3148) + 621
Operating Cash Flow06 = 1,437.8131
Diff: 2
Section: 2 Free Cash Flow
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6)
Calculate the change in net working capital for Year 6.
A) -$264
B) -$18
C) $80
D) $195
E) $246
Answer: A
Explanation: A) NWC = (Current Assets - Cash) - (Current Liabilities - Short Term Debt)
NWC06 = (4,385 - 1,467) - (3,651 - 715) = -18
NWC05 = (3,701 - 920) - (3,162 - 627) = 246
Change in NWC = NWC06 - NWC05 = -18 - 246 = -$264
Diff: 2
Section: 2 Free Cash Flow
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7)
Calculate Sanitary Supermarket's capital expenditures for Year 6.
A) $186
B) $265
C) $324
D) $621
E) $886
Answer: E
Explanation: E) Capital Expenditures06 = Net Fixed Assets06 - Net Fixed Assets05 + Depreciation06
Capital Expenditures06 = 9,637 - 9,372 + 621 = $886
Diff: 2
Section: 2 Free Cash Flow
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8)
Calculate free cash flow for Sanitary Supermarket for Year 6.
A) $551
B) $816
C) $1,191
D) $1,438
E) $1,702
Answer: B
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Explanation: B) Operating Cash Flow = Sales - COGS - SG&A - Taxes
Operating Cash Flow = EBIT * (1 - T) + Depreciation
T = Taxes/Income Before Taxes
T = 288/915 = 0.3148
Operating Cash Flow06 = 1,192 * (1 - 0.3148) + 621
Operating Cash Flow06 = 1,437.8131
NWC = (Current Assets - Cash) - (Current Liabilities - Short Term Debt)
NWC06 = (4,385 - 1,467) - (3,651 - 715) = -18
NWC05 = (3,701 - 920) - (3,162 - 627) = 246
Change in NWC = NWC06 - NWC05 = -18 - 246 = -$264
Capital Expenditures06 = Net Fixed Assets06 - Net Fixed Assets05 + Depreciation06
Capital Expenditures06 = 9,637 - 9,372 + 621 = $886
Free Cash Flow = Operating Cash Flow - Change in NWC - Capital Expenditures
Free Cash Flow06 = $1,437.8131 - (-$264) - $886 = $815.8131
Diff: 4
Section: 2 Free Cash Flow
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9)
Jordan Marsh & Co. is department store chain in New England. Calculate the operating cash flow for
Year 5.
A) $283,016
B) $296,088
C) $320,036
D) $354,692
E) $486,757
Answer: A
Explanation: A) Operating Cash Flow = Sales - COGS - SG&A - Taxes
Operating Cash Flow = EBIT * (1 - T) + Depreciation
T = Taxes/Income Before Taxes
T = 23,948/83,686 = 0.2862
Operating Cash Flow05 = 129,367 * (1 - 0.2862) + 190,669
Operating Cash Flow05 = $283,016
Diff: 1
Section: 2 Free Cash Flow
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10)
Jordan Marsh & Co. is department store chain in New England. Calculate the change in net working
capital for 2005.
A) -$67,151
B) -$32,474
C) -$13,215
D) $13,215
E) $32,474
Answer: E
Explanation: E) NWC = (Current Assets - Cash) - (Current Liabilities - Short Term Debt)
NWC05 = (2,287,320 - 328,060) - (1,099,445 - 226,370) = 1,086,185
NWC04 = (2,281,704 - 292,062) - (1,062,676 - 126,745) = 1,053,711
Change in NWC = NWC05 - NWC04 = 1,086,185- 1,053,711 = $32,474
Diff: 2
Section: 2 Free Cash Flow
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11)
Jordan Marsh & Co. is department store chain in New England. Calculate the capital expenditures for
Year 5.
A) -$9,284
B) $170,789
C) $171,838
D) $175,494
E) $181,385
Answer: E
Explanation: E) Capital Expenditures = Net Fixed Assets 05 - Net Fixed Assets04 + Depreciation05
Capital Expenditures05 = 1,049,505- 1,058,789 + 190,669 = $181,385
Diff: 2
Section: 2 Free Cash Flow
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12)
Jordan Marsh & Co. is department store chain in New England. What was free cash flow in Year 5 for
Jordan Marsh?
A) $17,388
B) $69,157
C) $77,281
D) $82,229
E) $92,898
Answer: B
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Explanation: B) Free Cash Flow = Operating Cash Flow - Change in NWC - Capital Expenditures
Operating Cash Flow = EBIT * (1 - T) + Depreciation
T = Taxes/Income Before Taxes
T = 23,948/83,686 = 0.2862
Operating Cash Flow05 = 129,367 * (1 - 0.2862) + 190,669
Operating Cash Flow05 = $283,016
NWC = (Current Assets - Cash) - (Current Liabilities - Short Term Debt)
NWC05 = (2,287,320 - 328,060) - (1,099,445 - 226,370) = 1,086,185
NWC04 = (2,281,704 - 292,062) - (1,062,676 - 126,745) = 1,053,711
Change in NWC = NWC05 - NWC04 = 1,086,185- 1,053,711 = $32,474
Capital Expenditures = Net Fixed Assets05 - Net Fixed Assets04 + Depreciation05
Capital Expenditures05 = 1,049,505- 1,058,789 + 190,669 = $181,385
Free Cash Flow = Operating Cash Flow - Change in NWC - Capital Expenditures
Free Cash Flow05 = $283,016 - 32,474 - 181,385= $69,157
Diff: 4
Section: 2 Free Cash Flow
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LO3: Determine the Value of a Company
1) Santa's Workshop Inc. shares are currently trading at $30.50 each. The market yield on BBW's debt is
7% and the firm's beta is 0.85. The T-Bill rate is 4% and the expected return on the market (E (kM)) is 8%.
The company's target capital structure is 30% debt and 70% equity. The corporate tax rate is 30%. What is
BBW's WACC?
A) 4.90%
B) 6.65%
C) 7.40%
D) 8.50%
E) 10.00%
Answer: B
Explanation: B) Cost of Common Equity:
E(ke) = kf + βE(km) - kf)
E(ke) = 0.04 + 0.85*(0.08 - 0.04)
E(ke) = 0.074 or 7.40%
After-Tax Cost Of Debt
The pre-tax cost of debt is the yield to maturity on the company's bonds, or 6%.
The after tax cost of debt is:
kd (1 - T) = 7% * (1 - 0.30)
kd (1 - T) = 0.049 or 4.9%
WACC = ωdkd(1 - T) + ωeke
WACC = (0.30 * 0.049) + (0.70 * 0.074)
WACC = 0.0665 or 6.65%
Diff: 2
Section: 3. DCF
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2) Santa's Workshop shares are currently trading at $14.75 each. The market yield on Santa's debt is 6%
and the firm's beta is 0.48. The T-Bill rate is 3.5% and the market risk premium (E(kM) - kF) is 6.25%. The
company's target capital structure is 50% debt and 50% equity. The corporate tax rate is 40%. Calculate
Santa's WACC.
A) 1.95%
B) 3.60%
C) 4.00%
D) 5.05%
E) 6.50%
Answer: D
Explanation: D) Cost of Common Equity:
E(ke) = kf + β(E(km) - kf)
E(ke) = 0.035 + 0.48 * (0.0625)
E(ke) = 0.065 or 6.5%
After-Tax Cost Of Debt
The pre-tax cost of debt is the yield to maturity on the company's bonds, or 6%.
The after tax cost of debt is:
kd (1-T) = 6% * (1 - 0.40)
kd (1-T) = 0.036%
WACC = ωdkd(1 - T) + ωeke
WACC = (0.50 * 0.036) + (0.50 * 0.065)
WACC = 0.0505 or 5.05%
Diff: 2
Section: 3. DCF
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3) Badger Inc. has 10 million shares of common stock outstanding, which currently trade for $22 per
share. The company also has 125,000 bonds each with a face value of $1,000 and annual coupons of $80.
The bonds have 5 years to maturity and the next coupon is due in one year. The yield on the bonds is 8%.
The company's beta is 0.65, the risk free rate is 4.25% and the expected return on the market is 12%. The
tax rate is 40%. Calculate Badger's WACC.
A) 4.25%
B) 4.80%
C) 5.50%
D) 7.75%
E) 8.46%
Answer: E
Explanation: E) DEBT
Market Value of Bonds = # bonds * Price of Bonds
Market Value of Bonds = 50,000*$1,000 = $50M
Since the coupon rate is equal to the yield, the bonds trade for their face value.
EQUITY
Market Value of Equity = # shares * Price per Share
Market Value of Equity = 10M * $22 = $220M
V = D+ E = 50M + 220M = $270M
Debt Weight = D/V = $125M/$270M = 0.18519
Equity Weight = E/V = $220M/$270M = 0.81481
The after-tax cost of debt is:
kd * (1 - T)
Where
kd = ytm = the yield to maturity of the bonds
kd * (1 - T) = 8% * (1 - 40%) = 4.8%
Cost of Common Equity:
E(ke) = kf + β(E(km) - kf)
E(ke) = 0.0425 + 0.65 * (0.12 - 0.0425)
E(ke) = 7.75%
WACC = ωdkd(1 - T) + ωeke
WACC = (0.318519 * 0.048) + (0.81481 * 0.0775)
WACC = 0.08456 or 8.456%
Diff: 3
Section: 3. DCF
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4) Badger Inc. currently has 4 million shares of common stock outstanding, which currently trade for
$15.50 per share. The company also has 120,000 bonds each with a face value of $1,000 and annual
coupons of $50. The bonds have 7 years to maturity and the next coupon is due in one year. The yield on
the bonds is 5%. The company's beta is 1.10, the risk free rate is 2.5% and the expected return on the
market is 9%. The tax rate is 30%. Given the above data, calculate Badger's WACC.
A) 2.50%
B) 3.50%
C) 4.25%
D) 5.60%
E) 9.65%
Answer: D
Explanation: D) DEBT
Market Value of Bonds = # bonds * Price of Bonds
Market Value of Bonds = 120,000 * $1,000 = $120M
Since the coupon rate is equal to the yield, the bonds trade for their face value.
EQUITY
Market Value of Equity = # shares * Price per Share
Market Value of Equity = 4M * $15.50 = $62M
V = D + E = 120M + 62M = $182M
Debt Weight = D/V = $120M/$182M = 0.65934
Equity Weight = E/V = $62M/$182M = 0.34066
The after-tax cost of debt is:
kd * (1 - T)
Where
kd = ytm = the yield to maturity of the bonds
kd * (1 - T) = 5% * (1 - 30%) = 3.5%
Cost of Common Equity:
E(ke) = kf + β(E(km) - kf)
E(ke) = 0.025 + 1.10 * (0.09 - 0.025)
E(ke) = 9.65%
WACC = ωdkd(1 - T) + ωeke
WACC = (0.65934 * 0.035) + (0.34066 * 0.0965)
WACC = 0.05595 or 5.595%
Diff: 3
Section: 3. DCF
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5) Translove Airways is expected to generate free cash flow of $110.5 million next year. (Assume that free
cash flow is paid at the end of each year and we are at the beginning of a year.) After that, free cash flow
is expected to go grow at 1.75% per annum in perpetuity. Translove's WACC is 8.92%. What is the value
of Translove today?
A) $1,440 M
B) $1,541 M
C) $1,670 M
D) $1,739 M
E) $1,800 M
Answer: B
Explanation: B) V = PVFP + PVTP
PVFP = 1/(1 + kWACC) * FCF
PVFP = 1/(1.0892) * $110.5
PVFP = 101.4506
PVTP = 1/(1 + kWACC) * Terminal Value
Terminal Value = FCF * (1 + g)/(kWACC - g)
Terminal Value = 110.5 * (1.0175)/(0.0892 - 0.0175)
Terminal Value = 1,568.1137
PVTP = 1/(1.0892) * $1,568.1137
PVTP = 1,439.693
V = 101.4506 + 1,439.693
V = $1,541.1436 million
Diff: 2
Section: 3. DCF
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6) Translove Airways, is forecast to generate free cash flow of $60.99 million next year. (Assume that free
cash flow is paid at the end of each year and we are at the beginning of a year.) After that, free cash flow
is expected to go grow at 4.0% per annum in perpetuity. The WACC for Translove is 11.631%. What is the
value of Translove today?
A) $601 M
B) $744 M
C) $799 M
D) $831 M
E) $886 M
Answer: C
Explanation: C) V = PVFP + PVTP
PVFP = 1/(1 + kWACC) * FCF
PVFP = 1/(1.11631) * $60.99
PVFP = 54.6354
PVTP = 1/(1 + kWACC) * Terminal Value
Terminal Value = FCF * (1 + g)/(kWACC - g)
Terminal Value = 60.99 * (1.040)/(0.11631 - 0.040)
Terminal Value = 831.2095
PVTP = 1/(1.11631) * $831.2095
PVTP = 744.6046
V = 54.6354 + 744.6046
V = $799.2399 million
Diff: 2
Section: 3. DCF
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7) Analysts expect Morgan Industries Inc. to generate free cash flow of $105.10 million next year and
$118.40 million the year after. (Assume that free cash flow is paid at the end of each year and we are at
the beginning of a year.) After that, free cash flow is expected to go grow at 1.75% per annum in
perpetuity. The WACC for Morgan is 8.55%. What is the value of Morgan today?
A) $1,504 million
B) $1,604 million
C) $1,690 million
D) $1,701 million
E) $1,772 million
Answer: D
Explanation: D) V = PVFP + PVTP
2
PVFP = 1/(1 + kWACC) * FCF1 + 1/(1 + kWACC) * FCF2
2
PVFP = 1/(1.0855) * $105.10 + 1/(1.0855) * $118.40
PVFP = 197.3046
2
PVTP = 1/(1 + kWACC) * Terminal Value
Terminal Value = FCF2 * (1 + g)/( kWACC - g)
Terminal Value = 105.10 * (1.0175)/(0.0855 - 0.0175)
Terminal Value = 1,771.6471
2
PVTP = 1/(1.0855) * $1,771.6471
PVTP = 1503.5489
V = 197.3046 + 1,503.5489
V = $1,700.8535 million
Diff: 3
Section: 3. DCF
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8) Morgan Industries Inc. is forecast to generate free cash flow of $28.8 million next year and $45.3 million
the year after. (Assume that free cash flow is paid at the end of each year and we are at the beginning of a
year.) After that, free cash flow is expected to go grow at 2.50% per annum in perpetuity. Morgan's
WACC is 12%. Calculate the value of Morgan today.
A) $390 million
B) $428 million
C) $451 million
D) $489 million
E) $551 million
Answer: C
Explanation: C) V = PVFP + PVTP
2
PVFP = 1/(1 + kWACC) * FCF1 + 1/(1 + kWACC) * FCF2
2
PVFP = 1/(1.12) * $28.8 + 1/(1.12) * $45.3
PVFP = 61.8272
2
PVTP = 1/(1 + kWACC) * Terminal Value
Terminal Value = FCF2 * (1 + g)/( kWACC - g)
Terminal Value = 45.3*(1.025)/(0.12 - 0.025)
Terminal Value = 488.7632
2
PVTP = 1/(1.12) * $488.7632
PVTP = 389.6390
V = 61.8272 + 389.6390
V = $451.4662 million
Diff: 3
Section: 3. DCF
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9) Analysts expect Overhill Railroads to generate free cash flow of $25 million next year. (Assume that
free cash flow is paid at the end of each year and we are at the beginning of a year.) After that, free cash
flow is expected to go grow at 3.25% per annum in perpetuity. The WACC for Overhill Railroads is
9.90%. The firm has 10.5 million shares outstanding and the market value of its debt is $95 million.
Calculate the fair price for Overhill Railroads' shares today.
A) $26.76
B) $29.25
C) $32.76
D) $35.80
E) $39.13
Answer: A
Explanation: A) V = PVFP + PVTP
PVFP = 1/(1 + kWACC) * FCF
PVFP = 1/(1.099) * $25
PVFP = 22.7480
PVTP = 1/(1 + kWACC) * Terminal Value
Terminal Value = FCF*(1 + g)/( kWACC - g)
Terminal Value = 25*(1.0325)/(0.099 - 0.0325)
Terminal Value = 388.1579
PVTP = 1/(1.099) * $388.1579
PVTP = 353.1919
V = 22.7480 + 353.1919
V = $375.9399 million
E=V-D
E = 375.9399 - 95 = 280.9399
P = E/N = 280.9399/10.5 = $26.7562
Diff: 3
Section: 3. DCF
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10) Overhill Railroads is expected to generate free cash flow of $90 million next year. (Assume that free
cash flow is paid at the end of each year and we are at the beginning of a year.) After that, free cash flow
is forecast to go grow at 1.20% per annum in perpetuity. The WACC for Overhill Railroads is 11%. The
firm has 20.75 million shares outstanding and the market value of its debt is $100 million. What is the fair
price for Overhill Railroads' shares today?
A) $35.53
B) $36.33
C) $39.44
D) $41.11
E) $44.26
Answer: C
Explanation: C) V = PVFP + PVTP
PVFP = 1/(1 + kWACC) * FCF
PVFP = 1/(1.11) * $90
PVFP = 81.0811
PVTP = 1/(1 + kWACC) * Terminal Value
Terminal Value = FCF * (1 + g)/(kWACC - g)
Terminal Value = 90 * (1.012)/(0.12 - 0.012)
Terminal Value = 929.3878
PVTP = 1/(1.11) * $929.3878
PVTP = 837.2863
V = 81.0811 + 837.2863
V = $918.3674 million
E=V-D
E = 918.3674 - 100 = 818.3674
P = E/N = 818.3674/20.75 = $39.4394
Diff: 3
Section: 3. DCF
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11)
An analyst's forecast for Global Export's free cash flows for next year is provided in the table. Assume
that free cash flow is paid at the end of each year and we are at the beginning of a year. Last year's values
are for the year-end yesterday. Analysts expect cash flow to remain constant at next year's level in
perpetuity. The WACC for Global is 11.50%. What is the fair price for Global Export's shares today?
A) $38.10
B) $42.26
C) $43.79
D) $47.22
E) $51.79
Answer: C
Explanation: C) Free Cash Flow = Operating Cash Flow - ΔNWC - CAPEX
ΔNWC = NWCt - NWCt-1
ΔNWC = $30,450 - $26,050 = -$4,400
Free Cash Flow = 167,899 - (-4,400) - 23,400
Free Cash Flow = 148,899
V = FCF/kWACC = 148,899/0.115 = 1,294,773.90
E = V - D = 1,294,773.90 - 200,000 = 1,094,773.90
P = E/N = 1,094,773.90/25,000 = $43.7910
Diff: 3
Section: 3. DCF
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12)
The forecast for Global Export's free cash flows for next year is provided above. Assume that free cash
flow is paid at the end of each year and we are at the beginning of a year. Last year's values are for the
year-end yesterday. Analysts have forecasted cash flow to remain constant at next year's level in
perpetuity. The WACC for Global is 8.25%. Calculate the fair price for Global Export's shares today.
A) $21.46
B) $22.70
C) $25.98
D) $27.99
E) $32.52
Answer: A
Explanation: A) Free Cash Flow = Operating Cash Flow - ΔNWC - CAPEX
ΔNWC = NWCt - NWCt-1
ΔNWC = $23,090 - $17,490 = $5,600
Free Cash Flow = 62,648 - 5,600 - 22,400
Free Cash Flow = 34,648
V = FCF/kWACC = 34,648/0.0825 = 419,975.76
E = V - D = 419,975.76 - 98,100 = 321,875.76
P = E/N = 321,875.76/15,000 = $21.4584
Diff: 3
Section: 3. DCF
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13)
An analyst's forecast for SouthEast Air's free cash flows for next year is provided in the table. Assume
that free cash flow is paid at the end of each year and we are at the beginning of a year. Last year's values
are for the year-end yesterday. The analyst expects SouthEast's cash flow to remain constant at next year's
level in perpetuity. The WACC for SouthEast is 8%. Calculate the fair price for SouthEast's shares today.
A) $48.98
B) $50.73
C) $51.36
D) $57.48
E) $64.95
Answer: B
Explanation: B) Free Cash Flow = Operating Cash Flow - ΔNWC - CAPEX
Operating Cash Flow = EBIT × (1 - T) + Depreciation
Operating Cash Flow = 290,400 × (1 - 0.40) + 35,610
Operating Cash Flow = 209,850
ΔNWC = NWCt - NWCt-1
ΔNWC = $-35,559 - ($-33,150) = -$2,409
Capital Expenditures = Net fixed assets t - Net fixed assetst-1 + Depreciationt
CAPEX = $252,633- $240,335 + $35,610
CAPEX = $47,908
Free Cash Flow = 209,850 - (-2,409) - $47,908
Free Cash Flow = 164,351
V = FCF/kWACC = 164,351/0.08 = 2,054,387.50
E = V - D = 2,054,387.50- 25,000 = 2,029,387.50
P = E/N = 2,029,387.50/40,000 = $50.7347
Diff: 4
Section: 3. DCF
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14)
The forecast for SouthEast Air's free cash flows for next year is provided in the table above. Assume that
free cash flow is paid at the end of each year and we are at the beginning of a year. Last year's values are
for the year-end yesterday. Analysts have forecasted SouthEast's cash flow to remain constant at next
year's level in perpetuity. The WACC for SouthEast is 11%. Determine the fair price for SouthEast's
shares today.
A) $25.35
B) $26.81
C) $28.90
D) $30.82
E) $33.97
Answer: A
Explanation: A) Free Cash Flow = Operating Cash Flow - ΔNWC - CAPEX
Operating Cash Flow = EBIT × (1 - T) + Depreciation
Operating Cash Flow = 158,022 × (1 - 0.3099) + 21,044
Operating Cash Flow = 130,094.98
ΔNWC = NWCt - NWCt-1
ΔNWC = $-20,844 - ($-18,381) = -$2,463
Capital Expenditures = Net fixed assets t - Net fixed assetst-1 + Depreciationt
CAPEX = $164,877 - $152,734 + $21,044
CAPEX = $33,187
Free Cash Flow = 130,094.98 - (-2,463) - $33,187
Free Cash Flow = 99,370.982
V = FCF/kWACC = 99,370.982/0.11 = 903,372.57
E = V - D = 903,372.57 - 16,000 = 887,372.57
P = E/N = 887,372.57/35,000 = $25.3535
Diff: 4
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LO4: Perform DCF Valuation
1) There are no questions in this section.
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 18 Advanced Capital Structure
LO1: Calculate Leverage and a Fixed D/V Ratio
1) Big Kahuna Burger Inc. has a debt-to-equity ratio of 0.40. What is the debt-to-value ratio for Big
Kahuna?
A) 0.29
B) 0.40
C) 0.71
D) 0.90
Answer: A
Explanation: A) D/E = 0.40
E/V = (1/D/E)/ (1 + (1/D/E))
E/V = (1/0.40)/ (1 + (1/0.40))
E/V = 2.5/ (1 + 2.5)
E/V = 0.7143
D/V = 1 - E/V = 1 - 0.7143 = 0.2857
Diff: 1
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
2) Big Kahuna Burger Inc. is a premier hamburger supplier to North American restaurants. Big Kahuna
has debt-to-equity ratio of 40% and is committed to maintaining that ratio in perpetuity. Big Kahuna's
cost of debt is 6%. Paul's Patties Inc., a competing and very similar company, has no debt and its
shareholders require a return of 11%. The tax rate is 35%. What is Big Kahuna's (levered) cost of equity?
A) 10%
B) 11%
C) 12%
D) 13%
Answer: D
Explanation: D) Proposition II with taxes and a constant debt-to-equity ratio is:
kE = kU + (kU - kD) * D/E
kE = 0.11 + (0.11 - 0.06) * 0.40 = 0.13
Diff: 2
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
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3) Universal Exports has debt-to-equity ratio of 70% and is committed to maintaining that ratio in
perpetuity. Universal's cost of debt is 3.5%. Vandelay Industries Inc., a competing import and export
company, has no debt and its shareholders require a return of 8%. The tax rate is 35%. What is Universal's
WACC?
