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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 4 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 7 Copyright © 2015 Pearson Canada, Inc. 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 8 Copyright © 2015 Pearson Canada, Inc. 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 9 Copyright © 2015 Pearson Canada, Inc. 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 10 Copyright © 2015 Pearson Canada, Inc. 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 11 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 13 Copyright © 2015 Pearson Canada, Inc. 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 14 Copyright © 2015 Pearson Canada, Inc. 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 15 Copyright © 2015 Pearson Canada, Inc. 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 16 Copyright © 2015 Pearson Canada, Inc. 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 17 Copyright © 2015 Pearson Canada, Inc. 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 18 Copyright © 2015 Pearson Canada, Inc. 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 19 Copyright © 2015 Pearson Canada, Inc. 20 Copyright © 2015 Pearson Canada, Inc. 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 39 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 43 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 46 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 48 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 49 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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. 54 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 56 Copyright © 2015 Pearson Canada, Inc. 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 57 Copyright © 2015 Pearson Canada, Inc. 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 58 Copyright © 2015 Pearson Canada, Inc. 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 59 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 60 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 61 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 62 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 63 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 64 Copyright © 2015 Pearson Canada, Inc. 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 65 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 66 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 67 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 68 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 69 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 70 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 71 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 72 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 73 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 74 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 75 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 76 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 77 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 78 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 79 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 80 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 81 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 82 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 83 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 84 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 85 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 86 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 87 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 88 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 89 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 90 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 91 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 92 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 93 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 94 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 95 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 96 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 97 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 98 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 99 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 100 Copyright © 2015 Pearson Canada, Inc. 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: 3.4 101 Copyright © 2015 Pearson Canada, Inc. 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. 102 Copyright © 2015 Pearson Canada, Inc. 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 103 Copyright © 2015 Pearson Canada, Inc. 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 104 Copyright © 2015 Pearson Canada, Inc. 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 105 Copyright © 2015 Pearson Canada, Inc. 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 106 Copyright © 2015 Pearson Canada, Inc. 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 107 Copyright © 2015 Pearson Canada, Inc. 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 108 Copyright © 2015 Pearson Canada, Inc. 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 109 Copyright © 2015 Pearson Canada, Inc. 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 110 Copyright © 2015 Pearson Canada, Inc. 1) There are no questions in this section. AACSB: Analytical Thinking 111 Copyright © 2015 Pearson Canada, Inc. 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 112 Copyright © 2015 Pearson Canada, Inc. 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 113 Copyright © 2015 Pearson Canada, Inc. 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 114 Copyright © 2015 Pearson Canada, Inc. 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 115 Copyright © 2015 Pearson Canada, Inc. 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 116 Copyright © 2015 Pearson Canada, Inc. 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 117 Copyright © 2015 Pearson Canada, Inc. 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 118 Copyright © 2015 Pearson Canada, Inc. 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 119 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 120 Copyright © 2015 Pearson Canada, Inc. 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 121 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 122 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 123 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 124 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 125 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 126 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 127 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 128 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 129 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 130 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 131 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 132 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 133 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 134 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 135 Copyright © 2015 Pearson Canada, Inc. 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. 136 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 137 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 138 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 139 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 140 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 141 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 142 Copyright © 2015 Pearson Canada, Inc. 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: 2.1 143 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 2.3 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 Section: 2.3 AACSB: Analytical Thinking 144 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2.3 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 Section: 2.3 AACSB: Analytical Thinking 145 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2.3 AACSB: Analytical Thinking 146 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.2 AACSB: Analytical Thinking 147 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 148 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 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 Section: 3.2 AACSB: Analytical Thinking 149 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 150 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 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 Section: 3.2 AACSB: Analytical Thinking 151 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 152 Copyright © 2015 Pearson Canada, Inc. 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 Section: 4.1 AACSB: Analytical Thinking 153 Copyright © 2015 Pearson Canada, Inc. 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 Section: 4 AACSB: Analytical Thinking 154 Copyright © 2015 Pearson Canada, Inc. 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 Section: 4.1 AACSB: Analytical Thinking 155 Copyright © 2015 Pearson Canada, Inc. 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 Section: 4.1 AACSB: Analytical Thinking 156 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 157 Copyright © 2015 Pearson Canada, Inc. 