A) 4.9%
B) 5.6%
C) 7.5%
D) 8.0%
Answer: C
Explanation: C) M&M Proposition II with taxes and a constant debt-to-equity ratio gives the cost of
equity:
kE = kU + (kU - kD) * D/E
kE = 0.08 + (0.08 - 0.035) * 0.7 = 0.1115
To calculate the capital structure weights, let D/E = x. Then, a little algebra produces:
wE = E/V = 1/(1 + x)
wD = D/V = x/(1 + x)
Since D/E = 0.70
wE = E/V = 1/ (1 + x) = 1/1.7 = 0.5882
wD = D/V = x/ (1 + x) = 0.7/1.7 = 0.4118
The after-tax cost of debt is:
= kD * (1 - T) = 0.035 * (1 - 0.35) = 0.02275
The weighted average cost of capital is:
kw = wE × kE + wD × kD * (1 - T)
kw = 0.5882 * 11.15% + 0.4118 * 2.275% = 7.5%
Diff: 2
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
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4) Analysts expect Duff Brewing Company to generate $10 million of free cash flow at the end of the
current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Duff's free cash flow is
forecast to grow at 1.75% in perpetuity. Duff has debt-to-equity ratio of 35% and is committed to
maintaining that ratio in perpetuity. Duff's cost of debt is 4%. Pawtucket Brewery Inc., a competing
company, has no debt and its shareholders require a return of 7%. The tax rate is 40%. Duff's shareholders
require a return of 8.05% and the company's WACC is 6.59%.What is the value of Duff (VL)?
A) $150.83M
B) $190.48M
C) $206.82M
D) $250.00M
Answer: C
Explanation: C) Since free cash flows grow at a constant rate in perpetuity, the present value is found
using the formula for the present value of a growing perpetuity. Since the capital structure is fixed, the
discount rate is the company's WACC.
VL = FCF/ (kW - g)
Where
FCF= Free Cash Flow for year-end
kW = the weighted average cost of capital
g = annual growth rate of free cash flow
VL = $10M/ (0.0659 - 0.0175) = $206.82M
Diff: 2
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
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5) Analysts have forecasted Duff Brewing Company to generate $10 million of free cash flow at the end of
the current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts also expect
Duff's free cash flow to grow at 1.75% in perpetuity. Duff has debt-to-equity ratio of 35% and is
committed to maintaining that ratio in perpetuity. Duff's cost of debt is 4%. The current market value of
Duff's bonds is $53.62 million. Duff has 100 million shares outstanding that trade for $1.53. Pawtucket
Brewery Inc., a competing company, has no debt and its shareholders require a return of 7%. The tax rate
is 40%. Duff's shareholders require a return of 8.05% and the company's WACC is 6.59%. What is the
present value of the Duff's tax shields?
A) $16.14M
B) $27.48M
C) $28.98M
D) $29.50M
Answer: A
Explanation: A) M&M Proposition I with taxes is:
VL = VU + PV (Tax Shields)
PV (Tax Shields) = VL - VU
VL = E + D
VU = FCF/ (kU - g)
Where
FCF= Free Cash Flow for year-end
kU = the required return of stockholders in an unlevered firm
g = annual growth rate of free cash flow
VU = $10M/ (0.07 - 0.0175) = $190.48 million
E = $1.53 × 100 million = $153 million
VL = E + D = $153 M + $53.62 = $206.62 million
PV(Tax Shields) = VL - VU = $206.62 - $190.48 = $16.14M
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
630
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6) Stay Puft Marshmallows Inc. has no debt and its shareholders require a return of 11.5%. There are 175
million shares outstanding and the shares trade for $6.62. Stay Puft has announced a stock repurchase. It
intends to buy 27.5 million shares at a price of $7 per share. The repurchase will be debt financed. After
the repurchase, the company's debt-to-equity ratio will be 0.40 and it will maintain that ratio in
perpetuity. The cost of debt is 5.25% and the tax rate is 30%. What will the WACC be with the new capital
structure?
A) 9.26%
B) 9.71%
C) 10.15%
D) 11.05%
Answer: D
Explanation: D) kE = kU + (kU - kD) * D/E
kE = 0.115 + (0.115 - 0.0525) * 0.40
kE = 0.14
To calculate the capital structure weights, let D/E = x. Then, a little algebra produces:
wE = E/V = 1/(1 + x)
wD = D/V = x/(1 + x)
Since D/E = 0.40
wE = E/V = 1/(1 + x) = 1/1.40 = 0.7143
wD = D/V = x/(1 + x) = 0.40/1.40 = 0.2857
The after-tax cost of debt is:
= kD * (1 - T) = 0.0525 * (1 - 0.30) = 0.03675
kw = wE × kE + wD × kD × (1 - T)
kw = 0.7143 × 0.14 + 0.2857 × 0.03675
kw = 0.1105
Diff: 2
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
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7) Analysts forecast Stay Puft Marshmallows to generate $110 million of free cash flow at the end of the
current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts also expect Stay
Puft's cash flow to grow at 2% in perpetuity. Stay Puft has no debt and its shareholders require a return of
11.5%. There are 175 million shares outstanding and the shares trade for $6.62. Stay Puft has announced a
stock repurchase. It intends to buy 37.5 million shares at a price of $7 per share. The repurchase will be
debt financed. After the repurchase, the company's debt-to-equity ratio will be 0.2796 and it will maintain
that ratio in perpetuity. The cost of debt is 5.25% and the tax rate is 30%. What will the value of the
company be after the repurchase?
A) $956M
B) $978M
C) $1,201M
D) $1,231M
Answer: C
Explanation: C) kE = kU + (kU - kD) * D/E
kE = 0.115 + (0.115 - 0.0525) * 0.2796
kE = 0.1325
To calculate the capital structure weights, let D/E = x. Then, a little algebra produces:
wE = E/V = 1/(1 + x)
wD = DB/V = x/(1 + x)
Since D/E = 0.2796
wE = E/V = 1/(1 + x) = 1/1.2796 = 0.7815
wD = D/V = x/(1 + x) = 0.2796/1.2796 = 0.2185
The after-tax cost of debt is:
= kD * (1 - T) = 0.0525 * (1 - 0.30) = 0.03675
kw = wE × kE + wD × kD × (1 - T)
kw = 0.7815 × 0.1325 + 0.2815 × 0.03675
kw = 0.1116
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC
g = annual growth rate of free cash flow
VL = 110/ (0.1116 - 0.02)
VL = $1,201.4 million or $1.20 billion
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
632
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8) Analysts forecast Stay Puft Marshmallows to generate $110 million of free cash flow at the end of the
current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts also expect Stay
Puft's cash flow to grow at 2% in perpetuity. Stay Puft has no debt and its shareholders require a return of
11.5%. There are 175 million shares outstanding and the shares trade for $6.62. Stay Puft has announced a
stock repurchase. It intends to buy 31.5 million shares at a price of $7 per share. The repurchase will be
debt financed. After the repurchase, the company's debt-to-equity ratio will be 0.2264 and it will maintain
that ratio in perpetuity. The cost of debt is 5.25% and the tax rate is 30%. What will the stock price be after
the repurchase?
A) $5.62
B) $6.40
C) $6.79
D) $6.85
Answer: C
Explanation: C) kE = kU + (kU - kD) * D/E
kE = 0.115 + (0.115 - 0.0525) * 0.2264
kE = 0.1292
To calculate the capital structure weights, let D/E = x. Then, a little algebra produces:
wE = E/V = 1/(1 + x)
wD = DB/V = x/(1 + x)
Since D/E = 0.2264
wE = E/V = 1/(1 + x) = 1/1.2264 = 0.8154
wD = D/V = x/(1 + x) = 0.2264/1.2264= 0.1846
The after-tax cost of debt is:
= kD *(1 - T) = 0.0525 * (1- 0.30) = 0.03675
kw = wE × kE + wD × kD × (1 - T)
kw = 0.8154 × 0.1292 + 0.1846 × 0.03675
kw = 0.1121
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC
g = annual growth rate of free cash flow
VL = 110/(0.1121 - 0.02)
VL = $1,194.45
E = VL - D = $1,194.45 - (31.5 × 7)
E = VL - D = $1,194.45 - 220.5
E = $973.95
NAfter = NBefore - NRepurchased
NAfter = 175 - 31.5 = 137.5
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P = E/N = $973.95/143.5 = $6.79
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
9) Analysts forecast Stay Puft Marshmallows to generate $110 million of free cash flow at the end of the
current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts also expect Stay
Puft's cash flow to grow at 2% in perpetuity. Stay Puft has no debt and its shareholders require a return of
11.5%. There are 175 million shares outstanding and the shares trade for $6.62. Stay Puft has announced a
stock repurchase. It intends to buy 22.5 million shares at a price of $7 per share. The repurchase will be
debt financed. Assume that Stay Puft will maintain its resulting debt-to-equity ratio in perpetuity. The
cost of debt is 5.25% and the tax rate is 30%. What will the stock price be after the repurchase?
A) $6.45
B) $6.73
C) $6.90
D) $7.76
Answer: B
Explanation: B) Debt-to-equity (debt-to-value) ratio not given.
New debt :
$7 × 22.5 million shares = $157.5 million
D = $157.5
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC
g = annual growth rate of free cash flow
kE = kU + (kU - kD) * D/E
kw = wE × kE + wD × kD * (1 - T)
kw = wE × [kU + (kU - kD) * D/E] + wD × kD * (1 - T)
VL = FCF/ (wE × kU + (kU - kD) * D/E + wD × kD * (1 - T) - g)
Simplifying and solving for VL yields:
VL = (FCF + kDDT)/ (kU - g)
VL = (110 + 0.0525 × 157.5 × 0.30)/(0.115 - 0.02)
VL = $1,184.01
E = VL - D = $1,184.01 - 157.5
E = $1,026.51
NAfter = NBefore - NRepurchased
NAfter = 175 - 22.5 = 152.5 million
P = E/N = $1,026.51/152.5 = $6.73
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
634
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10) Analysts forecast Stay Puft Marshmallows to generate $110 million of free cash flow at the end of the
current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts also expect Stay
Puft's cash flow to grow at 2% in perpetuity. Stay Puft has debt with a market value of $239.39 million.
The bondholders have a required return of 5.25%. The company's debt-to-equity ratio is 0.25 and it will
maintain that ratio in perpetuity. The company's WACC is 11.19%. The tax rate is 30%. How much debt
will the company have next year on January 1?
A) $239.99
B) $244.18
C) $289.20
D) $305.22
Answer: B
Explanation: B) V1 = FCF2/(kW - g) = FCF1(1 + g)/(kW - g)
Where
FCF1 = Free Cash Flow for year-end = $99.6 million
kW = WACC
g = annual growth rate of free cash flow
V1 = 110 × (1.02)/(0.1119 - 0.02)
V1 = $1,220.89
To calculate the D/V, let D/E = x. Then, a little algebra produces:
D/V = x/(1 + x)
Since D/E = 0.25
wD = D/V = x/(1 + x) = 0. 25/1.25 = 0.2
If debt is 15% of value, then debt must be:
D1 = 0.2 * V1
D1 = 0.2 × $1,220.89
D1 = $244.18
This is 2% larger than the debt at Year 0.
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
635
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11) Analysts expect Goliath National Bank (GNB) to generate $250 million of free cash flow at the end of
the current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts forecast
GNB's cash flow to grow at 1.5% in perpetuity. GNB has no debt and its shareholders require a return of
9%. There are 300 million shares outstanding which trade for $11.11. The CFO of Goliath National Bank
wants to borrow and use the borrowed funds to repurchase shares. The bank will borrow enough funds
such that its debt-to-value ratio is 20% and it plans to maintain that ratio in perpetuity. (D/E = 0.25) The
cost of debt is 4% and the tax rate is 35%. What stock price should the company offer for repurchased
shares such that the post-repurchase stock price is equal to the repurchase price?
A) $10.48
B) $10.77
C) $11.54
D) $11.87
Answer: C
Explanation: C) The value of the company after the repurchase is:
VL = FCF/ (kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC = wE × kE + wD × kD × (1-T)
wD = 0.20
g = annual growth rate of free cash flow = 0.01
kE = kU + (kU - kD) * D/E
kE = 0.09 + (0.09 - 0.04) * 0.25
kE = 0.1025
kw = wE kE + wD kD (1 - T)
kw = 0.80 × 0.1025 + 0.2 × 0.04 × (1 - 0.35)
kw = 0.0872
VL = 250/ (0.0872 - 0.015)
VL = $3,462.60
The price after the repurchase is:
PA = EA/NA
NA = N B - NR
The number of shares repurchased is the new debt divided by the repurchase price (recall that P R = PA):
NR = D/PA
So,
PA = EA/ (NB - D/PA)
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Simplify
PA (NB - D/PA) = EA
PA NB - D = EA
PA NB = EA + D
PA = VL /NB
PA = $3,462.60/300
PA = $11.54
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
637
Copyright © 2015 Pearson Canada, Inc.
12) Analysts expect Bluth Company Inc. to generate $90 million of free cash flow at the end of the current
year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts expect Bluth's cash flow
to remain constant in perpetuity. Bluth has no debt and its shareholders require a return of 10%. There
are 125 million shares outstanding which trade for $7.20. The CFO of Bluth, Mr. George Bluth, wants to
borrow and use the borrowed funds to repurchase shares. The company will borrow enough funds such
that its debt-to-value ratio is 40% and it plans to maintain that ratio in perpetuity. (D/E = 0.6666.) The cost
of debt is 4% and the tax rate is 30%. What stock price should the company offer for repurchased shares
such that the post-repurchase stock price is equal to the repurchase price?
A) $7.20
B) $7.56
C) $7.72
D) $8.00
Answer: B
Explanation: B) The value of the company after the repurchase is:
VL = FCF/kW
Where
FCF= Free Cash Flow for year-end
kW = WACC = wE × kE + wD × kD × (1 - T)
wD = 0.40
kE = kU + (kU - kD) * D/E
kE = 0.10 + (0.10 - 0.04) * 0.6666
kE = 0.14
kw = wE kE + wD kD (1 - T)
kw = 0.60 × 0.14 + 0.40 × 0.04 × (1 - 0.30)
kw = 0.0952
VL = 90/0.0952
VL = $945.38
The price after the repurchase is:
PA = EA/NA
NA = N B - NR
The number of shares repurchased is the new debt divided by the repurchase price (recall that P R = PA):
NR = D/PA
So,
PA = EA/(NB - D/PA)
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Simplify
PA (NB - D/PA) = EA
PA NB - D = EA
PA NB = EA + D
PA = VL /NB
PA = $945.38/125
PA = $7.56
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
13) Analysts expected Clampett Oil to generate free cash flow of $1.6391 billion in one year. Assume that
cash flows occur on Dec 31 and today is January 1. Analysts expect Clampett's cash flow to grow at 4% in
perpetuity. Clampett has $3 billion of debt, which is equal to 15% of its value, and is committed to
maintaining that ratio in perpetuity. The required return of shareholders is 13.43% and the required
return of lenders is 8%. The tax rate is 35%. There are 417.8 million shares outstanding. What is the fair
price for one share of Clampett Oil?
A) $41
B) $42
C) $43
D) $44
Answer: A
Explanation: A) The value of the company is:
VL = FCF/ (kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC = wE kE + wD kD (1 - T)
wD = 0.15
g = annual growth rate of free cash flow = 0.04
kw = wE kE + wD kD (1 - T)
kw = 0.85 × 0.1343 + 0.15 × 0.08 × (1 - 0.35)
kw = 0.121955
VL = 1,639.1/ (0.121955 - 0.04)
VL = $20,000
E = VL - D = $20,000 - $3,000 = $17,000
P = E/N = 17,000/417.8 = $40.69
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
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14) In November of 2012, Commerce Bank, an investment firm, won a bidding war to buy all of the shares
(417.8 million) of Clampett Oil for $45 per share. Clampett shares had been trading for $38 prior to the
buyout. The purchase was debt financed ($18,801 million). The new debt was added to the $3 billion of
debt that predated the buyout. The new debt resulted in a debt-to-value ratio of 83.5% which Clampett
was committed to maintaining in perpetuity. Analysts expected Clampett to generate free cash flow of
$1.6391 billion in the year after the buyout. Assume that cash flows occur on Dec 31 and today is January
1. Analysts expected Clampett's cash flow to grow at 4% in perpetuity. Clampett's cost of debt was 8%
and its cost of unlevered equity was 12.6155%. The tax rate was 35%. What was the value of Commerce
Bank's equity in the company after the buyout?
A) $4.3 billion
B) $5.3 billion
C) $6.3 billion
D) $7.3 billion
Answer: A
Explanation: A) New debt is equal to cost of buyout:
$45 × 417.8 million shares = $18,801 million
Total Debt after buyout:
D = $18,801 + $3,000 = $21,801
The value of the company is:
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC = wE kE + wD kD (1 - T)
wD = 0.835
g = annual growth rate of free cash flow = 0.04
kE = kU + (kU - kD) * D/E
kE = 0.126155 + (0.126155 - 0.08) * (0.835/0.165)
kE = 0.3597
kw = wE kE + wD kD (1 - T)
kw = 0.165 × 0.3597 + 0.835 × 0.08 × (1 - 0.35)
kw = 0.1028
VL = 1,639.1/ (0.1028 - 0.04)
VL = $26,110.24
E = VL - D = $26,110.24 - $21,801 = 4,309 million
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
640
Copyright © 2015 Pearson Canada, Inc.
15) In November of 2012, Commerce Bank, an investment firm, won a bidding war to buy all of the shares
(417.8 million) of Clampett Oil for $45 per share. Clampett shares had been trading for $36 prior to the
buyout. The purchase was debt financed ($18,801 million). The new debt was added to the $3.0 billion of
debt that predated the buyout. Commerce Bank intended to hold the debt of Clampett constant at that
level (in dollar terms) in perpetuity. Analysts expected Clampett to generate free cash flow of $1.6391
billion in the year after the buyout. Assume that cash flows occur on Dec 31 and today is January 1.
Analysts expected Clampett's cash flow to grow at 4% in perpetuity. Clampett's cost of debt was 8% and
its cost of unlevered equity was 12.6155%. The tax rate was 35%. What was the value of Commerce Bank's
equity in the company after the buyout?
A) $1.85 billion
B) $2.85 billion
C) $3.85 billion
D) $4.85 billion
Answer: D
Explanation: D) New debt is equal to cost of buyout:
$45 × 417.8 million shares = $18,801 million
Total Debt after buyout:
D = $18,801 + $3,000 = $21,801
The value of the company is (by M&M Prop I with taxes):
VL = VU + PVTS = VU + TD
VL = FCF/(kU - g) +TD
Where
FCF= Free Cash Flow
kU = required return of unlevered shareholders
T = tax rate = 40%
g = annual growth rate of free cash flow = 0.05
VL = 1,639.1/ (0.126155 - 0.04) + 0.35 × $21,801
VL = $26,655.36
E = VL - D = $26,655.36 - $21,801 = 4,854 million or 4.85 billion
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
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16) In October of 2012, Jed Clampett's management team offered to buy all of the shares (417.8 million) of
Clampett Oil for $52 per share. The purchase was debt financed. The new debt would have been added to
the $3.0 billion of debt that predated the buyout. Clampett was committed to maintaining its debt-tovalue ratio at the post-buyout level in perpetuity. Analysts expected Clampett to generate free cash flow
of $1.6319 billion the year after the deal. Assume that cash flows occur annually. Cash flows were
expected to grow at 4% in perpetuity. Clampett's cost of debt was 8% and its cost of unlevered equity was
12.6155%. The tax rate was 35%. In the deal, Jed's management team was to receive 15% of the equity (in
the post buyout company). What was that share worth on the date of the deal? Assume that the deal was
successful and completed immediately.
A) $129 million
B) $256 million
C) $350 million
D) $404 million
Answer: C
Explanation: C) Debt-to-equity (debt-to-value) ratio not given.
New debt is equal to cost of buyout:
$52 × 417.8 million shares = $21,725.6 million
Total Debt after buyout:
D = $21,725.6 + $3,000 = $24,725.6
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow
kW = WACC = wE × kE + wD × kD * (1 - T)
g = annual growth rate of free cash flow
WACC cannot be calculated because wD (D/V) unknown. So, use Proposition II (with constant D/V)
kE = kU + (kU - kD) * D/E
Substitute into WACC:
kw = wE kU + wE (kU - kD) * D/E + wD kD (1 - T)
Recall that D/E = wD/wE
Substitute this into valuation formula
VL = FCF/ (wE kU + (kU - kD) * wD + wD kD (1 - T) - g)
Simplify and solve for VL yields:
VL = (FCF + kDDT)/ (kU - g)
VL = (1,639.1 +0.08 × $24,725.6 × 0.35)/(0.126155 - 0.04)
VL = $27,060.73
E = VL - D = $27,060.73 - $24,725.6
E = $2,335.13
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15% of the equity would have been worth $350.27 million.
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
17) Analysts expected Clampett Oil to generate free cash flow of $1.6391 billion in one year. Assume that
cash flows occur on Dec 31 and today is January 1. Analysts expect Clampett's cash flow to grow at 4% in
perpetuity. Clampett has $3.0 billion of debt, which is equal to 15% of its value and it is committed to
maintaining that ratio in perpetuity. The required return of shareholders is 13.43% and the required
return of lenders is 8%. The tax rate is 35%. There are 417.8 million shares outstanding. Assume that
Clampett adjusts its capital structure annually to maintain its fixed debt-to-equity ratio. How much will it
borrow (repay) one year from today?
A) $100M
B) $110M
C) $120M
D) $130M
Answer: C
Explanation: C) D1 = (D/V) * V1
D1 = (0.15) * V1
The value of the company in one year is:
V1 = FCF2/(kW - g) = FCF1(1 + g)/(kW - g)
Where
FCF2 = Free Cash Flow in two years
g = annual growth rate of free cash flow = 0.04
kW = WACC = wE kE + wD kD (1 - T)
wD = 0.15
kw = 0.85 × 0.1343 + 0.15 × 0.08 × (1 - 0.35)
kw = 0.121955
VL = 1,639.1(1.04)/(0.121955 - 0.04)
VL = $20,800
If debt is 15% of value, then debt must be:
D1 = 0.15 * V1
D1 = 0.15 × $20,800
D1 = $3,120 M
ΔD = D1 - D0 = $3,120 - $3,000 = $120 M
This is $120 million larger than the debt at Year 0, so Calmpett borrows more.
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
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18) In November of 2012, Commerce Bank, an investment firm, won a bidding war to buy all of the shares
(417.8 million) of Clampett Oil for $48.31 per share. Clampett shares had been trading for $42 prior to the
buyout. The purchase was debt financed ($20.184 billion). The new debt was added to the $3.0 billion of
debt that predated the buyout. The new debt resulted in a debt-to-value ratio of 87.3% which Clampett
was committed to maintaining in perpetuity. Clampett's cost of debt was 8% and its cost of unlevered
equity was 12.6155%. The tax rate was 35%. What was the required return of Clampett's shareholders
(Grekko & Associates) after the buyout?
A) 32%
B) 36%
C) 40%
D) 44%
Answer: D
Explanation: D) kE = kU + (kU - kD) * D/E
To calculate D/E, take D/V and divide by E/V:
D/V/ (E/V) = D/V * (V/E) = D/E.
Since D/V = 0.873, E/V = 0.127
D/E = 0.873/0.127 = 6.87
kE = 0.126155 + (0.126155 - 0.08) * (0.873/0.127)
kE = 0.44
Diff: 2
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
644
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19) Spacely Sprockets Inc. is a premier aerospace supplier. Analysts expected Spacely to generate free
cash flow of $4 billion in one year. Assume that cash flows occur on Dec 31 and today is January 1.
Analysts expect the cash flows to grow at 3% in perpetuity. Spacely has $14.82854 billion of debt, which is
equal to 25% of its value and it is committed to maintaining that ratio in perpetuity. The required return
of shareholders is 12% and the required return of lenders is 4.25%. The tax rate is 30%. There are 1.5
billion shares outstanding.
What is the fair price for Spacely's shares?
A) $26.66
B) $27.66
C) $28.66
D) $29.66
Answer: D
Explanation: D) The stock price is:
P = E/N
Where
E = equity
N = the number of shares = 1.5B
E = VL - D = VL - $6.4516B
VL = FCF/ (kW - g)
Where
FCF = Free Cash Flow for year-end = $5B
kW = WACC = wE kE + wD kD (1 - T)
wD = 0.25
g = annual growth rate of free cash flow = 0.03
kw = wE kE + wD kD (1 - T)
kw = 0.75 × 0.12 + 0.25 × 0.0425 × (1 - 0.30)
kw = 0.0974375
VL = 4,000/ (0.0974375 - 0.03)
VL = $59,314.180 M
E = VL - D = $59,314.180 - $14,828.54 = $44,485.64 million
P = E/N = $44,485.63 /1,500 = $29.66
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
645
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20) Spacely Sprockets Inc. is a premier aerospace supplier. Analysts expected Spacely to generate free
cash flow of $4 billion in one year. Assume that cash flows occur on Dec 31 and today is January 1.