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. 158 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.1 AACSB: Analytical Thinking 159 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1 AACSB: Analytical Thinking 160 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.1 AACSB: Analytical Thinking 161 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.1 AACSB: Analytical Thinking 162 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.1 AACSB: Analytical Thinking 163 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 1.1 AACSB: Analytical Thinking 164 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.1 AACSB: Analytical Thinking 165 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.1 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 Section: 1.1 AACSB: Analytical Thinking 166 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.1 AACSB: Analytical Thinking 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 Section: 1.2 AACSB: Analytical Thinking 167 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.2 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 Section: 1.2 AACSB: Analytical Thinking 168 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.2 AACSB: Analytical Thinking 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 Section: 1.2 AACSB: Analytical Thinking 169 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.2 AACSB: Analytical Thinking 170 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.3 AACSB: Analytical Thinking 171 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.3 AACSB: Analytical Thinking 172 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1.3 AACSB: Analytical Thinking 173 Copyright © 2015 Pearson Canada, Inc. = 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 Section: 1.3 AACSB: Analytical Thinking 174 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 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 Section: 1.3 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 Section: 1.3 175 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 176 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 177 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 178 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 179 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 180 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 181 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 182 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 183 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 2.3 AACSB: Analytical Thinking 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 Diff: 2 Section: 2.3 AACSB: Analytical Thinking 184 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 2 Section: 2.3 AACSB: Analytical Thinking 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 Section: 2.3 AACSB: Analytical Thinking 185 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2.3 AACSB: Analytical Thinking 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 Diff: 2 Section: 2.3 AACSB: Analytical Thinking 186 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 2.3 AACSB: Analytical Thinking 187 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2.3 AACSB: Analytical Thinking 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 Diff: 2 Section: 2.3 AACSB: Analytical Thinking 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 Section: 2.3 188 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 2.3 AACSB: Analytical Thinking 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. Diff: 1 Section: 2.3 AACSB: Analytical Thinking 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. Diff: 1 Section: 2.3 AACSB: Analytical Thinking 189 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2.3 AACSB: Analytical Thinking 190 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 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 Section: 3.1 AACSB: Analytical Thinking 191 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 192 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 193 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 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 Diff: 2 Section: 3.1 AACSB: Analytical Thinking 194 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.1 AACSB: Analytical Thinking 195 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.1 AACSB: Analytical Thinking 196 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.1 AACSB: Analytical Thinking 197 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.1 AACSB: Analytical Thinking 198 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 199 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 200 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 201 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 202 Copyright © 2015 Pearson Canada, Inc. 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% Diff: 2 Section: 3.2 AACSB: Analytical Thinking 203 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 2 Section: 3.2 AACSB: Analytical Thinking 204 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 3 Section: 3.2 AACSB: Analytical Thinking 205 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 206 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 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 Section: 3.3 AACSB: Analytical Thinking 207 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 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 Section: 3.3 208 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 3.3 AACSB: Analytical Thinking 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 Diff: 2 Section: 3.3 AACSB: Analytical Thinking 209 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 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 Diff: 2 Section: 3.3 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.3 AACSB: Analytical Thinking 210 Copyright © 2015 Pearson Canada, Inc. 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% Diff: 3 Section: 3.3 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.3 AACSB: Analytical Thinking 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: 2 211 Copyright © 2015 Pearson Canada, Inc. Section: 3.3 AACSB: Analytical Thinking 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% Diff: 3 Section: 3.3 AACSB: Analytical Thinking 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% Diff: 2 Section: 3.3 AACSB: Analytical Thinking 212 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 213 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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. Diff: 3 Section: 3.3 AACSB: Analytical Thinking 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. Diff: 2 Section: 3.3 AACSB: Analytical Thinking 214 Copyright © 2015 Pearson Canada, Inc. 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% Diff: 2 Section: 3.3 AACSB: Analytical Thinking 215 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 216 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 217 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 218 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 219 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 220 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 221 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 222 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 223 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 224 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 225 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 226 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 227 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 228 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.3 AACSB: Analytical Thinking 229 Copyright © 2015 Pearson Canada, Inc. 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 $1,000. The yield curve derived from the bond prices in the table below is best described as Term (years) Price ($) 230 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 231 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 232 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 233 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 234 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 235 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 236 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 237 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 238 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 239 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 240 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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% Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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% Diff: 2 241 Copyright © 2015 Pearson Canada, Inc. 