Analysts expect the cash flows to grow at 1.5% in perpetuity. Spacely has $12.1304 billion of debt, which
is equal to 25% of its value and it is committed to maintaining that ratio in perpetuity. The required
return of shareholders is 12% and the required return of lenders is 4.25%. The tax rate is 30%. There are
1.5 billion shares outstanding and each trade for $24.26.
Cosmo G. Spacely announced today that he has acquired 5% of Spacely's shares. Cosmo intends to make
a tender offer for all of Spacely's shares at a price of $25. The board of directors has recommended against
the offer. To defend against the tender offer, the board has announced a debt-financed stock repurchase.
The company will buyback 33.3% (500M) of the shares at a price of $26. What stock price will prevail after
the repurchase? (Assume that the company commits to its new debt-to-value ratio in perpetuity.)
A) $25.33
B) $25.66
C) $26.33
D) $26.66
Answer: A
Explanation: A) The stock price is:
P = E/N
Where
E = equity after repurchase
N = the number of shares after = 1.5B - 0.5B = 1.0B
E = VL - D
VL = FCF/ (kW - g)
D is known. It is the old debt plus the total cost of repurchased shares.
D = $12,130.4 + ($26 × 500M)
D = $25,130.4
However, WACC cannot be calculated because wD (D/V) unknown. So, use Proposition II (with constant
D/V)
kE = kU + (kU - kD) * D/E
Substitute into WACC:
kw = wE kU + wE (kU - kD) * D/E + wD kD (1 - T)
Recall that D/E = wD/wE
Substitute this into valuation formula
VL = FCF/ (wE kU + (kU - kD) * wD + wD kD (1 - T) - g)
Simplify and solve for VL yields:
VL = (FCF + kDDT)/(kU - g)
One last snag: kU is not given. Back-solve it from Proposition II, since kE given:
kU = D/V × kD + E/V × kE
kU = 0.25 × 4.25% + 0.75 × 12%
kU = 10.0625%
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VL = (4,000 + 0.0425 × $25,130.4 × 0.30)/ (0.100625 - 0.015)
VL = $50,457.37
E = VL - D = $50,457.37 - $25,130.4
E = $25,326.97
P = E/N = $25,326.97/1,000 = $25.33
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
647
Copyright © 2015 Pearson Canada, Inc.
21) Analysts expect Flimsy Construction Inc. to generate $200 million of free cash flow at the end of the
current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts expect Flimsy's
cash flow to grow at 2% in perpetuity. Flimsy has no debt and its shareholders require a return of 8%.
There are 300 million shares outstanding and the shares trade for $11.11. Flimsy has announced a stock
repurchase. It intends to buy 50 million shares at a price of $12 per share. The repurchase will be debt
financed. What will the stock price be after the repurchase? Assume that Flimsy will maintain its
resulting debt-to-equity ratio in perpetuity. The cost of debt is 5% and the tax rate is 35%.
A) $11.03
B) $11.25
C) $11.43
D) $11.63
Answer: D
Explanation: D) Debt-to-equity (debt-to-value) ratio not given.
New debt:
$12 × 50 million shares = $600 million
D = $600
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC
g = annual growth rate of free cash flow
kE = kU + (kU - kD) * D/E
kw = wE × kE + wD × kD * (1 - T)
kw = wE × kU + (kU - kD) * D/E + wD × kD * (1 - T)
VL = FCF/( wE × kU + (kU - kD) * D/E + wD × kD * (1 - T) - g)
Simplify and solve for VL yields:
VL = (FCF + kDDT)/(kU - g)
VL = (200 +0.05 × 600 × 0.35)/(0.08 - 0.02)
VL = $3,508.3333M
E = VL - D = $3,508.3333M - $600M
E = $2,908.333
NAfter = NBefore - NRepurchased
NAfter = 300 - 50 = 250 million
P = E/N = $2,908.333/250 = $11.63
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
648
Copyright © 2015 Pearson Canada, Inc.
22) Analysts expect the Montana Dental Floss Company to generate $200 million of free cash flow at the
end of the current year. (Assume that cash flows occur on Dec 31 and today is January 1.) Analysts expect
Montana's cash flow to grow at 1.5% in perpetuity. Montana has no debt and its shareholders require a
return of 9%. There are 200 million shares outstanding which trade for $13.33. The CFO of Montana
wants to borrow and use the borrowed funds to repurchase shares. The company will borrow enough
funds such that its debt-to-value ratio is 25% and it plans to maintain that ratio in perpetuity. (D/E =
0.3333.) The cost of debt is 5% and the tax rate is 40%. What stock price should the company offer for
repurchased shares such that the post-repurchase stock price is equal to the repurchase price?
A) $14.29
B) $14.39
C) $14.49
D) $14.59
Answer: A
Explanation: A) The value of the company after the repurchase is:
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC = wE × kE + wD × kD × (1 - T)
wD = 0.25
g = annual growth rate of free cash flow = 0.015
kE = kU + (kU - kD) * D/E
kE = 0.09 + (0.09 - 0.05) * 0.3333
kE = 0.1033
kw = wE kE + wD kD (1 - T)
kw = 0.75 × 0.1033 + 0.25 × 0.05 × (1 - 0.4)
kw = 0.085
VL = 200/(0.085 - 0.015)
VL = $2,857.14
The price after the repurchase is:
PA = EA/NA
NA = N B - NR
The number of shares repurchased is the new debt divided by the repurchase price (recall that P R = PA):
NR = D/PA
So,
PA = EA/(NB - D/PA)
Simplify
PA = VL /NB
PA = $2,857.14/200
PA = $14.29
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
649
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AACSB: Analytical Thinking
23) American Motors Inc. has a debt-to-equity ratio of 0.90. What is the firm's debt-to-value ratio?
A) 0.47
B) 0.57
C) 0.67
D) 0.77
Answer: A
Explanation: A) D/E = 0.9
E/V = (1/(D/E)) / (1 + (1/(D/E)))
E/V = (1/0.9) / (1 + (1/0.9))
E/V = 1.111 / (1 + 1.111)
E/V = 0.526
D/V = 1 - E/V = 1 - 0.526 = 0.474
Diff: 2
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
650
Copyright © 2015 Pearson Canada, Inc.
24) GloboChem used to be all equity financed and its investors required a return of 6.5%. Recently,
GloboChem borrowed such that its D/V ratio is 40%. It considers that ratio to be optimal and will
maintain it in perpetuity. The borrowed funds were used to repurchase shares. The lenders' required
return is 5%. The tax rate is 35%. What is the required return of stockholders now?
A) 6.5%
B) 6.8%
C) 7.1%
D) 7.5%
Answer: D
Explanation: D) kE = kU + [kU - kD] × (D/E) = 0.065 + [0.065 - 0.05] × 0.66667 = 0.075
Diff: 2
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
25) Analysts expected RJR Nabisco to generate free cash flow of $1.41 billion in one year. Assume that
cash flows occur on Dec 31 and today is January 1. Analysts expect RJR's cash flow to grow at 4.5% in
perpetuity. RJR has $4.5 billion of debt, which is equal to 21.23% of its value and it is committed to
maintaining that ratio in perpetuity. The required return of shareholders is 12.54% and the required
return of lenders is 10%. The tax rate is 40%. There are 250 million shares outstanding. What is the price
of an RJR share?
A) $66.80
B) $66.90
C) $67.00
D) $67.10
E) $67.20
Answer: A
Explanation: A) The value of the company is:
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC = wE kE + wD kD (1 - T)
wD = 0.2123
g = annual growth rate of free cash flow = 0.045
kw = wE kE + wD kD (1 - T)
kw = 0.7877 × 0.1254 + 0.2123 × 0.1 × (1 - 0.40)
kw = 0.111511
VL = 1,410/(0.11151 - 0.045)
VL = $21,200
E = VL - D = $21,200 - $4,500 = 16,700
P = E/N = 16,700/250 = $66.80.
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
651
Copyright © 2015 Pearson Canada, Inc.
26) In November of 1988, KKR, an investment firm, won a bidding war to buy all of the shares (250
million) of RJR Nabisco for $108 per share. RJR shares had been trading for $55 prior to the buyout. The
purchase was debt financed ($27 billion). The new debt was added to the $4.5 billion of debt that
predated the buyout. The new debt resulted in a debt-to-value ratio of 82.58% which RJR was committed
to maintaining in perpetuity. Analysts expected RJR to generate free cash flow of $1.41 billion in the year
after the buyout. Assume that cash flows occur on Dec 31 and today is January 1. Analysts expected RJR's
cash flow to grow at 5% in perpetuity. RJR's cost of debt was 10% and its cost of unlevered equity was
12%. The tax rate was 40%. What was the value of KKR's equity in the company after the buyout?
A) $5.6 billion
B) $6.1 billion
C) $6.6 billion
D) $6.9 billion
Answer: C
Explanation: C) New debt is equal to cost of buyout:
$108 × 250 million shares = $27,000 million
Total Debt after buyout:
D = $27,000 + $4,500 = $31,500
The value of the company is:
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow for year-end
kW = WACC = wE kE + wD kD (1 - T)
wD = 0.8258
g = annual growth rate of free cash flow = 0.05
kE = kU + (kU - kD) * D/E
kE = 0.12 + (0.12 - 0.10) * (0.8258/0.1742)
kE = 0.21481
kw = wE kE + wD kD (1 - T)
kw = 0.8258 × 0.21481 + 0.1742 × 0.1 × (1 - 0.40)
kw = 0.086968
VL = 1,410/(0. 086968 - 0.05)
VL = $38,141.10
E = VL - D = $38,141.10 - $31,500 = $6,641.10 million
Diff: 3
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
652
Copyright © 2015 Pearson Canada, Inc.
27) In October of 1988, F. Ross Johnson's management team offered to buy all of the shares (250 million)
of RJR Nabisco for $75 per share. The purchase was debt financed. The new debt would have been added
to the $4.5 billion of debt that predated the buyout. RJR was committed to maintaining its debt-to-value
ratio at the post-buyout level in perpetuity. Analysts expected RJR to generate free cash flow of $1.13
billion in one year (Dec 31). Assume that cash flows occur annually. Cash flows were expected to grow at
5% in perpetuity. RJR's cost of debt was 10% and its cost of unlevered equity was 12%. The tax rate was
40%. Under the terms of the deal, Johnson's management team invested nothing but would hold 18.5% of
the equity (in the post buyout company). What was that share worth? Assume that today is January 1 and
that the deal was completed successfully this morning.
A) $1.143 billion
B) $1.343 billion
C) $1.543 billion
D) $1.743 billion
Answer: A
Explanation: A) Debt-to-equity (debt-to-value) ratio not given.
New debt is equal to cost of buyout:
$75 × 250 million shares = $18,750 million
Total Debt after buyout:
D = $18,750 + $4,500 = $23,250
VL = FCF/(kW - g)
Where
FCF= Free Cash Flow
kW = WACC = wE × kE + wD × kD * (1 - T)
g = annual growth rate of free cash flow
WACC cannot be calculated because wD (D/V) unknown. So, use Proposition II (with constant D/V)
kE = kU + (kU - kD) * D/E
Substitute into WACC:
kw = wE kU + wE (kU - kD) * D/E + wD kD (1 - T)
Recall that D/E = wD/wE
Substitute this into valuation formula
VL = FCF/( wE kU + (kU - kD) * wD + wD kD (1 - T) - g)
Simplify and solve for VL yields:
VL = (FCF + kDDT)/(kU - g)
VL = (1,130 + 0.10 × $23,250 × 0.40)/(0.12 - 0.05)
VL = $29,428.57
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E = VL - D = $29,428.57 - $23,250
E = $6,178.57
18.5% of the equity would have been worth $1.143 billion.
Diff: 4
Section: 1 Leverage and a Fixed D/V Ratio
AACSB: Analytical Thinking
654
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LO2: Define Leverage and Systematic Risk
1) The ballistic missile division of Yuzhmash evaluates all new projects by calculating the NPV based on
the missile division's own cost of capital. The division's capital structure is composed of $0.3B of debt and
$1.1B of equity, and their corporate tax rate is 27%. What is the division's equity beta? To help you,
Mickey Yangel, the CEO, has identified a pure play missile company, MBDA Inc. Their equity beta is
0.75, they have $2.5B of debt, their equity is worth $5.5B, and the corporate tax rate is 31%. Assume that
the debt betas for both companies are zero.
A) 0.405
B) 0.516
C) 0.656
D) 0.750
Answer: C
Explanation: C) First, unlever MBDA's equity beta to find the asset beta.
βU =
βE
E/V = 5.5 / (5.5 + 2.5) = 0.6875
βV = 0.6875 * 0.75 = 0.515625
Then, compute the equity beta for the missile division using the asset beta for MBDA:
βE =
βU
βE = (0.3 + 1.1) / 1.1 * 0.515625 = 0.65625
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
655
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2)
You are valuing a privately owned company called Try-N-Save, which operates a chain of discount retail
stores in the Springfield region. To estimate the required return of stock holders you need an asset beta
for the consumer retail business. You have the above data on two pure-play grocery companies. What is
the (equally weighted) average of the asset betas for Mega Lo Mart and Superstore USA? Assume that
debt betas are zero and that all three companies pursue capital structure policies with a fixed debt-tovalue ratio.
A) 0.317
B) 0.424
C) 0.531
D) 2.530
Answer: B
Explanation: B) Each of the two betas must be unlevered.
βU =
βE
For Mega Lo Mart:
βU = (7.9 / 11) * 0.74 = 0.53145
For Superstore USA:
βU = (3 / 10.7) * 1.13 = 0.31682
The average is: (0.53145 + 0.31682) / 2 = 0.424
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
656
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3) You are valuing a privately owned paper company called Wernham Hogg. To estimate the required
return of stock holders you need an asset beta for the paper business. You have determined that the most
similar business to Wernham is Dunder Mifflin, which has an equity beta of 0.28 and a debt-to-equity
ratio of 0.45. What is the asset beta for the paper business based on Dunder Mifflin? Assume that debt
betas are zero and that both companies pursue capital structure policies with a fixed debt-to-value ratio.
A) 0.087
B) 0.126
C) 0.193
D) 0.690
Answer: C
Explanation: C) βU =
βE
D/E = 0.45
E/V = (1 / D/E) / (1 + (1 / D/E))
E/V =(1 / 0.45) / (1 + (1 / 0.45))
E/V = 2.222 / (1 + 2.222)
E/V = 0.6897
βU = (0.6897) * 0.28 = 0.193
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
4) You have been hired to calculate an equity beta for the energy division of a large multinational
company. The energy division is financed with 30% debt and 70% equity. The most similar pure-play
energy company is Roxxon Energy Corp., which has an equity beta of 0.99. Roxxon is financed with 20%
of debt. What equity beta should you use for the energy division? Assume that debt betas are zero and
that both companies pursue capital structure policies with a fixed debt-to-value ratio.
A) 0.139
B) 0.554
C) 0.690
D) 1.131
Answer: D
Explanation: D) First, unlever Roxxon's equity beta to find the asset beta.
βU =
βE
E/V = (1 - D/V) = (1 - 0.2) = 0.8
βU = 0.8 * 0.99 = 0.792
Then, compute the equity beta for the energy division using the asset beta:
βE =
βU
βE = (1 / 0.7) * 0.792 = 1.1314
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
657
Copyright © 2015 Pearson Canada, Inc.
5) Trans American Airlines is financed with 50% debt and 50% equity. The company's equity beta is 0.5.
What is the asset beta for Trans American? Assume that the company's debt beta is zero and that it
pursues a capital structure policy with a fixed debt-to-value ratio.
A) 0.125
B) 0.250
C) 0.500
D) 1.000
Answer: B
Explanation: B) βU =
βE
E/V = 0.5
βU = (0.5) * 0.5 = 0.25
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
6) The asset beta for the barbeque business is 0.301. Strickland Propane is financed with 15% debt and
85% equity. What is Strickland's equity beta? Assume that the company's debt beta is zero and that it
pursues a capital structure policy with a fixed debt-to-value ratio.
A) 0.05
B) 0.26
C) 0.35
D) 2.00
Answer: C
Explanation: C) βE =
βU
βE = (1 / 0.85) * 0.301 = 0.354
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
658
Copyright © 2015 Pearson Canada, Inc.
7) The Toy Division of Wacky Products Inc. evaluates all new product proposals by calculating the NPV
based on the Toy Division's own cost of capital. The division's capital structure is composed of $0.2B of
debt and $1.2B of equity, and the Toy division pays a corporate tax rate of 29%. What is the Toy
Division's equity beta? To help you, Fred Schwarz, the CEO, has identified a pure play toy company, Toy
Bazaar Inc. Their equity beta is 1.7, they have $1.5B of debt, their equity is worth $7.5B, and the corporate
tax rate is 30%. Assume that the debt betas for both companies are zero.
A) 1.214
B) 1.417
C) 1.653
D) 1.700
Answer: C
Explanation: C) First, unlever Toy Bazaar's equity beta to find the asset beta.
βU =
βE
E/V = 7.5 / (7.5 + 1.5) = 0.83333
βU = 0.83333 * 1.7 = 1.41666
Then, compute the equity beta for the Toy Division using the asset beta for Toy Bazaar:
βE =
βU
βE = (0.2 + 1.2)/1.2 * 1.41666 = 1.652777
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
659
Copyright © 2015 Pearson Canada, Inc.
8)
You are valuing a privately owned company called Minute Mart, which operates a chain of convenience
stores. To estimate the required return of stock holders you need an asset beta for the convenience store
business. You have the above data on two pure-play companies. What is the (equally weighted) average
of the asset betas for Kwik-E-Mart and J-Mart? Assume that debt betas are zero and that both companies
pursue capital structure policies with a fixed debt-to-value ratio.
A) 0.500
B) 0.699
C) 0.916
D) 1.615
Answer: B
Explanation: B) Each of the two betas must be unlevered.
βU =
βE
For Kwik-E-Mart:
βU = (9.1 / 12.4) * 0.93 = 0.6825
For J-Mart:
βU = (4.0 / 8.0) * 2.30 = 1.15
The average is: (0.6825 + 1.15) / 2 = 0.91625
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
660
Copyright © 2015 Pearson Canada, Inc.
9) You are valuing a privately owned coffee shop chain called Spresso. To estimate the required return of
stock holders you need an asset beta for the coffee shop business. You have determined that the most
similar business to Spresso is Cup-o-chinos, which has an equity beta of 1.00 and a debt-to-equity ratio of
0.50. What is the asset beta for the coffee shop business based on Cup-o-chinos? Assume that debt betas
are zero and that both companies pursue capital structure policies with a fixed debt-to-value ratio.
A) 0.667
B) 1.000
C) 1.250
D) 2.000
Answer: A
Explanation: A) βU =
βE
D/E = 0.50
E/V = (1 / D/E) / (1 + (1 / D/E))
E/V = (1 / 0.50) / (1 + (1 / 0.50))
E/V = 2 / (1 + 2)
E/V = 0.6667
βU = (0.6667) * 1 = 0.6667
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
10) You have been hired to calculate an equity beta for the film division of large entertainment company,
Entertainment 720. The film division is financed with 33% debt and 67% equity. The most similar pureplay film studio is World Wide Studios, which has an equity beta of 0.19. World Wide is financed with
70% of debt. What equity beta should you use for the film division? Assume that debt betas are zero and
that both companies pursue capital structure policies with a fixed debt-to-value ratio.
A) 0.06
B) 0.07
C) 0.08
D) 0.09
Answer: D
Explanation: D) First, unlever World Wide Studios' equity beta to find the asset beta:
βU =
βE
E/V = (1 - D/V) = (1 - 0.7) = 0.3
βU = 0.3 * 0.19 = 0.057
Then, compute the equity beta for the film division using the asset beta for World Wide:
βE =
βU
βE = (1 / 0.67) * 0.057 = 0.0851
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
661
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11) Big Belly Burger Inc. is financed with 5% debt and 95% equity. The company has an equity beta of 1.5.
What is the asset beta for Big Belly Burger? Assume that the company's debt beta is zero and that it
pursues a capital structure policy with a fixed debt-to-value ratio.
A) 0.075
B) 1.425
C) 1.579
D) 30.00
Answer: B
Explanation: B) βU =
βE
E/V = 0.95
βU = 0.95 * 1.5 = 1.425
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
12) The asset beta for the snow removal business is 0.10. Mr. Plow is financed with 90% debt and 10%
equity. What is Mr. Plow's equity beta? Assume that Mr. Plow's debt beta is zero and that it pursues a
capital structure policy with a fixed debt-to-value ratio.
A) 0.25
B) 0.50
C) 1.00
D) 1.67
Answer: C
Explanation: C) βE =
βU
βE = (1 / 0.10) * 0.10 = 1.00
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
13) Pacific Courier has an equity beta of 1.10 and a debt beta of 0.05. Pacific maintains a debt-to-value
ratio 0.60. It regards that ratio as optimal and intends to maintain it in perpetuity. What is Pacific
Courier's asset beta?
A) 0.44
B) 0.47
C) 0.50
D) 0.53
Answer: B
Explanation: B) βU =
βE +
βD
D/V = 0.60
E/V = 1 - D/V = 0.40
βU = 0.60 * 0.05 + 0.40 * 1.10 = 0.47
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
662
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14) The asset beta for the aerospace business is equal to 0.66. Quest Aerospace has a debt beta of 0.31 and
it maintains a debt-to-value ratio 0.52. It regards that ratio as optimal and intends to maintain it in
perpetuity. What is the equity beta for Quest?
A) 1.04
B) 1.38
C) 1.67
D) 2.13
Answer: A
Explanation: A) βE =
βU -
βD
E/V = 1 - (D/V) = 1 - 0.52 = 0.48
V/E = 1/0.48 = 2.083
D/E = V/E - 1 = 2.083 - 1 = 1.083
βE = 2.083 * 0.66 - 1.083 * 0.31 = 1.039
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
15) Cogswell Cogs Inc. has an equity beta of 1.44 and a debt beta of 0.2. Cogswell maintains a debt-tovalue ratio 0.66. It regards that ratio as optimal and intends to maintain it in perpetuity. What is
Cogswell's asset beta?
A) 0.42
B) 0.52
C) 0.62
D) 0.72
Answer: C
Explanation: C) βU =
βE -
βD
D/V = 0.66
E/V = 1 - D/V = 0.34
βU = 0.34 * 1.44 + 0.66 * 0.2 = 0.62
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
663
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16) The asset beta for the quarrying business is equal to 1.41. Slate and Gravel has a debt beta of 1.14 and
it maintains a debt-to-value ratio 0.44. It regards that ratio as optimal and intends to maintain it in
perpetuity. What is the equity beta for Slate and Gravel?
A) 0.27
B) 1.27
C) 1.41
D) 1.62
Answer: D
Explanation: D) βE =
βU -
βD
E/V = 1 - (D/V) = 1 - 0.44 = 0.56
V/E = 1/0.56 = 1.7857
D/E = V/E - 1 = 1.7857 - 1 = 0.7857
βE = 1.7857 * 1.41 - 0.7857 * 1.14 = 1.622
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
17) Birmingham Motors has an equity beta of 1.93 and a debt beta of 0.28. Birmingham maintains a debtto-value ratio 0.21. It regards that ratio as optimal and intends to maintain it in perpetuity. What is
Birmingham Motors' asset beta?
A) 0.63
B) 1.23
C) 1.58
D) 1.67
Answer: C
Explanation: C) βU =
βE -
βD
D/V = 0.21
E/V = 1 - D/V = 0.79
βU = 0.21 * 0.28 + 0.79 * 1.93 = 1.58
Diff: 1
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
664
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18) The asset beta for the children's toy business is equal to 0.33. Happy-Go-Lucky Toys Inc. has a debt
beta of 0.20 and it maintains a debt-to-value ratio 0.58. It regards that ratio as optimal and intends to
maintain it in perpetuity. What is the equity beta for Happy-Go-Lucky Toys?
A) 0.14
B) 0.51
C) 1.51
D) 1.96
Answer: B
Explanation: B) βE =
βU -
βD
E/V = 1 - (D/V) = 1 - 0.58 = 0.42
V/E = 1/0.42 = 2.38095
D/E = V/E - 1 = 2.38095 - 1 = 1.38095
βE = 2.38095 * 0.33 - 1.38095 * 0.20 = 0.5095
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
19) You are a junior analyst at an investment bank. You and a colleague have been asked to produce an
estimate of a private company's value by forecasting its free cash flow and discounting those cash flows
using the weighted average cost of capital. You are working on the stockholders' required return. You
have collected the equity betas from some publicly traded pure-play companies in the same industry. The
next task is to unlever those betas to calculate an asset beta (unlevered equity beta). Your colleague
suggests using the following formula. What is your (best) response?
βU =
A) That is the correct formula.
B) That is the incorrect formula, because we cannot assume that the debt beta is zero.
C) That is the incorrect formula, because it assumes a constant amount of debt and we are assuming a
constant debt-to-value ratio.
D) That is the incorrect formula. The BU and the BE are reversed.
Answer: C
Explanation: C) The formula suggested by your colleague is the Hamada formula, named after Professor
Robert Hamada. It is derived from the Modigliani and Miller model that assumes corporate taxes and a
constant dollar value of debt. When valuing companies with the WACC, the analyst makes the implicit
assumption of a constant debt-to-value ratio. This assumption is reflected in the WACC weights. Since the
same WACC is used to discount every year's cash flows, the analyst is assuming that the company
maintains its debt-to-value ratio in perpetuity.
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
665
Copyright © 2015 Pearson Canada, Inc.
20) You are valuing Organic Market Inc., a grocery store chain. You want to estimate the unlevered return
on equity. You need an estimate of the asset beta for the organic food retailing industry. You have the
following data on Whole Foods Inc., a pure-play firm in the sector. What is the asset beta for Whole
Foods? Assume that its capital structure policy is to maintain a debt-to-value ratio of 41% in perpetuity.
Assume that the debt beta is zero.
A) BA = 0.29
B) BA = 0.41
C) BA = 0.59
D) BA = 1.18
Answer: B
Explanation: B) βU =
βE
βU = (7.7/13) × 0.70 = 0.4146
Diff: 2
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
666
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21) You are valuing Organic Market Inc., a young and growing grocery store chain. You want to estimate
the unlevered return on equity. You need an estimate of the asset beta for the food retailing industry. You
have data on two pure-play competitors (in the table). Estimate the asset beta as the average of the
unlevered betas for the pure-play competitors. Assume that all three companies maintain a capital
structure policy of a fixed debt-to-value ratio at their current levels. Assume that the debt betas are zero.
A) BU = 0.65
B) BU = 0.72
C) BU = 0.76
D) BU = 0.87
Answer: B
Explanation: B)
BE
Saferoad
1.3
Krooger
0.97
βU =
βE
βU =
β
βU = (7.8/11.8) × 1.31 =0.8659
βU = (23/34.5) × 0.87 = 0.58
(0.869 + 0.58)/2 = 0.723
Diff: 3
Section: 2 Leverage and Systematic Risk
AACSB: Analytical Thinking
667
Copyright © 2015 Pearson Canada, Inc.
LO3: Explain the Effects of Asymmetric Risk and Agency Conflicts on Leverage
1) When there is a debt overhang, companies will reject positive NPV projects.
Answer: TRUE
Explanation: True. If a firm is facing financial distress, and the market value of debt is below its face
value, then any increase in firm value is split between stockholders and lenders. For this reason it will not
be in the best interest of the owners to invest in positive NPV projects as they will not receive all of the
payoffs. This problem is exacerbated if the probability of default increases.
Diff: 1
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
2) To have a debt overhang problem, the face value of the debt must be greater than the company's free
cash flow in the worst state of nature.
Answer: TRUE
Explanation: True. If the free cash flow is greater than the face value of the debt in the worst state of
nature, then the company will always be able to pay its debts. In that case, the benefits (incremental cash
flows) from new projects are not shared and there is no debt overhang problem.
Diff: 1
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
3) Highly leveraged firms may not be able to obtain financing for positive NPV projects.
Answer: TRUE
Explanation:
True. The debt overhang problem shows that neither lenders nor stockholders will finance a positive
NPV project.
Diff: 1
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
4) What is the name given to the conflict between lenders and owners where neither claimholder will
finance a new positive NPV project?
A) Asset Substitution Problem
B) Risk Shifting Problem
C) Debt Overhang Problem
D) Short-sighted Investment Problem
Answer: C
Explanation: C) Under the debt overhang problem, neither lenders nor stockholders want to finance a
positive NPV project because the cash flows (payoffs) from the project are shared.
Diff: 1
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
668
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5) The Electric Company faces uncertain times. If the economy is strong it expects cash flows of $50,000 at
the end of the year and if the economy is weak only $30,000. (The states of nature are equally probable.)
The company owes $40,000 which is due at the end of the year. The assistant to the head scientist, Mr.
Aye Gore, has stumbled on a new product: wireless electricity. The project requires an investment of
$8,000 to bring the product to market, but the concept is so good that project cash flows of $10,000 (in one
year) are assured. Assume that required returns are zero. Which claimholder is willing to invest the
$8,000 to fund the project?
A) Stockholders
B) Existing Lenders
C) No one
Answer: C
Explanation: C) SHAREHOLDERS
With New Project
Cash flow to stockholders if strong = $50 + $10 - $40 = $20
Cash flow to stockholders if weak = $30 + $10 - $40 = $0
Expected Cash Flows = 0.5 * $20 + 0.5 * 0 = $10
Without New Project
Expected Cash Flows = 0.5 * $10 + 0.5 * 0 = $5
Incremental Expected Cash Flow = $5. Investment = $8. Stockholders will not invest.
LENDERS
With New Project
Cash flow to lenders if strong = $40
Cash flow to lenders if weak = $40
Expected Cash Flows = 0.5 * $40 + 0.5 * $40 = $40
Without New Project
Expected Cash Flows = 0.5 * $40 + 0.5 * $30 = $35
Incremental Expected Cash Flow = $5. Investment = $8. Lenders will not invest.
Diff: 3
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
669
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6) Your friend owns a derelict apartment house on Telegraph Hill in San Francisco overlooking the bay.
The property is worth $10 million but there is a $12 million mortgage on it. A property developer has
approached your friend with the idea of renovating the building. The renovation will raise the value of
the property by $4 million (to $14 million) and will cost only $3 million. Your friend doesn't have the $3
million. He is offering you the opportunity to be the sole shareholder if you assume the liabilities and
invest in the renovations. Will you invest in the project? What is the most that you would invest? i.e.,
What is your break-even investment? Assume that your required return is zero and the mortgage interest
rate is zero.
A) $0
B) $1 million
C) $2 million
D) $3 million
Answer: C
Explanation: C) Cash flow to stockholders after renovation = $14 - $12 - $3 = -$1
The most you should invest is $2 million. Then the NPV is zero.
Diff: 2
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
7) What is the name given to the conflict between lenders and owners where a company accepts a
negative NPV project?
A) Asset Substitution Problem
B) Debt Overhang Problem
C) Short-sighted Investment Problem
D) Reluctance to Liquidate Problem
Answer: A
Explanation: A) Under the asset substitution (risk shifting) problem, stockholders have an incentive to
accept high risk projects even if they have a negative NPV.
Diff: 1
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
8) The stockholders of a highly leveraged firm might prefer a high-risk, negative NPV project to a lowrisk, positive NPV project.
Answer: TRUE
Explanation: True. The asset substitution problem shows that stockholders will accept negative NPV
projects if they have high payoffs in some states of nature.
Diff: 1
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
670
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9)
A company has $10 million in cash and has debt with a face value of $10 million due in one year. The
company has two projects it can undertake: Project A and Project B. Both require an investment of $10
million and payoff in one year. The payoffs to each project depend on the economy as shown in the table.
The states of nature are equally probable. Assume that required returns are zero. Which project would
stockholders prefer and which project would lenders prefer?
A) Stockholder Project A. Lenders Project A.
B) Stockholder Project A. Lenders Project B.
C) Stockholder Project B. Lenders Project B.
D) Stockholder Project B. Lenders Project A.
Answer: B
Explanation: B) PROJECT A
Cash flow to stockholders if strong = $12 - $10 = $2
Cash flow to stockholders if weak = $0
Expected Cash Flows = 0.5 * $2 + 0.5 * 0 = $1
Cash flow to lenders if strong = $10
Cash flow to lenders if weak = $6
Expected Cash Flows = 0.5 * $10 + 0.5 * $6 = $8
PROJECT B
Cash flow to stockholders if strong = $10.1 - $10 = $0.1
Cash flow to stockholders if weak = $10.1 - $10 = $0.1
Expected Cash Flows = 0.5 * $0.1 + 0.5 * $0.1 = $0.1
Cash flow to lenders if strong = $10
Cash flow to lenders if weak = $10
Expected Cash Flows = 0.5 * $10 + 0.5 * $10 = $10
Diff: 3
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
671
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10)
Ponzi Inc. has $10 million cash and a debt with a face value of $11 million due in one year. The R&D
department has developed three projects: A, B and C. Each project requires an investment of $10 million
and pays off in one year. The payoffs and probabilities for each of the projects are shown in the table. The
shareholders are voting to select one of the projects tonight. Which one will be selected?
A) A
B) B
C) C
D) None. Keeping the $10 million of cash is preferable.
Answer: C
Explanation: C) PROJECT A
Cash flow to stockholders if strong = $11.5 - $11 = $0.5
Cash flow to stockholders if weak = $11.5 - $11 = $0.5
Expected Cash Flows = 0.5 * $0.5 + 0.5 * 0.5 = $0.5
PROJECT B
Cash flow to stockholders if strong = $12 - $11 = $1
Cash flow to stockholders if weak = $0
Expected Cash Flows = 0.5 * $1 + 0.5 * $0 = $0.5
PROJECT C
Cash flow to stockholders if strong = $18 - $11 = $7
Cash flow to stockholders if weak = $0
Expected Cash Flows = 0.1 * $7 + 0.9 * $0 = $0.7
Diff: 3
Section: 3
AACSB: Analytical Thinking
11) The stockholder-bondholder agency conflict that results in near bankrupt companies adopting
negative NPV projects is called the
A) Asset Substitution Problem.
B) Debt Overhang Problem.
C) Principal-Agent Problem.
D) The Long-Shot Problem.
Answer: A
Explanation: A) The asset substitution problem arises when a company exchanges its low-risk assets for
high-risk investments. This substitution transfers value from a firm's bondholders to its shareholders.
Diff: 2
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
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12) If stockholders of companies that are near bankruptcy adopt high risk, negative NPV projects, then
who gains and who loses?
A) Stockholders gain at lender's expense
B) Lenders gain at stockholders' expense
C) Everybody gains
D) Everybody loses
Answer: A
Explanation: A) The asset substitution problem arises when a company exchanges its low-risk assets for
high-risk investments. This substitution transfers value from a firm's bondholders to its shareholders.
Diff: 2
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
13) The stockholder-bondholder agency conflict that results in near bankrupt companies avoiding
positive NPV projects is called the
A) Asset Substitution Problem.
B) Debt Overhang Problem.
C) Principal-Agent Problem.
D) The Long-Shot Problem.
Answer: B
Explanation: B) The debt overhang problem occurs when the face value of the debt exceeds the market
value of the debt because a firm has insufficient cash or assets to pay the face value. The problem is that
claimholders do not have the individual incentive to finance positive NPV projects because the benefits
from the project are shared across claimholder groups.
Diff: 2
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
673
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14) Fritz Electrics is in trouble. Its only asset is an account receivable for $250,000 due at the end of the
week but there is only a 60% chance that the customer will pay. Fritz owes a local loan shark $200,000 and
that loan is also due at the end of the week. Fritz has invented a perpetual motion machine. If he builds a
prototype, then he can sell it at the end of the week for $100,000 to Edison Electrics. However, he needs
$50,000 for parts. Fritz has approached a syndicate of banks to arrange a loan for the $50,000, but their
position will be subordinate to the loan shark (for obvious reasons). Assume that all interest rates and
returns are zero. If the loan is arranged and the prototype sold, then what is the change in the value of the
owner's equity?
A) $0
B) $24,000
C) $30,000
D) $36,000
E) $60,000
Answer: C
Explanation: C) BEFORE
Dshark = E(cash flows to lender) = 0.6 × 200,000 + 0.4 × 0 = 120,000
E = E(cash flows to owner) = 0.6 × 50,000 + 0.4 × 0 = 30,000
AFTER
Dshark = 0.6 × 200,000 + 0.4 × 100,000 = 160,000
Dbanks = 0.6 × 50,000 + 0.4 × 0 = 30,000
E = 0.6 × 100,000 + 0.4 × 0 = 60,000
CHANGE = 60,000 - 30,000 = 30,000
Diff: 3
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
674
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15) Fritz Electrics is in trouble. Its only asset is an account receivable for $250,000 due at the end of the
week but there is only a 80% chance that the customer will pay. Fritz owes a local loan shark $200,000 and
that loan is also due at the end of the week. Fritz has invented a perpetual motion machine. If he builds a
prototype, then he can sell it at the end of the week for $100,000 to Edison Electrics. However, he needs
$60,000 for parts. Fritz has approached a syndicate of banks to arrange a loan for the $60,000, but their
position will be subordinate to the loan shark (for obvious reasons). Assume that all interest rates and
returns are zero. After doing their due-diligence, will the syndicate lend Fritz the money?
A) Yes, the NPV on their loan is positive.
B) Yes, the NPV on their loan is $0
C) No, the NPV on their loan is -$12,000
D) No, the NPV on their loan is -$24,000
Answer: C
Explanation: C) BEFORE
Dshark = E(cash flows to lender) = 0.8 × 200,000 + 0.2 × 0 = 160,000
E = E(cash flows to owner) = 0.8 × 50,000 + 0.2 × 0 = 40,000
AFTER
Dshark = 0.8 × 200,000 + 0.2 × 100,000 = 180,000
Dbanks = 0.8 × 60,000 + 0.2 × 0 = 48,000
NPV = $48,000 - $60,000 = -$12,000
Diff: 3
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
16) Fritz Electrics is in trouble. Fritz has $50,000 of cash in the bank, but Fritz owes a local loan shark
$200,000 and the loan is due at the end of the week. Fritz has proposed to the board of directors that he
take the cash to the local horse track and bet on a horse named Bessie to win. Bessie's odds of winning are
20% and a winner gets five times their bet. What is the NPV of the Bessie project?
A) $0
B) $10,000
C) $20,000
D) $30,000
E) $50,000
Answer: A
Explanation: A) BEFORE
E(cash flows) = 0.2 × (5 × 50,000) + 0.8 × 0 = 50,000
NPV = E(cash flows) - Investment = $50,000 - $50,000 = $0
Diff: 3
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
675
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17) Fritz Electrics is in trouble. Fritz has $50,000 of cash in the bank, but Fritz owes a local loan shark
$200,000 and the loan is due at the end of the week. Fritz has proposed to the board of directors that he
take the cash to the local horse track and bet on a horse named Bessie to win. Bessie's odds of winning are
20% and a winner gets five times their bet. If the Bessie project is approved, then what is the change in the
value of the owner's equity?
A) $0
B) $2,000
C) $5,000
D) $10,000
E) $20,000
Answer: D
Explanation: D) BEFORE:
Dshark = 50,000
E=0
AFTER:
Dshark = E(cash flows to lender) = 0.2 × 200,000 + 0.8 × 0 = 40,000
E = 0.2 × 50,000 + 0.8 × 0 = 10,000
Change in Equity = 10,000 - 0 = 10,000
Diff: 3
Section: 3 Other Effects of Leverage
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 19 Futures & Options
LO1: Understand the Basics of Forward Contracts
1) The ________ of a forward contract is obligated to ________ delivery and pay for the contracted goods
at the forward price; the ________ of a forward contract is obligated to ________ delivery and accept
payment for the goods at the forward price.
A) buyer; make; seller; take
B) buyer; take; seller; make
C) seller; take; buyer; make
D) seller; make; buyer; take
Answer: B
Explanation: B) A forward is a contract between two parties: the buyer and the seller. The buyer agrees to
take delivery of the asset on the maturity date and the seller agrees to deliver the asset on that date. The
price (the forward price) is agreed to when the contract is initiated.
Diff: 1
Section: 1 Forward Contracts
AACSB: Analytical Thinking
2) Which of the following describe a contract that is a legally binding agreement between two parties, that
is privately negotiated, and calls for the purchase and sale of an asset in the future at a price agreed-upon
today?
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A) Futures
B) Option
C) Swap
D) Forward
Answer: D
Explanation: D) This type of contract is called a Forward contract. A futures contract is very similar, but
here are two important differences: futures contracts are traded on an exchange and the terms of the
contract are not privately negotiated. The terms of a futures contract are set by the exchange, and only the
price is negotiated by the counterparties.
Diff: 1
Section: 1 Forward Contracts
AACSB: Analytical Thinking
677
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LO2: Understand Futures Contracts, How Futures Are Traded, and the Payoffs to
Futures Contracts
1) The dollar value of one NY Snowfall Index futures contract is the product of the CME snowfall index
(for New York) and the futures contract multiple of $200.
The New York CME snowfall index is measured monthly and is equal to ten times the cumulative
snowfall for the calendar month. If twenty feet of snow fall in March, then the CME NY snowfall index is
200 = (10 * 20) and the contract value is 200 * $200 = $40,000. The contract is cash settled, so at the
settlement date, cash is exchanged between losing and winning counterparties to settle the contract.
You are planning a ski trip to Mount Killington (north of New York in southern New Hampshire). You
are worried that there may be no snow. To hedge the risk of a bad ski trip, what position should you take
in the NY Snowfall Index futures contract?
A) Short
B) Long
Answer: A
Explanation: A) If there is very little snow, then your trip will be ruined and the CME snowfall index will
be lower than expected. As a result, the CME Snowfall Index Futures price will fall. To hedge the risk,
you should sell at the high futures price before the trip and execute an offset trade at the lower futures
price after the trip. The profit from the short position will offset your grief from the bad ski trip.
Diff: 2
Section: 2 Futures Contracts
AACSB: Analytical Thinking
678
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2) The CME Tornado Index Futures contract is cash settled. The dollar value of one CME Tornado Index
Futures contract is the product of the CTI index and the futures contract multiple of $1,000.
The CTI Tornado force measure takes two input variables: the average wind speed of a Tornado (in miles
per hour) and the radius of the base of the Tornado force winds (in miles).
For the Tornado Index Futures contract, the CTI index is the sum of the CTI values for all Tornados which
make landfall between Texas and Nebraska. If twenty tornados hit with an average CTI value of 4, then
the CTI index is 20 * 4=80 and the CME Tornado Index Futures contract value is 80 * $1,000 = $80,000.
The contract is cash settled, so at the settlement date, cash is exchanged between losing and winning
counterparties to settle the contract.
You are planning to travel to the New Orleans in the coming months. However, the trip is right in the
middle of tornado season. You are worried that a tornado will ruin your vacation. To hedge the risk,
what position should you take in the CME Tornado Index futures contract?
A) Short
B) Long
Answer: B
Explanation: B) Your vacation is likely to be ruined if there is an active tornado season. If there are a
large number of tornados, then the CTI index will be higher than expected and the futures price will rise.
You should buy the contract before the trip and execute an offset trade at the higher futures price after
the trip. The profit from the long position will offset your grief from the bad vacation.
Diff: 2
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AACSB: Analytical Thinking
3) The short position in a futures contract has the obligation to sell the underlying asset, but the long
position has a choice.
Answer: FALSE
Explanation: This is false. In a futures contract, the buyer has an obligation to buy the asset at the agreed
upon price on the maturity date and the seller has an obligation to deliver the asset on that date.
Diff: 1
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AACSB: Analytical Thinking
4) Most futures contracts are completed when the buyer takes delivery of the goods from the seller.
Answer: FALSE
Explanation: This is false. Making (or taking) delivery of the goods may be the most obvious way to
complete a futures trade, but it is not the most common. The clearinghouse allows for a second way:
through an offset (reversing) trade. In fact, less than 1% of all contracts are completed with actual
physical delivery of the goods.
Diff: 1
Section: 2 Futures Contracts
AACSB: Analytical Thinking
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5) Price risk refers to the risk of a price fluctuating in an unwanted direction: sellers don't like price
declines and buyers don't like price increases.
Answer: TRUE
Explanation: This is true by definition. Price risk refers to the risk of the price (or value) of an asset,
commodity, security, or portfolio will move adversely in the future.
Diff: 1
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AACSB: Analytical Thinking
6) Forward contracts offer traders more flexibility than futures contracts, but they are less liquid.
Answer: TRUE
Explanation: True. The terms (quantity, type of asset, maturity date, and price) of forward contracts are
privately negotiated between the buyer and seller. The terms of futures contracts are standardized and set
by the exchange, they cannot be changed by the counterparties. The only term negotiated is the price.
This makes forward contracts much more flexible and customizable, but also less liquid as there a much
larger market for standardized contracts.
Diff: 1
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AACSB: Analytical Thinking
7) Open Interest is the same as volume.
Answer: FALSE
Explanation: This is false. Open interest refers to the contracts that are still outstanding at the end of the
day, i.e. they haven't been offset. Volume represents the total amount of trading activity, i.e. the number
of contracts that changed hands in a given day.
Diff: 1
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AACSB: Analytical Thinking
8) The futures price is the price for delivery on the settlement date; the spot price is the price for delivery
immediately.
Answer: TRUE
Explanation: This is true. The futures price is the price which the buyer agrees to pay when she takes
delivery of the underlying asset on the settlement date (and the seller agrees to accept). The spot price is
the current delivery price at which an asset can be bought or sold right now.
Diff: 1
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AACSB: Analytical Thinking
9) Futures traders do not need to worry about their trading counterparty defaulting on their obligations
because of the Clearinghouse.
Answer: TRUE
Explanation: This is true. After a trade is initiated, both counterparties deal only with the clearinghouse.
It serves a guarantor, ensuring that all traders meet their obligations and that no trader is hurt by a
counterparty defaulting. It does so by requiring a performance bond be posted by each trader with their
broker. The clearinghouse calculates profits and losses daily, crediting the accounts of those traders that
profit and debiting the accounts of those who lost.
Diff: 1
Section: 2 Futures Contracts
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10) Billy Ray Valentine forecasted a hot summer and great wheat harvests, which he believed would
cause wheat prices to fall. To profit from his expectations he sold 1 July wheat futures contract for 5,000
bushels at $1.50 per bushel. On March 1, the spot price fell to $1 and the futures price fell to $1.05. Billy
decided to execute an offset trade. What was Billy's cumulative profit?
A) -$5,250
B) $2,000
C) $2,250
D) $7,500
Answer: C
Explanation: C) Cumulative Profit = Short Sale Proceeds - Purchase Cost
Cumulative Profit = (1 × 5,000 × $1.50) - (1 × 5,000 × $1.05)
Cumulative Profit = $7,500 - $5,250
Cumulative Profit = $2,250
Diff: 2
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AACSB: Analytical Thinking
11) In order to sell a futures contract short you must already own the underlying commodity.
Answer: FALSE
Explanation: This is false. The only requirement for buying or selling a futures contract is that you post a
performance bond, or initial margin, with your broker. This is typically between 5% and 10% of the value
of the futures position. If you have a short position, then you are obligated to deliver the underlying
commodity on the settlement date, but you do not need to own it until then.
Diff: 1
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AACSB: Analytical Thinking
12) A speculator who thinks that the S&P 500 index will rise should
A) Buy S&P 500 futures contracts.
B) Sell S&P 500 futures contracts.
Answer: A
Explanation: A) Buy S&P 500 futures contracts. If the speculator is correct and the S&P 500 index does
rise, a long position in S&P 500 futures contracts will allow him or her to profit from the increase. The
profit will be the difference between the settlement price at maturity (or the offset price) and the purchase
price (the futures price when the long position is initiated) multiplied by the contract multiple and the
number of contracts the speculator chooses to buy.
Diff: 1
Section: 2 Futures Contracts
AACSB: Analytical Thinking
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13)
Consider the information on the Chicago Board of Trade Gold Futures contract in the table above.
Today is June 1st and you want to use CBOT gold futures contracts to speculate on the price of gold,
which you think is going to rise. The current spot price for gold is $1,248.70. The futures price for July
delivery is $1,250. You buy 1 contract for July delivery. What is your cumulative profit on the transaction
if the futures price for gold is $1,258.20 in July?
A) $800
B) $820
C) $950
D) $1,100
Answer: B
Explanation: B) Cumulative Profit = Sale Proceeds - Purchase Cost
Cumulative Profit = (1 × 100 × $1,258.20) - (1 × 100 × $1,250)
Cumulative Profit = $125,820 - $125,000
Cumulative Profit = $820
Diff: 2
Section: 2 Futures Contracts
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14)
Consider the information on the Chicago Board of Trade Gold Futures contract in the table and answer
the following question.
Today is June 1st and you want to use CBOT gold futures contracts to speculate on the price of gold,
which you think is going to fall. The current spot price for gold is 650. The futures price for October
delivery is 658.9. You sell 1 contract for October delivery. What is your cumulative profit on the
transaction if the futures price for gold is 641 in October?
A) $900
B) $1,200
C) $1,790
D) $1,850
Answer: C
Explanation: C) Cumulative Profit = Short Sale Proceeds - Purchase Cost
Cumulative Profit = (1 × 100 × 658.9) - (1 × 100 × 641)
Cumulative Profit = $65,890 - $64,100
Cumulative Profit = $1,790
Diff: 2
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AACSB: Analytical Thinking
15) A speculator, not a hedger, would purchase a futures contract even though they had no interest or
ownership in the underlying asset.
Answer: TRUE
Explanation: This is true. A speculator hopes that the underlying asset's value increases (or decreases) so
they can make a profit. The speculator does not necessarily own the asset; they just believe that they can
predict the direction its price will move. A hedger is only interested in protecting themselves from the
price risk they face from try to buy or sell an asset or commodity.
Diff: 2
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16) Organized trading is much more common in forward contracts than futures contracts.
Answer: FALSE
Explanation: This is false. Although forward contracts were developed first, today there is much more
interest in the trading of futures contracts. Unlike forward contracts, where the counterparties negotiate
all of the terms, futures are highly standardized and terms are determined by the exchange. Futures are
identical in terms of quantity, quality, delivery month, etc. This standardization makes futures much
more liquid, and led to an active secondary market for futures contracts.
Diff: 1
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AACSB: Analytical Thinking
17) The difference between hedgers and speculators is that hedgers usually sell futures contracts and
speculators usually buy futures.
Answer: FALSE
Explanation: This is false. Hedgers and speculators can each take long or short positions in futures
contracts. Consider the bakery that would buy futures to hedge against the price of wheat rising.
Conversely, a farmer could sell futures to hedge against the price of their crop falling. A speculator may
think the price of a commodity will rise, and therefore buy futures contracts, or that it might fall, and sell
futures.
The main difference between hedging and speculating is how risk is approached. Hedgers try to reduce
or mitigate risk, whereas Speculators adopt risk in exchange for the opportunity for profit.
Diff: 1
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18) If you are long 1 futures contract, then you have the obligation to buy the underlying asset on the
maturity date.
Answer: TRUE
Explanation: This statement is true by definition. The buyer of a futures contract agrees to buy the asset
on the maturity date for the agreed upon futures price. The seller agrees to deliver the asset on that date.
Diff: 1
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AACSB: Analytical Thinking
19) If you are a buyer of a commodity, then
A) you can hedge adverse price movements by taking a long position in the futures contract for that
commodity.
B) you can hedge adverse price movements by taking a short position in the futures contract for that
commodity.
C) you cannot hedge adverse price movements using futures contracts. Buyers of commodities are subject
to price risk.
Answer: A
Explanation: A) When you take a long position in a futures contract, you have the obligation to buy the
commodity at a specified price. This guarantees that you can buy the goods at that price, regardless of
adverse price movements. You have "locked-in" the price agreed upon in the futures contract.
Diff: 1
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Section: 2 Futures Contracts
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20) In a futures contract the futures price is
A) determined by the futures exchange.
B) determined by the seller of the contract.
C) determined by the buyer and seller when the delivery of the commodity takes place.
D) determined by the buyer and seller when they initiate the contract.
Answer: D
Explanation: D) The futures price is determined by the counterparties when they initiate the contract. In
fact, the futures price is the only term of the contract determined by the counterparties. The other terms of
the contract (quantity, type of asset and maturity date) are determined by the futures exchange.
Diff: 1
Section: 2 Futures Contracts
AACSB: Analytical Thinking
21)
MONTH
Feb
Mar
May
July
Aug
LAST
88.400
87.650
89.400
91.500
92.000
OPEN
88.475
------92
----
HIGH
89.2
88.400
89.825
92
93.000
LOW
87.95
87.650
89.400
91.500
----
SETTLE
88.275
87.65
89.4
91.5
92
Frozen Pork Bellies futures contracts trade on the CME. Each contract calls for the delivery of 40,000 lbs.
of USDA-inspected Pork Bellies. A summary of today's trading is provided in the table, above. The price
of the contract is quoted in dollars per hundred pounds (100lbs). A month ago you thought an increased
demand for bacon would cause the price of frozen pork bellies to rise. To profit from this expectation you
purchased one February contract at a price of $85. If you execute an offset trade today at the settlement
price, then what is your cumulative profit?
A) $1,310
B) $1,360
C) $1,390
D) $1,400
Answer: A
Explanation: A) Cumulative Profit = Sale Proceeds - Purchase Cost
Cumulative Profit = (1 × 40,000 × $88.275) - (1 × 40,000 × $85)
Cumulative Profit = $35,310 - $34,000
Cumulative Profit = $1,310
Diff: 2
Section: 2 Futures Contracts
AACSB: Analytical Thinking
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22) A trader who has a ________ position in gold futures wants the price of gold to ________ in the future.
A) long; decrease
B) long; increase
C) short; increase
D) short; stay the same
Answer: B
Explanation: B) By taking a long position, the trader commits to buy gold at a specified price. If the
futures price rises the trader can execute an offset trade and sell futures contracts. The trader has
committed to sell gold at a higher price than he or she is buying it for, and will profit the difference.
Diff: 1
Section: 2 Futures Contracts
AACSB: Analytical Thinking
23) It is May 1st and you think that a dry growing season will cause poor corn harvests, and thus the
price of corn will rise. To profit from your expectation you purchase one CME corn futures contract for
July delivery. To close your position in corn futures before the maturity date you must
A) buy one July corn futures contract.
B) sell one July corn futures contract.
C) deliver corn to your counterparty.
D) It is not possible to close a futures position before the maturity date.
Answer: B
Explanation: B) To close your position before the maturity date you must execute an offset (reversing)
trade. You are long one July corn futures contract so you must do the opposite: sell one July corn futures
contract. Therefore B is the correct answer.
The other way to complete a futures trade is to make or take delivery of the underlying asset, but that can
only be done on the maturity date.
Diff: 1
Section: 2 Futures Contracts
AACSB: Analytical Thinking
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24) Ray Kinsella sold 20 wheat futures contracts in May. The contracts are for November delivery at a
price of $5.3525/bu. Ray sold the contracts to protect against a drop in wheat prices. It is now November
and wheat prices have fallen considerably to $3.00/bu. To complete the hedge transaction, Ray can
I. Deliver 100,000bu of wheat to Chicago.
II. Buy 20 November wheat contracts.
III. Do nothing and let the futures contract expire.
A) I
B) II
C) III
D) I or II
Answer: D
Explanation: D) The most obvious way to complete a futures trade is to make or take delivery of the
underlying asset on the maturity date. Ray has a short position in the wheat futures contracts, so he can
sell his wheat for the futures price of $5.3525/bu.
A second option is for Ray to execute an offset (or reversing) trade by taking a new long position in 20
November wheat contracts. Ray would simultaneously sell his wheat to his local grain elevator at the
$3.00/bu spot price.
Therefore, both I and II are correct.
Diff: 1
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25) CME Corn Futures - Quotes
Month
Last
Change
July
658'0 a
+4'6
Sept.
577'6
-1'2
Dec
545'0
-1'4
Prior Settle Open
653'2
654'0
579'0
579'0
546'4
546'4
High
660'6
583'6
551'0
Low
652'0
572'6
541'4
Volume
45,021
56,200
75,414
The table above shows information on CME Corn Futures contracts. Prices are shown in cents per bushel,
with a minimum tick size of 1/4 cent per bushel. There are 5,000 bushels per contract. You have a short
position in one September Corn futures contract. As shown in the Prior Settle column, the futures price at
the close of trading yesterday was $5.79. The balance in your margin account was $2,895. If at the end of
today the settlement price for corn futures is $5.7475, then what is your daily profit?
A) $62.50
B) $212.50
C) $2,682.50
D) $3,107.50
Answer: B
Explanation: B) The daily profit is:
Daily Profitt = 5,000 × (Pt - Pt-1)
Daily Profit = 5,000 × ($5.79 - $5.7475)
Daily Profit = $212.50
Diff: 2
Section: 2 Futures Contracts
AACSB: Analytical Thinking
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26) CME Silver Futures - Quotes
Month
Last
Change Prior Settle
Sept.
19.275
+0.722
18.553
Dec
19.390
+0.792
18.598
Mar
19.415
+0.766
18.649
Open
18.480
18.565
18.600
High
19.440
19.480
19.415
Low
18.170
18.215
18.600
Volume
59,465
2,795
729
The table above shows information on CME silver futures contracts. Prices are shown in cents per troy
ounce, with each contract calling for the delivery of 5,000 troy ounces. You have a long position in five
December silver futures contracts. As shown in the Prior Settle column, the futures price at the close of
trading yesterday was $18.598. The balance in your margin account was $1,115. Today the settlement
price for silver futures is $19.490. What is your daily profit?
A) $4,460
B) $19,800
C) $22,300
D) $23,415
Answer: C
Explanation: C) The daily profit is:
Daily Profitt = 5,000 × (Pt - Pt-1) × 5
Daily Profit = 5,000 × ($19.490 - $18.598) × 5
Daily Profit = $22,300
Diff: 2
Section: 2 Futures Contracts
AACSB: Analytical Thinking
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27) You have a long position in one corn futures contract. Each futures contract calls for the delivery of
5,000 bushels of No. 2 corn. The initial margin was $2,500 and the maintenance margin is $1,250. At the
close of trading yesterday, the futures price was $5.23 per bushel and the balance in your margin account
was $3,250. Today, the settlement price for corn futures is $4.78. What is the balance in your account at
the end of today's trading? Assume that you made the minimum deposit necessary if there was a margin
call.
A) $1,000
B) $1,250
C) $1,500
D) $2,500
Answer: D
Explanation: D) Margin Account Balance, B, on day t is:
Bt = Bt-1 + Daily Profitt + Depositt
The Deposit on any day t depends on whether the daily profit, on its own, pushed the account balance
below the maintenance margin (MM) level. If the balance falls through MM, then the deposit is the
amount necessary to bring the account back to the initial margin (IM) level.
First calculate the temporary balance (TB) without any deposit:
TBt = Balancet-1 + Daily Profitt
If the temporary balance is above the maintenance margin level, then there is no deposit. If the temporary
balance is (equal to or) below the maintenance margin level, then the deposit is:
Depositt = IM - TBt
The following IF statement determines the size of the deposit:
IF TBt <= MM THEN Depositt = IM - TBt ELSE Depositt = 0.
In this case the daily profit is:
Daily Profit = 5,000 × (P1 - P0)
Daily Profit = 5,000 × ($4.78 - $5.23)
Daily Profit = -$2,250
The temporary balance, TB, is:
TB = $3,250 + (-$2,250)
TB = $1,000
This is below the maintenance margin level of $1,250, so the deposit is:
Depositt = IM - TBt
Deposit = $2,500 - $1,000
Deposit = $1,500
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The account balance at the end of the day is:
Bt = Bt-1 + Daily Profitt + Depositt
Bt = $3,250 + (-$2,250) + $1,500
Bt = $2,500
Diff: 3
Section: 2 Futures Contracts
AACSB: Analytical Thinking
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28) You have a short position in one corn futures contract. Each futures contract calls for the delivery of
5,000 bushels of No. 2 yellow corn. The initial margin was $2,500 and the maintenance margin is $1,250.
At the close of trading yesterday, the futures price was $5.23 per bushel and the balance in your margin
account was $1,750. Today, the settlement price for corn futures is $5.43. What is the balance in your
account at the end of today's trading? Assume that you made the minimum deposit necessary if there
was a margin call.
A) $1,500
B) $1,750
C) $2,500
D) $3,250
Answer: C
Explanation: C) Margin Account Balance, B, on day t is:
Bt = Bt-1 + Daily Profitt + Depositt
The Deposit on any day t depends on whether the daily profit, on its own, pushed the account balance
below the maintenance margin (MM) level. If the balance falls through MM, then the deposit is the
amount necessary to bring the account back to the initial margin (IM) level.
First calculate the temporary balance (TB) without any deposit:
TBt = Balancet-1 + Daily Profitt
If the temporary balance is above the maintenance margin level, then there is no deposit. If the temporary
balance is (equal to or) below the maintenance margin level, then the deposit is:
Depositt = IM - TBt
The following IF statement determines the size of the deposit:
IF TBt <= MM THEN Depositt = IM - TBt ELSE Depositt = 0.
In this case the daily profit is:
Daily Profit = 5,000 × (P0 - P1)
This is a short position, so you sold yesterday and are buying at today's close.
Daily Profit = 5,000 × ($5.23 - $5.43)
Daily Profit = -$750
The temporary balance, TB, is:
TBt = Balancet-1 + Daily Profitt
TB = $1,750 + (-$750)
TB = $1,000
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This is below the maintenance margin level of $1,250, so the deposit is:
Depositt = IM - TBt
Deposit = $2,500 - $1,000
Deposit = $1,500
The account balance at the end of the day is:
Bt = Bt-1 + Daily Profitt + Depositt
Bt = $1,750 + (-$750) + $1,500
Bt = $2,500
Diff: 3
Section: 2 Futures Contracts
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29)
The basis of a futures contract is defined as the difference between the spot price and the futures price for
the same asset:
Basist = Spot Pricet - Futures Pricet
The CME NASDAQ-100 Futures contract is cash settled with a contract value equal to $100 times the
NASDAQ-100 Index price. Consider the futures prices in the table above. What is the basis of the
September futures contract on its maturity date?
A) -1.38
B) 0.00
C) 1.38
D) 2.42
Answer: B
Explanation: B) According to the convergence principle, the futures price is equal to the spot price at the
settlement date, so the basis is zero.
Diff: 1
Section: 2 Futures Contracts
AACSB: Analytical Thinking
30) The basis for a given asset (i.e. wheat) is identical in all locations and markets.
Answer: FALSE
Explanation: This is false. Basis is defined as the spot price minus the futures price for the same asset. We
know the spot price for a given asset will vary by location due to different levels of supply and demand.
The price of No. 2 soft red wheat is likely not the same in Texas as it is in Chicago. Because the spot price
varies by location, so does the basis.
Diff: 1
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AACSB: Analytical Thinking
31) As the maturity date approaches, the futures price should get closer and closer to the spot price.
Answer: TRUE
Explanation: This is true. This property of futures contracts is called convergence. The reason for this is
straight forward. If a trader buys a futures contract on the maturity date, they will effectively take
delivery of the asset immediately. This transaction is equivalent to a spot contract. By the law of one
price, the futures price must equal the spot price on the maturity date.
Diff: 2
Section: 2 Futures Contracts
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32) Which of the following is true of a short position in a futures contract?
A) A short position benefits when the price of the underlying asset falls.
B) To short sell a futures you must already have bought one or you can borrow one from your broker.
C) With a futures contract you have the choice but not the obligation to sell the underlying asset.
D) To sell a futures you must already have bought one or you can borrow one from your broker, AND, a
short position benefits when the price of the underlying asset falls
Answer: A
Explanation: A) When a trader enters a short futures position, she agrees to sell the underlying asset on
the contract expiration date for a fixed price, which is the futures price. If the spot price of the underlying
asset falls after the short position is opened, then the trader benefits. The intuition for the benefit is that
she will be able to sell the asset at expiration for more than it is worth. The mechanics of the benefit are as
follows: As the spot price falls, the futures price will fall in tandem, and the implicit profit will be added
to the trader's margin account as the account is marked-to-market.
Diff: 1
Section: 2 Futures Contracts
AACSB: Analytical Thinking
LO3: Describe How Futures Are Used to Hedge Price Risk
1) Farmer Jones sold wheat futures contracts at a price of $3 per bushel. She will profit from her futures
position if
A) the futures price goes up.
B) the futures price goes down.
Answer: B
Explanation: B) The futures price goes down. By taking a short position, Farmer Jones commits to sell
wheat at a price of $3 per bushel. If the futures price drops below $3 she can offset by buying futures
contracts at the lower price. Farmer Jones will profit the difference.
Diff: 1
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
2) Wonka Industries uses large amounts of cocoa in the production of its famous chocolate bars. Wonka
uses CME cocoa futures contracts to hedge against the risk of cocoa prices rising. The CME futures
contract calls for the delivery of 10 metric tons of cocoa. To hedge the price risk, Wonka should
A) sell cocoa futures contracts.
B) buy cocoa futures contracts.
Answer: B
Explanation: B) A hedge is a transaction designed to offset exposure to price risk. Wonka needs to
purchase cocoa in the future. To lock-in the purchase price, it should take a long position in the futures
market.
Diff: 1
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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3) Schwabl's restaurant uses wheat to bake its kummelweck buns. It requires 50,000 bushels in 2 months
on July 10th. The spot price of wheat is $1.0525 per bushel and the July futures contract is trading for a
price of $1.068/bu. Each contract is for 5,000 bushels. Assume Schwabls enters the appropriate position in
July wheat futures contracts to hedge its price risk. On July 10th it buys its wheat in the spot market at
$1.071/bu and closes out the futures position. Unfortunately, the wheat futures price had not achieved
convergence on the day the position was closed—the futures price was $1.07 when Schwabls closed its
position. What was the cost per bushel of wheat? The purchase cost includes the cumulative profit from
the futures transactions.
A) $1.0525/bu
B) $1.0690/bu
C) $1.0700/bu
D) $1.0710/bu
Answer: B
Explanation: B) Cumulative Profit = (Pt - Pt-1) × 5,000 × n
Where
Pt = the futures price for the offset trade
Pt-1 = the futures price when the long position initiated
n = the number of contracts
n = 50,000/5,000 = 10 contracts
Cumulative Profit = (1.07 - 1.068) × 5,000 × 10
Cumulative Profit = $100
The total cost of the wheat is the total spot market purchase minus the futures profit.
Total Cost = ($1.071 × 50,000) - ($100)
Total Cost = $53,450
Cost per bushel = $53,450/50,000bu = $1.069/bu
Diff: 3
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
4) What is the name for the process of reducing a firm's exposure to adverse price fluctuations?
A) Speculation
B) Diversification
C) Hedging
D) Risk Management
Answer: C
Explanation: C) This process is called hedging. Hedging involves taking an offsetting position in a
related security, like a futures contract. Producers that expect to sell a commodity in the future can lock-in
the sale price by taking a short position in the futures market. Firms that need to buy a commodity in the
future can lock-in the purchase price taking a long position in the futures market.
Diff: 1
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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5) Krusty Burger requires pork for producing its famous Meat-Flavored Sandwich. Frozen Pork Bellies
futures contracts trade on the CME. Each contract calls for the delivery of 40,000 lbs. of USDA-inspected
Pork Bellies. Krusty requires 40,000lbs on July 10. Today the spot price of pork bellies is $1.177 per pound
and the July futures contract is trading for a price of $1.2055/lbs. Assume Krusty enters the appropriate
position in July futures contracts to hedge its price risk. On July 10th it buys its pork from local pig
farmers at $1.1655/lbs. and closes out the futures position. Unfortunately, the pork bellies futures price
had not achieved convergence on the day the position is closed–the futures price is $1.1700 when Krusty
Burger closes its position. What is the cost per pound of pork? The purchase cost includes the cumulative
profit from the futures transactions.
A) $1.1255
B) $1.1655
C) $1.1770
D) $1.2010
Answer: D
Explanation: D) Cumulative Profit = (Pt - Pt-1) × 5,000 × n
Where
Pt = the futures price for the offset trade
Pt-1 = the futures price when the long position initiated
n = the number of contracts
n = 40,000/40,000 = 1 contract
Cumulative Profit = (1.17 - 1.2055) × 40,000 × 1
Cumulative Profit = -$1,420
The total cost of the pork is the total spot market purchase minus the futures profit.
Total Cost = ($1.1655 × 40,000) - (-$1,420)
Total Cost = $46,650 - (-$1,420)
Total Cost = $48,040
Cost per pound = $48,040/40,000bu = $1.201
Diff: 3
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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6) CME Corn Futures - Quotes
Month
Last
Change Prior Settle
Dec
639'0
+0'4
638'4
Mar
648'0
+0'2
647'6
May
655'0
+0'4
654'4
July
657'0 a
+0'6
656'2
Sep
601'4 a
-1'6
603'2
Open
638'0
647'4
654'4
656'2
603'0
High
644'6
654'0
661'0
663'4
607'2
Low
636'0
645'2
652'4
655'0
601'0 a
Volume
17,091
11,192
2,535
1,926
200
The table above shows information on CME corn futures contracts. Prices are in cents per bushel with a
minimum tick size of 1/4 cent per bushel. Thus, a price of quote of 601'4 is equivalent to $6.015 per bushel.
There are 5,000 bushels per contract. Mr. Greenjeans grows corn on 2,000 acres near Sioux City, Iowa. He
expects to harvest 165 bushels per acre or 330,000 bushels in total. Mr. Greenjeans hopes to sell his corn
for $6.015 per bushel when he harvests it in September, and he wants to use September corn futures
contracts to limit his price exposure.
In what direction should he trade the futures contract, and is he hedging or speculating?
A) Long, Hedge
B) Short, Hedge
C) Long, Speculating
D) Short, Speculating
Answer: B
Explanation: B) Mr. Greenjeans expects to sell corn in the fall. To lock-in the sale price he should take a
short position in the futures market. A hedge is a transaction designed to offset exposure to price risk.
That is exactly what Mr. Greenjeans is doing here, protecting himself from the risk of the price of corn
falling before he can harvest his crop.
Therefore B is the correct answer.
Diff: 1
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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7) CME Corn Futures - Quotes
Month
Last
Change Prior Settle
Dec
639'0
+0'4
638'4
Mar
648'0
+0'2
647'6
May
655'0
+0'4
654'4
July
657'0 a
+0'6
656'2
Sep
601'4 a
-1'6
603'2
Open
638'0
647'4
654'4
656'2
603'0
High
644'6
654'0
661'0
663'4
607'2
Low
636'0
645'2
652'4
655'0
601'0 a
Volume
17,091
11,192
2,535
1,926
200
The table above shows information on CME corn futures contracts. Prices are in cents per bushel with a
minimum tick size of 1/4 cent per bushel. Thus, a price of quote of 601'4 is equivalent to $6.015 per bushel.
There are 5,000 bushels per contract. Mr. Greenjeans grows corn on 2,000 acres near Sioux City Iowa. Mr.
Greenjeans expects to harvest 165 bushels per acre or 330,000 bushels in total. Mr. Greenjeans hopes to
sell his corn for $6.015 per bushel when he harvests it in September, so he uses CME September corn
futures contracts to lock in this price (at the price indicated in the table).
Assume that the summer passes and September arrives. The spot price of corn falls to $5.50/bu. Mr.
Greenjeans sells his harvest locally at the spot price. Simultaneously he executes an offset trade in the
futures market. Assume that, due to convergence, the futures price is equal to the spot price. What are his
total proceeds from selling his corn? The total proceeds include the profit (loss) from the futures
transactions.
A) $169,950
B) $1,815,000
C) $1,984,950
D) $2,154,900
Answer: C
Explanation: C) Cumulative Profit:
Cumulative Profit = (Pt-1 - Pt) × 5,000 × n
Where
Pt = the futures price for the offset trade
Pt-1 = the futures price when the long position initiated
n = the number of contracts
n = 330,000/5,000 = 66 contracts
Cumulative Profit = (6.015 - 5.50) × 5,000 × 66
Cumulative Profit = $169,950
The total proceeds from selling the corn is the sum of the total spot market revenues plus the futures
profit.
Total Proceeds = $5.50 × 330,000 + $169,950
Total Proceeds = $1,984,950
Diff: 3
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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8)
Today is January 1st. You are a soybean farmer. You want to hedge the price of your current crop. If your
soybeans will be ready for market in September, and you expect to have 75,000 bushels of soybeans, what
is the appropriate futures trade to enter into?
A) Go short one September contract
B) Go long one September contract
C) Go short fifteen September contracts
D) Go long fifteen September contracts
Answer: C
Explanation: C) A hedge is a transaction designed to offset exposure to price risk. You expect to sell
soybeans in the fall. To lock-in the sale price you should take a short position in the futures market.
The number of contracts, n, is equal to the total number of bushels divided by the number of bushels per
contract: n = 75,000/5,000 = 15 contracts.
Therefore you should go short fifteen September contracts.
Diff: 1
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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9) Today is January 1st. You are a soybean farmer that wants to hedge the price of your current crop.
Soybean futures contracts trade on the CME, and call for the delivery of 5,000 bushels of soybeans. Your
soybeans will be ready for market in September, and you expect to harvest 75,000 bushels. Assume you
enter the appropriate futures position to hedge your price risk at a futures price of $7.70/bu. In the fall
you sell your soybeans locally at the current spot price of $7.4275, and also execute an offset trade. Due to
convergence, the futures price is equal to the prevailing spot price. What are your total proceeds from
selling your soybeans? Total proceeds include the profits (loss) from the futures transactions.
A) $536,625
B) $558,425
C) $577,500
D) $595,375
Answer: C
Explanation: C) Cumulative Profit = (Pt-1 - Pt) × 5,000 × n
Where
Pt = the futures price for the offset trade
Pt-1 = the futures price when the short position initiated
n = the number of contracts
n = 75,000/5,000 = 15 contracts
Cumulative Profit = (7.70 - 7.4275) × 5000 × 15
Cumulative Profit = $20,437.50
The total proceeds from selling the soybean crop is the sum of the total spot market revenues plus the
futures profit.
Total Proceeds = $7.4275 × 75,000 + $20,437.50
Total Proceeds = $577,500
Diff: 3
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
10) To hedge the price risk associated with one of its major inputs, Binford Homes uses lumber futures
contracts which trade on the Chicago Mercantile Exchange (CME). The CME Random Length Lumber
futures contract calls for delivery of 110,000 board feet (110 MBF, 1 MBF is 1,000 board feet of lumber) of
random length 8-foot to 20-foot pieces. Primarily, the deliverable species are Western Spruce, Pine or Fir.
What kind of futures position will Binford Homes take in the CME lumber futures contract in order to
hedge the price risk it faces?
A) A long position in lumber futures contracts
B) A short position in lumber futures contracts
Answer: A
Explanation: A) A hedge is a transaction designed to offset exposure to price risk. Binford Homes needs
to buy lumber in the future for building purposes. To lock-in its purchase price, Binford should take a
long position in the futures market.
Diff: 1
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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11) To hedge the price risk associated with one of its major inputs, Binford Homes uses lumber futures
contracts which trade on the Chicago Mercantile Exchange (CME). The CME Random Length Lumber
futures contract calls for delivery of 110,000 board feet (110 MBF, 1 MBF is 1,000 board feet of lumber) of
random length 8-foot to 20-foot pieces. Primarily, the deliverable species is Western Spruce, Pine or Fir.
In October of last year, Binford Homes bought 100 CME lumber contracts for March delivery at a price of
$300 per MBF. It is now March 16th and the spot price for lumber is $263 per MBF. How can Binford
complete its futures trade?
I.
II.
III.
IV.
Sell the 100 CME contracts that they purchased.
At maturity take delivery of the lumber and pay the associated transportation costs.
Take a new short position in 100 CME March lumber contracts.
Buy 100 CME May lumber contracts.
A) I only
B) I or II
C) II or III
D) II only
Answer: C
Explanation: C) One way to complete a futures trade is to make or take delivery of the underlying asset
on the maturity date. Since Binford has a long position in the lumber futures contract, they can take
delivery of lumber and pay the associated transportation costs. A second option is for Binford to execute
an offset (or reversing) trade by taking a new short position in 100 CME March lumber contracts.
Therefore both II and III allow Binford to complete its futures trade.
Diff: 2
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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12) To hedge the price risk associated with one of its major inputs, Binford Homes uses lumber futures
contracts which trade on the Chicago Mercantile Exchange (CME). The CME Random Length Lumber
futures contract calls for delivery of 110,000 board feet (110 MBF, 1 MBF is 1,000 board feet of lumber) of
random length 8-foot to 20-foot pieces. Primarily, the deliverable species is Western Spruce-Pine-Fir.
In October of last year, Binford Homes bought 100 CME lumber contracts for March delivery at a price of
$300 per MBF. It is now March 16th and Binford buys lumber in the spot market, where it trades for $263
per MBF, and executes an offset trade in the futures market. Today's futures prices are quoted in the table
below.
Expiry Month
March
May
July
Settlement
Price
262.50
278.70
283.00
VOL
900
146
2
Open Interest
4000
416
26
What is your total purchase cost for the 110 MBF of lumber? The total purchase cost includes profits from
the futures transactions.
A) $300.50 per MBF
B) $300.00 per MBF
C) $262.50 per MBF
D) $263.00 per MBF
Answer: A
Explanation: A) Cumulative Profit = (Pt - Pt-1) × 110 × n
Where
Pt = the futures price for the offset trade
Pt-1 = the futures price when the long position initiated
n = the number of contracts
Cumulative Profit = (262.50 - 300) × 110 × 100
Cumulative Profit = -$412,500
The total cost of the lumber is the total spot market purchase minus the futures profit.
Total Cost = $263 × 11,000 - (-$412,500)
Total Cost = $3,305,500
Cost per MBF = $3,305,500/11,000 MBF = $300.50 per MBF
Diff: 3
Section: 3 Hedging with Futures Contracts
AACSB: Analytical Thinking
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LO4: Understand Option Contracts and How Options Are Traded
1) When an option is said to be in-the-money, the option has positive
A) volatility.
B) time value.
C) risk.
D) intrinsic value.
Answer: D
Explanation: D) Intrinsic value is simply the payoff to the option holder if the option is exercised today.
An option with positive intrinsic value, i.e. a positive payoff, is considered in-the-money.
Diff: 1
Section: 4 Option Contract
AACSB: Analytical Thinking
2) Which of the following describes an agreement that gives the right, but not the obligation, to buy a
specific asset at a specific price for a set period of time?
A) Forward
B) Future
C) Option
D) Swap
Answer: C
Explanation: C) The name for this type of contract is an option.
Options are contracts between two parties: a buyer (or owner) and a seller (or writer). There are two
kinds of options: calls and puts. Calls give the owner the right to buy a specific asset and puts give the
owner the right to sell.
Diff: 1
Section: 4 Option Contract
AACSB: Analytical Thinking
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3) Your company uses wheat in the production of a breakfast cereal. Which of the following actions
would allow you to reduce upside price fluctuations in the price wheat?
I.
II.
III.
IV.
Sell a futures contract on wheat.
Buy a futures contract on wheat.
Buy a call option on wheat futures.
Sell a call option on wheat futures.
A) II only
B) IV only
C) I or IV only
D) II or III only
Answer: D
Explanation: D) Either II or III will help stabilize your input price of wheat.
Buying a futures contract will oblige you at a later date to purchase wheat at a specified price. This means
that your wheat will cost only the price stated in the futures contract.
Buying a call option on wheat futures gives you the right at a later date to purchase wheat futures (which,
as described above, hedge your losses on that input price).
Either way, you are hedging the volatility in the price of wheat by setting a ceiling on the acquisition cost
of your wheat.
Diff: 3
Section: 4 Option Contract
AACSB: Analytical Thinking
4) An option that can be exercised by the buyer at any point prior to its expiration is a(n)
A) European option.
B) American option.
C) European option and an American option.
D) None of the above
Answer: B
Explanation: B) The definition of an American Option is one that can be exercised at any point prior to
expiration. In contrast, European options can only be exercised at expiration.
Diff: 1
Section: 4 Option Contract
AACSB: Analytical Thinking
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5) You sold (wrote) a call option on Initech stock with an exercise price of $165. The maturity date of the
option is in May and the option is an American style option. Which of the following statements is true?
A) You are obligated to sell Initech shares for $165 at any time prior to the option expiration date in May,
if the owner of the option chooses to exercise.
B) You are obligated to sell Initech shares for $165 when the option expires in May, regardless of the
stock's market price.
C) You have the right to sell Initech shares for $165 at any time prior to the option expiration in May,
regardless of the stock's market price.
D) You are obligated to buy Initech shares for $165 when the option expires in May, regardless of the
stock's market price.
Answer: A
Explanation: A) The writer of the call option is obligated to sell the underlying asset (at the agreed upon
strike price) if the option holder chooses to exercise. An American style option can be exercised at any
time before the expiration date.
Therefore, A is the correct answer.
Diff: 2
Section: 4 Option Contract
AACSB: Analytical Thinking
6) You are long 1 call option. Besides exercising the option, the other way to realize value from the option
is to
A) buy the stock.
B) retain the option until it expires.
C) sell a call option.
D) buy an equivalent put option.
Answer: C
Explanation: C) You have two choices when closing an option position:
1. The first is to simply exercise the option. This is assuming the option is an American style option,
which can be exercised at any time prior to expiration. If it were a European option you could only
exercise it on the expiry date.
2. The other option is to execute an offset trade. This is done by writing, or selling, an option with a
position opposite to the original position.
Diff: 1
Section: 4 Option Contract
AACSB: Analytical Thinking
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7) You wish to sell a put option on Goliath National Bank (GNB) with a strike price of $195. The option
expires in November. The option price is $17.10. In order to sell the put, you must first own shares of
GNB.
Answer: FALSE
Explanation: An option is a contract between two parties which gives the owner of the option the right to
buy or sell an underlying asset to the writer of the option at an agreed upon price.
There is no requirement for either party to own the underlying asset before entering into an option
contract.
Diff: 1
Section: 4 Option Contract
AACSB: Analytical Thinking
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LO5: Understand the Payoffs to Options Contracts
1)
Consider writing a put with a strike price of $360. Assume that the stock price rises to $390 by expiration.
The profit to the writer is
A) $0.
B) $4.20.
C) $25.80.
D) $30.00.
Answer: B
Explanation: B) The payoff for the writer is equal to -1 times the payoff to the holder.
Payoff of Short Put = -MAX (0, X - St)
Payoff = -MAX (0, $360 - $390)
Payoff = -MAX (0, -$30)
Payoff of Short Put = $0
Profit = Payoff + Premium
Profit = 0 + $4.20
Profit = $4.20
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Since the price at expiration is above the strike price, the buyer of the put option will not exercise, thus
the writer of the put will profit by the price of the option = $4.20
Diff: 2
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
2) Draw the profit diagram for a long position in a call option with a call premium of $3 and a strike price
of $50. What is the break-even stock price?
A) $47
B) $50
C) $53
D) $56
Answer: C
Explanation: C)
Call Break-even price = Strike Price + Call Premium
Call Break-even price = $50 + $3
Call Break-even price = $53
Diff: 1
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
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3) Draw the profit diagram for a long position in a put option with a put premium of $2 and an exercise
price of $35. What is the break-even stock price?
A) $31
B) $33
C) $35
D) $37
Answer: B
Explanation: B)
Put Break-even price = Strike Price - Put Premium
Put Break-even price = $35 - $2
Put Break-even price = $33
Diff: 1
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
4) You are long a put option with a strike price of $100. The option expires today and the underlying
security is trading at $94. If you purchased the option for $8, should you exercise the option?
A) Yes
B) No
Answer: A
Explanation: A) If you choose not to exercise the option, and simply let it expire, you incur a loss of $8
(the cost of the option).
If you choose to exercise the option, your profit (loss) is:
Payoff of Long Put = MAX (0, X - St)
Payoff = MAX (0, 100 - 94)
Payoff = MAX (0, 6)
Payoff of Long Put = $6
Profit = Payoff - Premium
Profit = $6.00 - $8.00
Profit = -$2.00
Therefore, you should exercise the option in order to reduce your loss from $8 to $2.
Diff: 2
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
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5) Jerry purchased a call option 3 months ago for $300 ($3 per share). It gives Jerry the right to buy 100
shares in Morley Tobacco for $20 per share. The call option expires today. What is the lowest price that
Jerry should exercise at and what is that lowest price at which Jerry would realize a profit?
A) $17, $20
B) $20, $17
C) $20, $23
D) $23, $20
Answer: C
Explanation: C) Jerry should exercise the option if the stock price is greater than or equal to $20, the
strike price.
The zero profit stock price can be solved by substituting zero into the expression for profit for a long call:
Profit = Payoff - Premium
0 = MAX (0, St - X) - Premium
0 = St - X - Premium
St = X + Premium
St = $20 + $3 = $23
Since the option cost $3 per share, Jerry will only recognize a profit if he exercises the option when the
stock price is greater than the $23 break-even price.
Diff: 2
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
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6) You have $10,000 to invest and you are considering buying 100 shares of Oceanic Airlines or 10 call
options on the shares. The call option expires in six months, has a strike price of $100 and has a premium
of $10 (per share). The stock price is currently $100. Assume that the stock price rises to $125 by the
option expiry date. What is the ratio of the rate of return on the calls over the return on the stock?
A) 1.0
B) 2.0
C) 4.0
D) 6.0
Answer: D
Explanation: D) Investment 1: Long Oceanic Airlines Stock
Return = (St - S0)/S0
Return = $125 - $100/$100
Return = 0.25 or 25%
Investment 2: Long call options on Oceanic Airlines Stock:
The option premium (per share) is $10. For a contract the premium is $1,000. Thus, you can afford to buy
10 contracts (controlling 1,000 shares) with $10,000.
Long Call Option Payoff (per share):
Payoff = MAX (0, St - X)
Payoff = MAX (0, $125 - $100)
Payoff = MAX (0, $25)
Payoff = $25
Profit (per share):
Profit = Payoff - Premium
Profit = $25 - $10
Profit = $15
Return (per share):
Return = $15/$10
Return = 1.5 or 150%
Ratio = 1.5/0.25
Ratio = 6.0
Diff: 3
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
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7) You have $10,000 to invest and you are considering short selling shares of Oceanic Airlines or
purchasing 10 put options on the shares. The stock price is currently $100. If you short sell, then your
broker requires you to deposit 50% margin into your brokerage account. So, you can afford to short sell
200 shares of Oceanic. The proceeds will be deposited in your account and you will have to deposit an
additional $10,000 of margin. The put option expires in six months, has a strike price of $100 and has a
premium of $10 (per share). Assume that the stock price falls to $75 by the option expiry date. What is the
ratio of the rate of return on the puts over the return on the short sale? In the case of the short sale, treat
your margin deposit as your investment.
A) -10.00
B) 1.00
C) 3.00
D) 5.00
Answer: C
Explanation: C) Investment 1: Short Oceanic Airlines Stock
Return = ($15,000 - $10,000)/$10,000
Return = 50%
Investment 2: Long put options on Oceanic Airlines Stock
The option premium (per share) is $10. For a contract the premium is $1,000. Thus, you can afford to buy
10 contracts (controlling 1,000 shares) with $10,000.
Option Payoff (per share):
Payoff = MAX (0, X - St)
Payoff = MAX (0, $100 - $75)
Payoff = $25
Profit (per share):
Profit = Payoff - Premium
Profit = $25 - $10 = $15
Return (per share):
Return = $15/$10
Return = 1.5 or 150%
Ratio = 1.5/0.5 = 3
Diff: 4
Section: 5 Option Payoffs and Profits
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AACSB: Analytical Thinking
8) You have $5,000 to invest and you are considering buying 100 shares of big-box retailer Buy n' Large or
10 call options on the shares. The call option expires in six months, has a strike price of $50 and has a
premium of $5 (per share). The stock price is currently $50. Assume that the stock price rises to $70 by the
option expiry date. What is the ratio of the rate of return on the calls over the return on the stock?
A) 2.50
B) 5.00
C) 7.50
D) 10.00
Answer: C
Explanation: C) Investment 1: Long Buy n' Large Stock
Return = (St - S0)/S0
Return = $70 - $50/$50
Return = 0.40 or 40%
Investment 2: Long call options on Buy n' Large Stock:
The option premium (per share) is $5. For a contract the premium is $500. Thus, you can afford to buy 10
contracts (controlling 1000 shares) with $5,000.
Long Call Option Payoff (per share):
Payoff = MAX (0, St - X)
Payoff = MAX (0, $70 - $50)
Payoff = MAX (0, $20)
Payoff = $20
Profit (per share):
Profit = Payoff - Premium
Profit = $20 - $5
Profit = $15
Return (per share):
Return = $15/$5
Return = 3.0 or 300%
Ratio = 3.0/0.4
Ratio = 7.5
Diff: 3
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
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9) You have $5,000 to invest and you are considering short selling shares of Binford Home Improvement
or purchasing 10 put options on the shares. The stock price is currently $50. If you short sell, then your
broker requires you to deposit 50% margin into your brokerage account. So, you can afford to short sell
200 shares of Oceanic. The proceeds will be deposited in your account and you will have to deposit an
additional $5,000 of margin. The put option expires in six months, has a strike price of $50 and has a
premium of $5 (per share). Assume that the stock price falls to $40 by the option expiry date. What is the
ratio of the rate of return on the puts over the return on the short sale? In the case of the short sale, treat
your margin deposit as your investment.
A) 1.0
B) 2.5
C) 5.0
D) 10.0
Answer: B
Explanation: B) Investment 1: Short Binford Home Improvement Stock
Return = ($7,000 - $5,000)/$5,000
Return = 40%
Investment 2: Long put options on Oceanic Airlines Stock
The option premium (per share) is $5. For a contract the premium is $500. Thus, you can afford to buy 10
contracts (controlling 1000 shares) with $5,000.
Option Payoff (per share):
Payoff = MAX (0, X - St)
Payoff = MAX (0, $50 - $40)
Payoff = $10
Profit (per share):
Profit = Payoff - Premium
Profit = $10 - $5 = $5
Return (per share):
Return = $5/$5
Return = 1.0 or 100%
Ratio = 1.0/0.4 = 2.5
Diff: 3
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10) What position has more downside exposure: a short position in a call option or a short-position in a
put option on the same stock? In other words, if the worst outcome occurred for each option, which
would lose more money?
A) Short Call
B) Short Put
C) Both lose an equal amount of money.
D) It depends on the premiums of the two options.
Answer: A
Explanation: A) The writer/seller of the call option wants the price to go down. If the price goes up, the
buyer of the call will profit. Because the price can rise infinitely, there is no maximum loss the
writer/seller can experience—it is infinite.
The writer/seller of the put option wants the price to go up. If the price goes down, the buyer of the put
will profit. However, since the lowest a price can go is zero, the writer/seller of the put has a limited loss.
Therefore, if the worst outcome occurred, the person short one call would lose more money.
Diff: 2
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11)
You purchase the BLU Oct $70 call option for a premium of $8.00. It is now the third Friday of October,
the expiration date of the option contract. Bluth's stock price has dropped to $66, and you did not exercise
the option. How much did you lose (per share)?
A) $4
B) $6
C) $8
D) $10
Answer: C
Explanation: C) The call gave you the option to purchase the stock at $70. At expiration the stock was
trading at only $66, so there is no incentive to exercise the option. Therefore, you let the call option expire.
Payoff of Long Call = MAX (0, St - X)
Payoff = MAX (0, $66 - $70)
Payoff = MAX (0, -$4.00)
Payoff of Long Call = $0
Profit = Payoff - Premium
Profit = 0 - $8.00
Profit = -$8.00
You still paid the $8 premium for the call option, so you lost $8 in total.
Diff: 2
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12) The maximum profit for an option buyer is the price paid for the option.
Answer: FALSE
Explanation: The maximum payoff to a call holder is the stock price less the exercise price:
Payoff = MAX (0, St - X)
The call holder's profit is the payoff less the purchase price of the option:
Profit = Payoff - Premium
The maximum profit for the call holder can be infinitely large as there is theoretically no limit to how
much the stock price can rise. For each dollar that the price rises (above the strike price) the holder earns
an additional dollar of profit.
The maximum payoff to a put holder is the exercise price less the stock price.
Payoff = MAX (0, X - St)
The put holder's profit is the payoff less the premium paProfit = Payoff - Premium
The maximum profit for the put holder is actually the strike price (less the premium paid), and it occurs
when the stock goes bankrupt and the stock price, St, falls to zero.
Diff: 1
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AACSB: Analytical Thinking
13) The maximum profit of an option writer is the premium.
Answer: TRUE
Explanation: The maximum possible payoff to a call/put writer is 0, as the option holder will never
exercise if their payoff is negative - they will simply let the option expire. Therefore the maximum profit
to a call/put writer is the premium.
Diff: 1
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14)
The figure above is a profit diagram for a
A) long call.
B) short call.
C) long put.
D) short put.
Answer: B
Explanation: B) The figure presents a graph of the profits to a call writer.
The y-intercept, of approximately $1.00, is the call option premium. We can see that the call writer earns
the premium until the stock price increases beyond the strike price of approximately $10.00. At this point
the writer begins to lose money. For each dollar that the price rises (above the strike) the writer loses a
dollar of profit.
As with all short call positions the highest profit that the call writer can earn is the premium, and the
maximum loss is theoretically unlimited as there is no limit to how high the stock price could rise.
Diff: 1
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15) Consider a call option on shares of Prestige Worldwide with a strike price of $575. The option
currently trades for a premium of $13.75. Prestige Worldwide shares are currently trading for $565. What
is the break-even price for a long call position?
A) $565
B) $575
C) $578.75
D) $588.75
Answer: D
Explanation: D) Call Break-even price = Strike Price + Call Premium
Call Break-even price = $575 + $13.75
Call Break-even price = $588.75
Diff: 2
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
16) Consider a call option on shares of Prestige Worldwide with a strike price of $575. The option
currently trades for a premium of $13.75. Prestige Worldwide shares are currently trading for $565. What
is the maximum profit that a call writer can earn on such an option?
A) $13.75
B) $551.25
C) $575.00
D) Unlimited Upside
Answer: A
Explanation: A) The payoff to a call writer is equal to -1 times the payoff to the holder.
Payoff of Short Call = -MAX (0, St - X)
Maximum payoff of $0 happens when stock price is lowest (assume it can drop to zero, i.e. the stock goes
bankrupt).
The premium is added to the payoff because the option writer receives the premium.
Maximum Profit = maximum payoff + premium
Maximum Profit = $0 + premium
In this example the premium, and thus the maximum profit the call writer can make, is $13.75.
Diff: 2
Section: 5 Option Payoffs and Profits
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17) Consider a put option on Research at Rest (RAR) with a December expiration date and a strike of $11.
The option currently trades for a premium of $1.30. RAR shares are trading today for $10.25. If RAR goes
bankrupt before mid-December, then what is the profit to the put owner?
A) $8.95
B) $9.70
C) $10.25
D) $12.30
Answer: B
Explanation: B) The maximum payoff to a put holder is the exercise price less the stock price.
Payoff of Long Put = MAX (0, X - St)
The profit to the holder is the payoff less the premium paProfit = Payoff - Premium
Assuming stock price drops to zero:
Profit = (X - St) - Premium
Profit = $11- $0 - $1.30
Profit = $ 9.70
Diff: 2
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
18) Draw the profit diagram for a short position in a call option on shares of Callahan Auto Parts. Assume
that the option is for one share of Callahan. The strike price for the option is $75. The option premium,
today, is $5.00. The option expires in 3 months. The stock price for Callahan is currently $68. What is the
maximum loss for the option position?
A) $5
B) $68
C) $75
D) Infinite
Answer: D
Explanation: D)
As the profit diagram illustrates, for each dollar that the price rises (above the strike price) the option
writer loses a dollar of profit. Theoretically the stock price could rise infinitely, leading to unlimited or
infinite losses by the option writer. In practice the option writer could simply execute an offsetting trade
if the stock price starts to rise rapidly.
Diff: 2
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19) Draw the profit diagram for a short position in a call option on shares of Callahan Auto Parts. Assume
that the option is for one share of Callahan. The strike price for the option is $75. The option premium,
today, is $5.00. The option expires in 3 months. The stock price for Callahan is currently $68. What is the
maximum gain that the option writer can make?
A) $5
B) $7
C) $68
D) $75
E) Unlimited
Answer: A
Explanation: A)
The payoff for the writer is equal to -1 times the payoff to the holder:
Payoff of Short Put = -MAX (0, St - X)
Maximum payoff of $0 happens when stock price is lowest (assume it can drop to zero, i.e. the stock goes
bankrupt).
The premium is added to the payoff because the option writer receives the premium.
Maximum Profit = maximum payoff + premium
Maximum Profit = $0 + premium
In this example the premium, and thus the maximum profit the call writer can make, is $5.
This is illustrated in the diagram as the profit to the call writer remains constant at $5 until the stock price
reaches the strike price of $75, at which point it begins to decline.
Diff: 2
Section: 5 Option Payoffs and Profits
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20) Draw the profit diagram for a short position in a call option on shares of Callahan Auto Parts. Assume
that the option is for one share of Callahan. The strike price for the option is $75. The option premium,
today, is $5.00. The option expires in 3 months. The stock price for Callahan is currently $68. What is the
break-even stock price?
A) $68
B) $70
C) $75
D) $80
Answer: D
Explanation: D)
Call Break-even price = Strike Price + Call Premium
Call Break-even price = $75 + $5
Call Break-even price = $80
Diff: 2
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21)
It is December 16th, and the table above shows prices of put options on shares of Dunder-Mifflin Paper.
Last month you bought a March put with a strike price of $21.00. You paid a premium of $0.5 per share.
Shares of Dunder-Mifflin are currently trading for $18.50. Because of bad news announced yesterday, you
think that today is the lowest level that the stock will reach before the option expires in March. As a
result, you want to close your position and take your profit. What is the profit of your long put position?
(Calculate your profit for a whole contract on 100 shares.)
A) $200
B) $250
C) $300
D) $350
Answer: B
Explanation: B) In order to close your position today, you execute an offset trade by writing (selling) a
March put with a strike price of $21.00.
The net profit from an offsetting trade is the difference between the premium received and the premium
paid.
The premium paid in November was $0.50 * 100 shares = $50
The premium that you receive December 16th, found in the table provided, is $3.00 * 100 shares = $300
Profit = Premium Received - Premium Paid
Profit = $300 - $50
Profit = $250.
Diff: 2
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22)
The table above shows prices of put options on shares of Dunder-Mifflin Paper. What is the time
premium of the March put option on Dunder-Mifflin shares with the $16 exercise price? The stock is
currently trading for $18.50.
A) $0
B) $0.50
C) $0.75
D) $1.25
Answer: C
Explanation: C) Time value = option premium - intrinsic value
First, we must calculate the intrinsic value of the put option:
Put Intrinsic Value = MAX (0, X - St)
Put Intrinsic Value = MAX (0, $16 - $18.50)
Put Intrinsic Value = MAX (0, -$2.50)
Put Intrinsic Value = $0
Now, we can calculate the time value using the information from the table and our previous calculation:
Time value = option premium - intrinsic value
Time value = $0.75 - $0.00
Time value = $0.75
Diff: 2
Section: 5 Option Payoffs and Profits
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23) Kramer-Costanza Inc. stock is currently trading for $21.96. Put options on Kramer-Costanza shares
which expire in four months have a strike price of $23.50 and are currently trading for $17.54. (Analysts
do not expect Kramer-Costanza Inc. to do well.) What is the profit from a writing put option if, at
maturity, the stock price is $13.96?
A) -$9.54
B) $5.96
C) $8.00
D) $17.54
Answer: C
Explanation: C) The payoff for the put writer is equal to -1 times the payoff to the holder.
Payoff of a Short Put = -MAX (0, X - St)
Payoff = -MAX (0, $23.50 - $13.96)
Payoff = -MAX (0, $9.54)
Payoff of Short Put = -$9.54
The premium is added to the payoff because the option writer receives the premium.
Profit = payoff + premium
Profit = -$9.54 + $17.54
Profit = $8.00
Diff: 2
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
24) Shares in Vandelay Industries trade for $46.12. Call options with a $45 strike price are selling for $4.80
and put options with the same strike price are selling for $2.45. What is the break-even price for long
positions in the call and put option respectively?
A) $49.80, $42.55
B) $49.80, $47.45
C) $50.92, $43.67
D) $50.92, $48.57
Answer: A
Explanation: A) Call Break-even price = Strike Price + Call Premium
Call Break-even price = $45 + $4.80
Call Break-even price = $49.80
Put Break-even price = Strike Price - Put Premium
Put Break-even price = $45 - $2.45
Put Break-even price = $42.55
Diff: 2
Section: 5 Option Payoffs and Profits
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25) Shares in Globex Corp. are trading today for $26. Call options on Globex shares, which expire in 6
months with a strike price of $25, are trading for $3.60. What is the payoff to a call option writer, at
maturity, if the stock price is $27? Assume that there is one share per contract.
A) -$3.60
B) -$2.00
C) -$1.60
D) $1.60
Answer: B
Explanation: B) The payoff to a call writer is equal to -1 times the payoff to the holder.
Payoff of Short Call = -MAX (0, St - X)
Payoff = -MAX (0, $27 - $25)
Payoff = -MAX (0, $2)
Payoff of Short Call = -$2.00
Diff: 2
Section: 5 Option Payoffs and Profits
AACSB: Analytical Thinking
26) Shares in Globex Corp. are trading for $26. Put options on Globex shares, which expire in 6 months
with a strike price of $25, are trading for $2.00. What is the payoff to a put option holder, at maturity, if
the stock price is $24? Assume that you close your position by exercising the option.
A) -$1
B) $0
C) $1
D) $2
Answer: C
Explanation: C) The payoff to a put holder is the exercise price less the stock price.
Payoff of Long Put = MAX (0, X - St)
Payoff = MAX (0, $25 - $24)
Payoff = MAX (0, $1)
Payoff of Long Put = $1.00
Diff: 2
Section: 5 Option Payoffs and Profits
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27)
Refer to the table of ENCOM stock option prices provided above. You purchase the $490 Call option on
ENCOM Inc. shares today. How high must the price of ENCOM's shares rise in order for you to break
even and earn $0 of profit on the call option?
A) $483.50
B) $490.00
C) $496.50
D) $509.70
Answer: C
Explanation: C) You paid a premium of $6.50 for the right to buy ENCOM Inc. shares at $490; therefore
you must recoup $6.50 to break even on this investment. The stock price must rise to $496.50 for you to
earn $0 of profit on the call option.
Algebraically:
Call Break-even price = Strike Price + Call Premium
Call Break-even price = 490 + 6.50
Call Break-even price = $496.50
Diff: 2
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28)
Assume that the short put profit diagram applies to the GNB Put with the strike price of $200 (Refer to
the Table of option prices, above). What is y-axis intercept for the profit diagram?
A) -$219.80
B) -$200.00
C) -$180.20
D) $180.20
Answer: C
Explanation: C) Correct profit diagram:
The y-intercept for the profit diagram of a short put position is the maximum possible loss to the put
writer.
The maximum loss for a short put position occurs when the stock price, S t, drops to zero (i.e. the stock
goes bankrupt). This is the bankruptcy scenario where the writer is obligated to purchase the shares from
the put owner for the strike price, X, but is unable to sell them as they are worthless. The writer gets to
keep the premium, which partially offsets the negative payoff.
Maximum Loss = -$X + premium
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For the Google put option with the strike price of $200:
Maximum Loss = -$200 + $19.80
Maximum Loss = -$180.2
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29)
Assume that the long call profit diagram applies to the GNB Call with the strike price of $180 (Refer to
the Table of option prices, above). What is x-axis intercept for the profit diagram?
A) $174.80
B) $180.00
C) $190.29
D) $195.20
Answer: D
Explanation: D) Correct profit diagram:
The x-intercept of the profit diagram is the break-even stock price, the stock price at which the holder of
the call earns $0 in profit.
Call Break-even price = Strike Price + Call Premium
Call Break-even price = 180 + 15.20
Call Break-even price = $195.20
Diff: 2
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30)
Assume that the short call profit diagram applies to the GNB Call with the strike price of $180 (Refer to
the Table of option prices, above). What is the profit/loss if the stock price is $195?
A) -$15.00
B) $0.20
C) $7.70
D) $15.20
Answer: B
Explanation: B) Correct profit diagram:
The payoff for the writer is equal to -1 times the payoff to the holder.
Payoff of Long Call = -MAX (0, St - X)
Payoff = -MAX (0, $195 - $180)
Payoff = -MAX (0, $15)
Payoff of Long Call = -$15
The premium is added to the payoff because the option writer receives the premium.
Profit = payoff + premium
Profit = -$15 + $15.20
Profit = $0.20
Diff: 2
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LO6: Understand Intrinsic Value and Time Value
1)
Consider the Put option on Heisler Brewing Co. with a strike price of $400. The Put option is
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
Answer: A
Explanation: A) Put Intrinsic Value = MAX (0, X - St)
Put Intrinsic Value = MAX (0, $400 - $379)
Put Intrinsic Value = MAX (0, $21)
Put Intrinsic Value = $21.00
Since the put option has positive intrinsic value, it is in-the-money.
Diff: 2
Section: 6 Option Pricing
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2)
Consider the Call option with a strike price of $370. What is the intrinsic value of the option?
A) $0
B) $5.90
C) $9.00
D) $14.90
Answer: C
Explanation: C) Call Intrinsic Value = MAX (0, S t - X)
Call Intrinsic Value = MAX (0, $379 - $370)
Call Intrinsic Value = MAX (0, $9)
Call Intrinsic Value = $9
Diff: 2
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3)
Consider the put with a strike price of $350. What is the time premium (or time value) of the option?
A) $0
B) $2.40
C) $26.60
D) $29.00
Answer: B
Explanation: B) Time Value Put = Option Price - Intrinsic Value
Time Value Put = Option Price - MAX (0, X - St)
Time Value Put = $2.40 - MAX (0, $350 - $379)
Time Value Put = $2.40 - 0
Time Value Put = $2.40
Diff: 2
Section: 6 Option Pricing
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4)
The options on Eldorado Mining expire in 3 months. The premium on the Eldorado put option with the
$17.5 strike price reflects
A) time value only.
B) intrinsic value only.
C) a combination of time value and positive intrinsic value.
Answer: C
Explanation: C) The intrinsic value of an option is the payoff to the option holder. As this option is a put
and the strike price, X, is higher than the current market price, S t, we know that the option has positive
intrinsic value:
Put Intrinsic Value = MAX (0, X - St)
Put Intrinsic Value = MAX (0, $17.5 - $16.91)
Put Intrinsic Value = MAX (0, $0.59)
Put Intrinsic Value = $0.59
As you can see however, the intrinsic value of $0.59 is only a portion of the $0.90 premium on the option.
The time value reflects the likelihood that the stock price will fall, and benefit the put holder, between
now and expiration. The greater the time until the expiration date, the greater the time value of the
option.
Time Value = option premium - intrinsic value
Time Value = $0.90 - $0.59
Time Value = $0.31
Therefore, the premium reflects a combination of time value and positive intrinsic value.
Diff: 2
Section: 6 Option Pricing
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5) Is an increase in the volatility of a stock's price good for the owner of a call option? Is it good for the
owner of a put option?
A) Bad for both.
B) Bad for the call owner. Good for the put owner.
C) Good for both.
D) Good for the call owner. Bad for the put owner.
Answer: C
Explanation: C) The higher the volatility of the price of the underlying asset, the higher will be the time
value of the option, all other things being equal. This is because a volatile asset's price is more likely to
jump up (or down), which is favourable for option holders who need the price to move in order to make
a profit (up for calls, down for puts).
Therefore, an increase in price volatility is beneficial for both call and put owners.
Diff: 1
Section: 6 Option Pricing
AACSB: Analytical Thinking
6) A put option on Ewing Oil is trading for $2.40 per share. The strike price of the option is $25. The stock
is currently trading at $23. The option is
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
Answer: A
Explanation: A) Put Intrinsic Value = MAX (0, X - St)
Put Intrinsic Value = MAX (0, $25 - $23)
Put Intrinsic Value = MAX (0, $2)
Put Intrinsic Value = $2.00
Since the put option has positive intrinsic value, it is in-the-money.
Diff: 2
Section: 6 Option Pricing
AACSB: Analytical Thinking
7) A put option on Duke & Duke Inc. shares is trading at $0.50 per share. The strike price is $50.The
current price of the stock is $45. The Intrinsic value of the option is
A) $4.50.
B) $5.00.
C) $45.00.
D) $50.00.
Answer: B
Explanation: B) Intrinsic Value of a Put = MAX (0, X - St)
Intrinsic Value = MAX (0, 50 - 45)
Intrinsic Value = $5.00
Diff: 2
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8) Which of the following statements is true?
A) Call options are in-the-money if the stock price is above the strike price. Put options are in-the-money
if the stock price is below the strike price.
B) Call options are in-the-money if the stock price is below the strike price. Put options are in-the-money
if the stock price is above the strike price.
C) Both call and put options are in-the-money if the stock price is above the strike price.
D) None of the above.
Answer: A
Explanation: A) Recall that an option is "in-the-money" when it has positive intrinsic value, and that the
intrinsic value is simply the payoff to the holder.
Intrinsic value for a call option is given by:
Call Intrinsic Value = MAX (0, St - X).
Therefore, call options are in-the-money when the stock price is greater than the strike price: S t > X.
Conversely, intrinsic value for a put option is given by:
Put Intrinsic Value = MAX (0, X - St)
Therefore put options are in-the-money when the strike price is greater than the stock price: X > S t.
Diff: 1
Section: 6 Option Pricing
AACSB: Analytical Thinking
9) Other things being equal, the ________ the price volatility of the underlying asset, the ________ a call
option will be.
A) lower, the greater the profit on
B) lower, the lower the profit on
C) greater, more valuable
D) greater, less valuable
Answer: C
Explanation: C) The higher the volatility of the price of the underlying asset, the higher will be the time
value of the option, all other things being equal. This is because a volatile asset's price is more likely to
jump up (or down), which is favourable for option holders who need the price to move in order to make
a profit (up for calls, down for puts).
Therefore, the greater the price volatility of the underlying asset, the greater the time value of the option
and the more valuable the option is.
Diff: 1
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10) If the stock price increases, the price of a put option on that stock ________ and that of a call option
________.
A) decreases, increases
B) decreases, decreases
C) increases, increases
D) stays the same, increases
Answer: A
Explanation: A) An option's premium (or price) is made up of two components: intrinsic value and time
value. The intrinsic value of an option is simply the payoff to the option holder.
To answer the question posed above, we can simply analyze the effect of an increase in stock price on an
option's intrinsic value.
The intrinsic value for a put option is: Put Intrinsic Value = MAX (0, X - St).
We can see that as the stock price increases the option loses intrinsic value and therefore its overall value
decreases.
The intrinsic value for a call option is: Call Intrinsic Value = MAX (0, St - X).
Conversely a call option gains intrinsic value as the stock price increases above the strike price, and its
overall value increases along with it.
Diff: 1
Section: 6 Option Pricing
AACSB: Analytical Thinking
11) Which of the following factors when increased does not increase a call option price, holding all else
constant?
A) Time to maturity
B) Volatility
C) The price of the underlying asset
D) The strike price
Answer: D
Explanation: D) We know that the call premium is at least equal to the intrinsic value of the option.
The intrinsic value of a call option is: Call Intrinsic Value = MAX (0, St - X).
We can see that as the strike price, X, rises, the call option's intrinsic value decreases and so does its price.
Diff: 1
Section: 6 Option Pricing
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12) The time premium has an inverse relationship with the amount of time remaining to expiration.
Answer: FALSE
Explanation: The time premium, or time value, of an option is the amount by which the option premium
exceeds its intrinsic value. The time premium reflects the likelihood that the stock price will rise (for calls)
or fall (for puts) between now and the expiration date.
As an option matures and grows nearer to its expiration date it becomes less likely that the price of the
underlying asset will change. As a result, the time premium decreases as the time remaining to expiration
decreases, implying a direct relationship.
Diff: 1
Section: 6 Option Pricing
AACSB: Analytical Thinking
13) Shares of Sweetums Candy Company, makers of the famous NutriYum Bars, are trading for $30.46.
You decide to purchase call options which expire in three months with a strike price of $28.67. The call
options are trading for $7.68. What is the time value of the option?
A) $1.79
B) $3.45
C) $5.89
D) $7.68
Answer: C
Explanation: C) Time value = option premium - intrinsic value
First, we must calculate the intrinsic value of the put option:
Call Intrinsic Value = MAX (0, St - X)
Call Intrinsic Value = MAX (0, $30.46 - $28.67)
Call Intrinsic Value = MAX (0, $1.79)
Call Intrinsic Value = $1.79
Now, we can calculate the time value using the information from the table and our previous calculation:
Time value = option premium - intrinsic value
Time value = $7.68 - $1.79
Time value = $5.89
Diff: 2
Section: 6 Option Pricing
AACSB: Analytical Thinking
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14) Shares in Globex Corp. are trading today for $26. Call options on Globex shares, which expire in 6
months with a strike price of $25, are trading for $3.60. What are the intrinsic value and time value for the
call option? Assume that there is one share per contract.
A) -$1.00, $4.60
B) $0, $3.60
C) $1.00, $2.60
D) $1.00, $3.60
Answer: C
Explanation: C) The intrinsic value of an option is the payoff to the holder if it were to be exercised
today:
Call Intrinsic Value = MAX (0, St - X)
Call Intrinsic Value = MAX (0, $26 - $25)
Call Intrinsic Value = MAX (0, $1)
Call Intrinsic Value = $1.00
Now, we can calculate the time value using the call premium and our previous calculation:
Time value = option premium - intrinsic value
Time value = $3.60 - $1.00
Time value = $2.60
Diff: 2
Section: 6 Option Pricing
AACSB: Analytical Thinking
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15)
Refer to the table of ENCOM stock option prices provided above. Which of the following options are "inthe-money"?
I.
II.
III.
IV.
The $440 Call.
The $490 Call.
The $410 Put.
The $490 Put.
A) I and III
B) II and IV
C) II and III
D) I and IV
Answer: D
Explanation: D) An option is said to be in-the-money when it has positive intrinsic value.
Therefore, a call option is "in the money" when the strike price, X, is less than the current market price, S t.
A put option is "in the money" when the strike price is greater than the current market price.
The $440 Call is "in the money" because its strike price of $440 is less than the current market price. The
$490 put is "in the money" because its strike price of $490 is greater than the current market price.
Therefore, D is the correct answer.
Diff: 2
Section: 6 Option Pricing
AACSB: Analytical Thinking
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16)
The table above shows stock option prices on Goliath National Bank Class A shares for the November
18th maturity date. The top part of the table shows stock data for Goliath National Bank. What is the
intrinsic value of the Call option with the $190 strike price?
A) $0.00
B) $0.29
C) $11.01
D) $188.70
Answer: B
Explanation: B) The intrinsic value of an option is the payoff to the holder if it were to be exercised today:
Call Intrinsic Value = MAX (0, St - X)
Call Intrinsic Value = MAX (0, $190.29 - $190)
Call Intrinsic Value = MAX (0, $0.29)
Call Intrinsic Value = $0.29
Diff: 2
Section: 6 Option Pricing
AACSB: Analytical Thinking
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17)
The table above shows stock option prices on Goliath National Bank Class A shares for the November
18th maturity date. The top part of the table shows stock data for Goliath National Bank. What is the time
premium of the Put option with the $185 strike price?
A) $2.50
B) $4.71
C) $5.29
D) $10.00
Answer: D
Explanation: D) Time value = option premium - intrinsic value
First, we must calculate the intrinsic value of the put option:
Put Intrinsic Value = MAX (0, St - X)
Put Intrinsic Value = MAX (0, $185 - $190.29)
Put Intrinsic Value = MAX (0, -$5.29)
Put Intrinsic Value = $0
Now, we can calculate the time value using the information from the table and our previous calculation:
Time value = option premium - intrinsic value
Time value = $10 - $0
Time value = $10
The time premium is any value the option has beyond the intrinsic value.
Because this option is out of the money, the intrinsic value is 0. Therefore, the entire value of the option is
attributed to the time premium.
Diff: 2
Section: 6 Option Pricing
AACSB: Analytical Thinking
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18)
The table above shows stock option prices on Goliath National Bank Class A shares for the November
18th maturity date. The top part of the table shows stock data for Goliath National Bank. Which is a
TRUE statement about the Put option with the $180 strike price?
A) The Put option is 'in-the-money'
B) The Put option is 'at-the-money'
C) The Put option is 'out-of-the-money'
Answer: C
Explanation: C) An option is considered to be out-of-the-money when it has an intrinsic value of zero.
The intrinsic value of a put is given by:
Put Intrinsic Value = MAX (0, X - St)
Therefore, a put option is "out-of-the-money" when the current market price is greater than the strike
price.
The current market price of Google's stock ($190.29) is greater than the strike price on the put option
($180). Therefore the option is out-of-the-money.
Diff: 2
Section: 6 Option Pricing
AACSB: Analytical Thinking
Corporate Finance Online (McNally)
Chapter 20 M&A
LO1: Describe the Various Ways that Corporate Acquisitions Can Be Financed
1) An advantage associated with a cash tender offer is that
A) target shareholders will not have to pay any taxes due on the sale of their stock.
B) the premium being paid to acquire the target firm's stock can be easily illustrated to the target firm's
shareholders.
C) the acquiring firm should see a rise in its credit rating by spending its cash.
D) stockholders can be forced to turn in their stock in exchange for cash.
Answer: B
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Diff: 1
Section: 1
AACSB: Analytical Thinking
2) In a typical stock exchange acquisition, the exchange ratio
A) determines how much cash will be paid for each share of the target firm's stock.
B) equals the market capitalization of the acquiring firm in relation to that of the target firm.
C) equals the number of shares offered by the acquiring firm in exchange for shares in the target firm.
D) is used to calculate the tax liability of target stockholders if they decide to sell their shares.
Answer: C
Diff: 1
Section: 1
AACSB: Analytical Thinking
3) A disadvantage of a stock tender offer is that
A) changes in the stock price of the acquiring firm could lead target shareholders to question the fairness
of the exchange ratio.
B) it imposes an immediate tax liability on the stockholders in the target company.
C) the financial flexibility of the acquiring firm is greatly reduced.
D) it allows stockholders to avoid any immediate tax consequences.
Answer: A
Diff: 1
Section: 1
AACSB: Analytical Thinking
4) A merger is best defined as
A) a hostile takeover of one firm by another through the acquisition of a controlling interest of common
stock.
B) the acquisition of one firm's shares by another firm, at a premium in relation to current market prices.
C) a partnership between two competing firms with the intent to achieve a common objective.
D) the acquisition of one firm by another, where the acquired firm ceases to exist.
Answer: D
Diff: 1
Section: 1 Introduction
AACSB: Analytical Thinking
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5) An Acquisition has occurred when
A) a company gains control over another company with or without the approval of the company being
acquired.
B) a company gains control over another company without any change in stock ownership.
C) a firm attempts to repurchase a majority of its own common stock on the open market.
D) a majority of board seats are purchased on the open market.
Answer: A
Diff: 1
Section: 1 Introduction
AACSB: Analytical Thinking
6) In a hostile takeover
A) one firm acquires another firm with the agreement of the management team of the firm being
acquired.
B) the purchase of one company by another leads to the dissolution of both companies and the formation
of a new company.
C) one firm acquires another firm in opposition to the desire of the acquired firm to remain independent.
D) a firm's assets are sold off to settle the claims of stakeholders in the event of bankruptcy.
Answer: C
Diff: 1
Section: 1 Introduction
AACSB: Analytical Thinking
7) Following an acquisition firms may pursue consolidation, in which
A) one firm offers to buy shares in another firm at an agreed upon price.
B) the Board of Directors for each firm collaborates to choose a new management team.
C) both firms cease to exist and a new one is created.
D) the divisions within the firm are merged such that fewer separate units emerge.
Answer: C
Diff: 1
Section: 1 Introduction
AACSB: Analytical Thinking
8) A tender offer
A) occurs when a firm makes an offer to buy shares in another firm, often at a discount.
B) occurs when a firm makes an offer to buy shares in another firm, often at a premium.
C) may be categorized as either friendly or hostile, depending on the reaction of a firm's creditors.
D) always results in the acquisition of one firm by another.
Answer: B
Diff: 1
Section: 1 Introduction
AACSB: Analytical Thinking
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9) Which of the following is NOT a label for a situation where all of the equity of a publicly listed firm is
purchased (the firm is delisted) and the purchase is financed largely by debt.
A) Leveraged Buyout
B) Management Buyout
C) Going Private
D) Tender Offer
Answer: D
Explanation: D) A tender offer. A management buyout is equivalent to a leveraged buyout but it is
initiated by management.
Diff: 1
Section: 1 Introduction
AACSB: Analytical Thinking
LO2: Discuss the Reasons Why Companies Merge or Expand Through Acquisitions
1) The concept of synergy can be defined as
A) the ability of a firm to make up for shortcomings through outsourcing.
B) a publicly traded company listing stock on multiple exchanges.
C) a firm's disposition of poorly performing business units.
D) the complementary nature of some firms that can result in greater value combined than the
summation of the value of the individual firms.
Answer: D
Diff: 1
Section: 2
AACSB: Analytical Thinking
2) Horizontal mergers involve
A) one firm acquiring another firm that operates in the same industry.
B) one firm acquiring another firm that operates in its supply chain.
C) a firm selling individual business units to other firms that operate in the same industry.
D) the consolidation of similar business units in a firm in order to streamline operations.
Answer: A
Diff: 1
Section: 2
AACSB: Analytical Thinking
3) An advantage of a vertical merger is
A) the elimination of a competitor.
B) a reliable supply of an element of production.
C) rapid expansion into new markets.
D) a reduction in tax liability.
Answer: B
Diff: 1
Section: 2
AACSB: Analytical Thinking
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4) Which of the following is not an incentive for companies to merge or expand through acquisitions?
A) To raise the company's interest coverage ratio by acquiring additional debt.
B) To take advantage of tax losses.
C) To capture synergies.
D) To reduce risk by diversification of the company revenue stream.
Answer: A
Diff: 1
Section: 2
AACSB: Analytical Thinking
5) Conglomerate mergers
A) that are primarily intended to increase size and diversification are often highly profitable for
shareholders.
B) ensure a reliable and steady supply of elements needed in production.
C) involve the acquisition of a firm that operates in a completely unrelated core business.
D) are designed to increase a firm's differentiation through the purchase of competing firms' common
stock.
Answer: C
Diff: 1
Section: 2
AACSB: Analytical Thinking
6) Which of the following would be an atypical method of making an acquisition?
A) Purchase of target company stock with cash.
B) Acquiring shares in a target company with shares of the acquiring company using a given exchange
ratio.
C) Purchase of target company debt with cash.
D) Acquiring shares in a target company with a combination of shares of the acquiring company and
cash.
Answer: C
Diff: 1
Section: 2
AACSB: Analytical Thinking
7) The Net Present Value of a merger can be expressed as
A) NPV = Benefit + Cost.
B) NPV = Synergy - Premium.
C) NPV = Benefit - Cost / (1 + r).
D) NPV = Synergy - Discount.
Answer: B
Diff: 1
Section: 2
AACSB: Analytical Thinking
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8) The NPV of a merger from the target firm's perspective is equal to the
A) premium.
B) yield to maturity.
C) discount rate.
D) value of synergies.
Answer: A
Diff: 1
Section: 2
AACSB: Analytical Thinking
9) The value an acquiring firm expects to gain can be quantified as
A) the sum of a target firm's synergies and post-merger free cash flows.
B) the sum of a target firm's pre-merger free cash flows and synergies.
C) the total assets of the target firm as of the most recent balance sheet date.
D) the premium paid plus synergies.
Answer: B
Diff: 1
Section: 2
AACSB: Analytical Thinking
10) The value of synergies is equal to
A) the future value of incremental cash flows that result from a merger.
B) the sum of each firm's market capitalization.
C) the present value of incremental cash flows that result from a merger.
D) the increase in marginal tax rate resulting from a merger.
Answer: C
Diff: 1
Section: 2
AACSB: Analytical Thinking
11) In an all cash acquisition, the cost to the acquiring firm is equal to
A) the cash value of the target firm's total assets.
B) the book value of the target firm's total assets.
C) the future value of the target firm's free cash flows.
D) the cash price offered per share times the number of shares outstanding.
Answer: D
Diff: 1
Section: 2
AACSB: Analytical Thinking
12) Following a successful cash offer, the value of the resulting merger can be expressed as
A) VT + A = VT + VA+ S - Cost.
B) VT + A = VT + VA - S + Cost.
C) VT + A = VT + VA - Cost.
D) VT + A = VT + VA.
Answer: A
Diff: 2
Section: 2
AACSB: Analytical Thinking
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13) The value of a firm resulting from a stock offer acquisition is calculated in the same manner as that of
a cash offer, except
A) the cash value of shares provided by the acquiring firm is added to the total value.
B) the cash value of shares provided by the acquiring firm is subtracted from the total value.
C) the cash value of total shares of the target company is not subtracted, as cash is not paid in an all stock
merger.
D) There is no difference is the calculation.
Answer: C
Diff: 1
Section: 2
AACSB: Analytical Thinking
LO3: Evaluate an Acquisition
1) A share rights plan (SRP) may also be referred to as a
A) poison pill.
B) golden parachute.
C) white knight.
D) greenmail.
Answer: A
Diff: 1
Section: 3
AACSB: Analytical Thinking
2) The goal of a share rights plan is to
A) allow a firm's shareholders to diversify their investment portfolios.
B) increase a target firm's level of debt so as to make it an unattractive target for a takeover.
C) allow target company shareholders to exercise stock options at a substantial discount in the event of a
takeover.
D) illustrate an acquiring firms commitment to strong corporate governance.
Answer: C
Diff: 1
Section: 3
AACSB: Analytical Thinking
3) A Staggered Board refers to
A) a board of directors with backgrounds in numerous industries.
B) a board of directors in which only a portion of the board comes up for re-election each year.
C) a board of directors in which individual directors alternate voting rights each fiscal year.
D) a takeover defense that allows a board of directors to be quickly replaced in the event of a merger.
Answer: B
Diff: 1
Section: 3
AACSB: Analytical Thinking
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4) Greenmail refers to
A) a target company repurchasing as much of its outstanding common stock as possible via the open
market.
B) a target company repurchasing stock from potential bidders, normally at a substantial discount.
C) a target company repurchasing stock from potential bidders, normally at a substantial premium.
D) a generous severance package given to senior managers in the event of a takeover.
Answer: C
Diff: 1
Section: 3
AACSB: Analytical Thinking
5) Which of the following legally prevents a potential bidder from buying additional shares in a target
company?
A) A share rights plan.
B) A staggered Board.
C) A golden parachute.
D) A standstill agreement.
Answer: D
Diff: 1
Section: 3
AACSB: Analytical Thinking
6) A white knight may assist a firm under threat of a hostile takeover by
A) outbidding other potential bidders while remaining favorable to the incumbent management of the
target firm.
B) providing direct investment to facilitate a higher number of positive NPV projects.
C) shorting potential bidder's stock on the open market.
D) providing generous severance packages to senior managers of the target firm.
Answer: A
Diff: 1
Section: 3
AACSB: Analytical Thinking
7) You estimate that the company's free cash flows will be $74,000 per year for the next ten years and
$90,000 per year every year thereafter in perpetuity. The company is all equity financed and the cost of
equity is 9%. What is the stand-alone value of the target company?
A) $837,516
B) $897,318
C) $639,218
D) $748,542
Answer: B
Explanation: B) VT = $74,000 × PVIFA10,9% + V10 × PVIF10,9%
V10 = terminal value at year 10 = $90,000/0.09 = $1,000,000
VT = $74,000 × 6.417656 + $1,000,000 × 0.422411
VT = $897,318
Diff: 2
Section: 3
AACSB: Analytical Thinking
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8) Company A is thinking of acquiring Company B, a similar firm that boasts an industry leading sales
force. Estimated free cash flows for Company B are expected to be $1.3 million annually for the next 5
years, and $900,000 annually every year thereafter. If the appropriate discount rate is 12%, what is the
stand-alone value of the Company B?
A) $8,941,911
B) $4,794,209
C) $8,500,000
D) $10,756,843
Answer: A
Explanation: A) VT = $1,300,000 × PVIFA5,12% + V5 × PVIF5, 12%
V5 = terminal value at year 5 = $900,000/0.12 = $7,500,000
VT = $1,300,000 × 3.604776 + $7,500,000 × 0.567427
VT = $8,941,911
Diff: 3
Section: 3
AACSB: Analytical Thinking
9) Your company's superior management skills you estimate that you can generate additional free cash
flows of $27,000 per year for the first 5 years. After a careful analysis of their books you realize that the
company also has unused tax benefits with a present value of $80,000. If the cost of equity is 11%, what is
the present value of the synergies to the acquisition?
A) $19,789
B) $171,861
C) $179,789
D) $185,900
Answer: C
Explanation: C) S = $80,000 + $27,000 × PVIFA5, 11%
S = $80,000 + $27,000 × 3.695900
S = $179,789
Diff: 1
Section: 3
AACSB: Analytical Thinking
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10) You estimate that the company you wish to acquire is worth $614,586 on a standalone basis. Your
company plans to offer $6.25 per share to the target company shareholders. The total number of shares
outstanding currently equals 150,000. What is the offer premium?
A) $947,914
B) $539,004
C) $937,500
D) $322,914
Answer: D
Explanation: D) Cost = C × NT
Cost = $6.25 × 150,000
Cost = $937,500
Premium = Cost - VT
Premium = $937,500 - $614,586
Premium = $322,914
Diff: 2
Section: 3
AACSB: Analytical Thinking
11) You estimate that the company you wish to acquire is worth $614,586 on a standalone basis and that
synergies have a present value of $216,090. Your company plans to offer $6.25 per share to the target
company shareholders. The total number of shares outstanding currently equals 150,000. What is the
NPV of the offer to the acquirer?
A) $947,914
B) -$106,824
C) -$539,004
D) $322,914
Answer: B
Explanation: B) NPV = Benefit - Cost
NPV = (VT + S) - $937,500
NPV = ($614,586 + $216,090) - $937,500
NPV = -$106,824
Diff: 2
Section: 3
AACSB: Analytical Thinking
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12) The current value of all future free cash flows your company expects to earn in the future is
$1,115,000, and the current number of shares outstanding is 250,000. You estimate that the company you
wish to acquire is worth $614,586 on a standalone basis and that synergies have a present value of
$216,090. Your company plans to offer $6.25 per share to the target company shareholders. The total
number of shares outstanding currently equals 150,000. What is the stock price after the merger?
A) $4.03
B) $2.52
C) $6.72
D) $5.75
Answer: A
Explanation: A) PT + A = VT+ A / NA
VT + A = VT + VA + S - Cost
VT + A = $614,586 + $1,115,000 + $216,090 - $937,500
VT + A = $1,008,176
PT + A = $1,008,176 / 250,000
PT + A = $4.03
Diff: 3
Section: 3
AACSB: Analytical Thinking
13) The present value of all future free cash flows your firm expects to generate is $930,000. According to
your firm's research, the target company is valued at $750,000. The present value of synergies is $190,450.
What is the value of the combined firm?
A) $1,680,000
B) $1,870,450
C) $1,489,550
D) $1,900,450
Answer: B
Explanation: B) VT + A = VA + VT + S
VT + A = $930,000 + $750,000 + $190,450
VT + A = $1,870,450
Diff: 1
Section: 3
AACSB: Analytical Thinking
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14) The present value of all future free cash flows your firm expects to generate is $930,000. Your firm
currently has 120,000 shares of stock outstanding, at a price of $12.50 per share. According to your firm's
research, the target company is valued at $750,000, has 80,000 shares of stock outstanding, and has a
current share price of $5.50. The exchange ratio for this transaction is 2:3. The present value of synergies
is $190,450. What is the new share price resulting from the merger?
A) $9.35
B) $15.59
C) $23.38
D) $10.79
Answer: D
Explanation: D) VT + A = VA + VT + S
VT + A = $930,000 + $750,000 + $190,450
VT + A = $1,870,450
PT + A = VT+A / (NA + NSE)
PT + A = $1,870,450 / (120,000 + 53,333)
53,333 = 80,000 * 2/3
PT + A = $10.79
Diff: 3
Section: 3
AACSB: Analytical Thinking
15) The new share price resulting from the merger is $11.00. According to your firm's research, the target
company is valued at $850,000, has 80,000 shares of stock outstanding, and has a current share price of
$5.50. The exchange ratio for this transaction is 2:3. The present value of synergies is $230,450. What is
the NPV of the offer to the acquirer?
A) $493,787
B) $512,430
C) -$354,976
D) $437,450
Answer: A
Explanation: A) NPV = Benefit - Cost
Benefit = VT + S
Benefit = $850,000 + $230,450
Benefit = $1,080,450
Cost = PT + A × NSE
Cost = $11.00 × 53,333
Cost = $586,663
NPV = $1,080,450 - 586,663
NPV = $493,787
Diff: 3
Section: 3
AACSB: Analytical Thinking
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16) Your firm is currently valued at $500,000. The firm you are looking to acquire has a value of $200,000,
has 25,000 shares of stock outstanding. In order to make this acquisition you plan to offer target
shareholders $8.25 per share. The present value of synergies is $36,000. What is the value of the
combined firm?
A) $493,750
B) $876,432
C) $529,750
D) $578,050
Answer: C
Explanation: C) VT + A = VA + VT + S - C × NT
VT + A = $500,000 + $200,000 + $36,000 - $8.25 × 25,000
VT + A = $529,750
Diff: 2
Section: 3
AACSB: Analytical Thinking
17) Your firm is currently valued at $500,000, has 100,000 shares of stock outstanding, with a share price
of $11.25. The firm you are looking to acquire has a value of $200,000, has 25,000 shares of stock
outstanding, with a share price of $7.00. In order to make this acquisition you plan to offer target
shareholders $8.25 per share, and shares in the newly merged company using an exchange ratio of 3:4.
The present value of synergies is $36,000. What is the new share price resulting from the merger?
A) $4.46
B) $13.55
C) $10.83
D) $6.45
Answer: A
Explanation: A) PT + A = VT+A / (NA + NSE)
PT + A = $529,750 / (100,000 + 18,750)
18,750 = 25,000 * 3/4
PT + A = $4.46
Diff: 2
Section: 3
AACSB: Analytical Thinking
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18) The share price resulting from the merger is $5.50. The firm you are looking to acquire has a value of
$200,000, has 25,000 shares of stock outstanding, with a share price of $7.00. In order to make this
acquisition you plan to offer target shareholders $8.25 per share, and shares in the newly merged
company using an exchange ratio of 3:4. The present value of synergies is $36,000. What is the NPV of
the offer to the acquirer?
A) $32,080
B) -$47,375
C) -$27,050
D) $84,50
Answer: B
Explanation: B) NPV = Benefit - Cost
Benefit = VT + S
Benefit =$200,000 + $36,000
Benefit = $ = $236,000
Cost = C × NT + PT+A × NSE
Cost = $8.25 × 25,000 + $5.50 × 18,750
Cost = $309,375
NPV = $$236,000 - $309,375
NPV = -$ = -$73,375
Diff: 3
Section: 3
AACSB: Analytical Thinking
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19) Rimmer Robotics Inc. is contemplating the acquisition of Kryten Androids. Information for the two
companies is given in the table below. Rimmer Robotics estimates that by combining the two companies,
it will reduce marketing and administrative costs by $1,000,000 per year in perpetuity. The synergies have
a present value of $8.333 million. What is the NPV from the acquisition to Rimmer shareholders if
Rimmer offers Kryten shareholders $9.50 of cash per share?
Value of Debt
Market Value of Firm, VU
Shares Outstanding
Stock Price
Rimmer
Robotics
$0
Kryten
Androids
$0
$30M
1M
$30
$15M
2M
$7.50
A) $2.55M
B) $4.33M
C) $6.00M
D) $8.33M
E) $15M
Answer: B
Explanation: B) NPV = benefit - cost
Benefit = the value of Kryten + synergies
Cost = total cost of cash offer
NPV = $7.50 * 2M + $8.333 - $9.50 * $2M
NPV = $23.33 - 19 = 4.33
Diff: 2
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
759
Copyright © 2015 Pearson Canada, Inc.
20) Rimmer Robotics Inc. is contemplating the acquisition of Kryten Androids. Information for the two
companies is given in the table below. Rimmer Robotics estimates that by combining the two companies,
it will reduce marketing and administrative costs by $1,000,000 per year in perpetuity. The synergies have
a present value of $8.333 million. What is the stock price for Rimmer after the acquisition if Rimmer offers
Kryten shareholders $9.50 of cash per share?
Value of Debt
Market Value of Firm, VU
Shares Outstanding
Stock Price
Rimmer
Robotics
$0
Kryten
Androids
$0
$30M
1M
$30
$15M
2M
$7.50
A) $11.67
B) $23.33
C) $28.90
D) $30.00
E) $34.33
Answer: E
Explanation: E) VM = VT + VA + Synergies - Cash Offer
P = VM/#Shares of Rimmer
VM = $15M + $30M + $8.33 - 19 = 34.33
P = 34.33/1 = 34.33
Diff: 3
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
760
Copyright © 2015 Pearson Canada, Inc.
21) Rimmer Robotics Inc. is contemplating the acquisition of Kryten Androids. Information for the two
companies is given in the table below. Rimmer Robotics estimates that by combining the two companies,
it will reduce marketing and administrative costs by $1,000,000 per year in perpetuity. The synergies have
a present value of $8.333 million. How many shares will be outstanding after the offer if Rimmer offers
Kryten shareholders 0.333 shares in the merged firm for each of their Kryten shares?
Value of Debt
Market Value of Firm, VU
Shares Outstanding
Stock Price
Rimmer
Robotics
$0
Kryten
Androids
$0
$30M
1M
$30
$15M
2M
$7.50
A) 1M
B) 1.667M
C) 2M
D) 3M
E) 3.333M
Answer: B
Explanation: B) Total = 1M + 0.33 * 2M
Total = 1 + 0.667 = 1.667
Diff: 2
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
761
Copyright © 2015 Pearson Canada, Inc.
22) Rimmer Robotics Inc. is contemplating the acquisition of Kryten Androids. Information for the two
companies is given in the table below. Rimmer Robotics estimates that by combining the two companies,
it will reduce marketing and administrative costs by $1,000,000 per year in perpetuity. The synergies have
a present value of $8.333 million. What is the NPV from the acquisition to Rimmer shareholders if
Rimmer offers Kryten shareholders 0.333 shares in the merged firm for each of their Kryten shares?
Value of Debt
Market Value of Firm, VU
Shares Outstanding
Stock Price
Rimmer
Robotics
$0
Kryten
Androids
$0
$30M
1M
$30
$15M
2M
$7.50
A) $2M
B) $3M
C) $4.33M
D) $5.33M
E) $7M
Answer: A
Explanation: A) NPV = benefit - cost
Benefit = value of target firm + synergies = $7.50 * 2M + $8.333 = $23.33
Cost = share of merged firm owned by Kryten * VM
VM = VT + VA + Synergies = $15M + $30M + $8.33 = 53.33
share of merged firm owned by Kryten = 0.667/1.667 = 0.4
Cost = 0.4 * (23.33 + 30) = 21.33
NPV = $23.33 - 21.33 = 2
Diff: 2
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
762
Copyright © 2015 Pearson Canada, Inc.
23) Rimmer Robotics Inc. is contemplating the acquisition of Kryten Androids. Information for the two
companies is given in the table below. Rimmer Robotics estimates that by combining the two companies,
it will reduce marketing and administrative costs by $1,000,000 per year in perpetuity. The synergies have
a present value of $8.333 million. What is the stock price for Rimmer after the acquisition if Rimmer offers
Kryten shareholders 0.333 shares in the merged firm for each of their Kryten shares?
Value of Debt
Market Value of Firm, VU
Shares Outstanding
Stock Price
Rimmer
Robotics
$0
Kryten
Androids
$0
$30M
1M
$30
$15M
2M
$7.50
A) $30
B) $31
C) $32
D) $33
E) $34
Answer: C
Explanation: C) VM = VT + VA + Synergies = $15M + $30M + $8.33 = 53.33
P = 53.33/1.66667 = $32
Diff: 2
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
763
Copyright © 2015 Pearson Canada, Inc.
24) Rimmer Robotics Inc. is contemplating the acquisition of Kryten Androids. Information for the two
companies is given in the table below. Rimmer Robotics estimates that by combining the two companies,
it will reduce marketing and administrative costs by $1,000,000 per year in perpetuity. The synergies have
a present value of $8.333 million. What is the NPV from the acquisition to Rimmer shareholders if
Rimmer offers Kryten shareholders $6.26 per share and 0.18 shares in the merged firm for each of their
Kryten shares?
Value of Debt
Market Value of Firm, VU
Shares Outstanding
Stock Price
Rimmer
Robotics
$0
Kryten
Androids
$0
$30M
1M
$30
$15M
2M
$7.50
A) $0
B) $0.5M
C) $1,0M
D) $1.5M
E) $2.0M
Answer: A
Explanation: A) NPV = benefit - cost
Benefit = value of target firm + synergies = $7.50 * 2M + $8.333 = $23.33
Cost = PT × NK + share of merged firm owned by Kryten * VM
VM = VT + VA + Synergies - PT × NK
VM = $15M + $30M + $8.333 - 6.26 × 1M = 40.81333
Shares of merged firm owned by Kryten = 0.18 × 2M = 0.36
Share owned by Kryten = 0.36/1.36 = 0.2647
Cost = 6.26 × 1M + 0.2647 × 40.8133 = 23.324
NPV = $23.33 - 23.33 = 0
Diff: 3
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
764
Copyright © 2015 Pearson Canada, Inc.
25) Apple Inc. is contemplating the acquisition of Blackberry Ltd. Information for the two companies is
given in the table below. Blackberry has many patents that would be valuable to Apple. Apple executives
estimate that the acquisition would unlock $5.5 billion of additional value. What is the NPV from the
acquisition to Apple shareholders if Apple offers Blackberry shareholders $17 of cash per share?
Apple
$0
Value of Debt
Market Value of Firm, VU ($B) $500
Shares Outstanding
860M
Stock Price
$581
Blackberry
$0
$4
500M
$8.00
A) $0.50B
B) $0.75B
C) $0.77B
D) $0.83B
E) $1.00B
Answer: E
Explanation: E) NPV = benefit - cost
Benefit = the value of Blackberry + synergies
Cost = total cost of cash offer
NPV = $4 + $5.5 - $17 * $500M
NPV = $9.5 - 8.5 = $1 billion
Diff: 2
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
765
Copyright © 2015 Pearson Canada, Inc.
26) Apple Inc. is contemplating the acquisition of Blackberry Ltd. Information for the two companies is
given in the table below. Blackberry has many patents that would be valuable to Apple. Apple executives
estimate that the acquisition would unlock $5.5 billion of additional value. Use this information to answer
the question that follows.
Apple
$0
Value of Debt
Market Value of Firm, VU ($B) $500
Shares Outstanding
860M
Stock Price
$581
Blackberry
$0
$4
500M
$8.00
What is the NPV from the acquisition to Apple shareholders if Apple offers Blackberry shareholders 0.03
shares in the merged firm for each of their Blackberry shares?
A) $0.50B
B) $0.75B
C) $0.77B
D) $0.83B
E) $1.00B
Answer: C
Explanation: C) NPV = benefit - cost
Benefit = value of target firm + synergies = $4B + $5.5 = $9.5
Cost = share of merged firm owned by Blackberry × VM
VM = VT + VA + Synergies = $4B + $500B + $5.5 = $509.5B
share of VM owned by Blackberry = (0.03 × 500)/(0.03 × 500+860) = 0.0171
Cost = 0.0171429 × 509.5 = 8.73
NPV = $9.50 - 8.73 = 0.77
Diff: 3
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
766
Copyright © 2015 Pearson Canada, Inc.
27) Apple Inc. is contemplating the acquisition of Blackberry Ltd. Information for the two companies is
given in the table below. Blackberry has many patents that would be valuable to Apple. Apple executives
estimate that the acquisition would unlock $5.5 billion of additional value. Use this information to answer
the question that follows.
Apple
$0
Value of Debt
Market Value of Firm, VU ($B) $500
Shares Outstanding
860M
Stock Price
$581
Blackberry
$0
$4
500M
$8.00
What is the NPV from the acquisition to Apple shareholders if Apple offers Blackberry shareholders $5.70
per share and 0.02 shares in the merged firm for each of their Blackberry shares?
A) $0.50B
B) $0.75B
C) $0.77B
D) $0.83B
E) $1.00B
Answer: D
Explanation: D) NPV = benefit - cost
Benefit = value of target firm + synergies = $4B + $5.5 = $9.5
Cost = PT × NK + share of merged firm owned by target × VM
VM = VT + VA + Synergies - PT × NK
VM = VT + VA + Synergies = $4B + $500B + $5.5 = $509.5B
share of VM owned by Blackberry = (0.02 × 500)/(0.02 × 500+860) = 0.01149
Cost = 7.7 × 500M + 0.0114943 × 509.50 = 8.67
NPV = $9.50 - 8.67 = 0.83
Diff: 3
Section: 3 Evaluating Acquisitions
AACSB: Analytical Thinking
767
Copyright © 2015 Pearson Canada, Inc.
LO4: Define Merger and Acquisition Terminology
1) The rights allocated to target company shareholders by the target company to thwart a hostile takeover
offer are called
A) Poison Pills.
B) Shark Repellant.
C) Pac Man Defense.
D) White Knight Rights.
Answer: A
Explanation: A) Poison pills.
Diff: 1
Section: 4 Defensive Tactics
AACSB: Analytical Thinking
2) Payments to a target firm's managers who leave after a takeover are called
A) stock options.
B) greenmail.
C) golden parachute.
D) severance.
Answer: C
Explanation: C) Golden parachute.
Diff: 1
Section: 4 Defensive Tactics
AACSB: Analytical Thinking
3) The term for a buy-out by the target firm of shareholders threatening to takeover a firm. The buy-out
price typically exceeds the prevailing market price.
A) Pac Man defense
B) Tender offer
C) Greenmail
D) Repurchase
Answer: C
Explanation: C) Greenmail.
Diff: 1
Section: 4 Defensive Tactics
AACSB: Analytical Thinking
768
Copyright © 2015 Pearson Canada, Inc.
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