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% Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 242 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 243 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 1 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 244 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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 Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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 Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 245 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 246 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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. Diff: 2 Section: 2 Zero Coupon Bond Yields and Pricing AACSB: Analytical Thinking 247 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3 Coupon Bond Features and Markets 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. Diff: 2 Section: 3 Coupon Bond Features and Markets 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 Section: 3 Coupon Bond Features and Markets AACSB: Analytical Thinking 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). Diff: 1 Section: 3 Coupon Bond Features and Markets AACSB: Analytical Thinking 248 Copyright © 2015 Pearson Canada, Inc. 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). Diff: 1 Section: 3 Coupon Bond Features and Markets 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 Section: 3 Coupon Bond Features and Markets 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. Diff: 1 Section: 3 Coupon Bond Features and Markets AACSB: Analytical Thinking 249 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 1 Section: 3 Coupon Bond Features and Markets 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. Diff: 2 Section: 3 Coupon Bond Features and Markets AACSB: Analytical Thinking 250 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 4 Coupon Bond Yields and Pricing 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 Diff: 3 Section: 4 Coupon Bond Yields and Pricing AACSB: Analytical Thinking 251 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 4 Section: 4 Coupon Bond Yields and Pricing AACSB: Analytical Thinking 252 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 4 Section: 4 Coupon Bond Yields and Pricing AACSB: Analytical Thinking 253 Copyright © 2015 Pearson Canada, Inc. 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 Section: 4 Coupon Bond Yields and Pricing AACSB: Analytical Thinking 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 Section: 4 Coupon Bond Yields and Pricing 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 Section: 4 Coupon Bond Yields and Pricing 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. Diff: 3 Section: 4 Coupon Bond Yields and Pricing 254 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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. Diff: 2 Section: 5 Coupon Bond Price Properties AACSB: Analytical Thinking 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. Diff: 2 Section: 5 Coupon Bond Price Properties 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. Diff: 2 Section: 5 Coupon Bond Price Properties AACSB: Analytical Thinking 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. 255 Copyright © 2015 Pearson Canada, Inc. Diff: 2 Section: 5 Coupon Bond Price Properties AACSB: Analytical Thinking 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. Diff: 2 Section: 5 Coupon Bond Price Properties AACSB: Analytical Thinking 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 Section: 5 Coupon Bond Price Properties 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. Diff: 2 Section: 5 Coupon Bond Price Properties AACSB: Analytical Thinking 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. Diff: 2 Section: 5 Coupon Bond Price Properties AACSB: Analytical Thinking 256 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 2 Section: 5 Coupon Bond Price Properties 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 Section: 5 Coupon Bond Price Properties 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 257 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Price Earnings Valuation Method AACSB: Analytical Thinking 258 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Price Earnings Valuation Method AACSB: Analytical Thinking 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 Section: 3.2 Price Earnings Valuation Method AACSB: Analytical Thinking 259 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Price Earnings Valuation Method AACSB: Analytical Thinking 260 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Price Earnings Valuation Method AACSB: Analytical Thinking 261 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Price Earnings Valuation Method AACSB: Analytical Thinking 262 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Price Earnings Valuation Method AACSB: Analytical Thinking 263 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Stock Repurchases and the Total Payout Model AACSB: Analytical Thinking 264 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Stock Repurchases and the Total Payout Model AACSB: Analytical Thinking 265 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Stock Repurchases and the Total Payout Model AACSB: Analytical Thinking 266 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Stock Repurchases and the Total Payout Model AACSB: Analytical Thinking 267 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Stock Repurchases and the Total Payout Model AACSB: Analytical Thinking 268 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 Stock Repurchases and the Total Payout Model AACSB: Analytical Thinking 269 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 270 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 Market-to-Book Valuation Method AACSB: Analytical Thinking 271 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 Market-to-Book Valuation Method AACSB: Analytical Thinking 272 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 Market-to-Book Valuation Method AACSB: Analytical Thinking 273 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 Market-to-Book Valuation Method AACSB: Analytical Thinking 274 Copyright © 2015 Pearson Canada, Inc. 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. AACSB: Analytical Thinking LO2: Define the Steps in the Capital Budgeting Process 275 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 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: 1 276 Copyright © 2015 Pearson Canada, Inc. Section: 2 AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 277 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 278 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 279 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 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. Diff: 1 Section: 3.2 AACSB: Analytical Thinking 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 280 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 2 Section: 3.2 AACSB: Analytical Thinking 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 281 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 282 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 283 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 2 Section: 3.2 AACSB: Analytical Thinking 284 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 285 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 286 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 2 Section: 3.2 AACSB: Analytical Thinking 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 Diff: 2 Section: 3.2 AACSB: Analytical Thinking 287 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 2 Section: 3.2 AACSB: Analytical Thinking 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. Diff: 3 Section: 3.2 AACSB: Analytical Thinking 288 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.2 AACSB: Analytical Thinking 289 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 290 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.2 AACSB: Analytical Thinking 291 Copyright © 2015 Pearson Canada, Inc. 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. Diff: 3 Section: 3.1 AACSB: Analytical Thinking 292 Copyright © 2015 Pearson Canada, Inc. 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 Diff: 3 Section: 3.1 AACSB: Analytical Thinking 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 Diff: 3 Section: 3.1 AACSB: Analytical Thinking 293 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 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 Section: 3.1 AACSB: Analytical Thinking 294 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.1 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 Section: 3.1 295 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 3.1 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 Section: 3.1 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 Section: 3.1 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 Section: 3.1 296 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 297 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.1 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 Section: 3.1 298 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 3.1 AACSB: Analytical Thinking 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 Section: 3.4 AACSB: Analytical Thinking 299 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 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 Section: 3.4 AACSB: Analytical Thinking 300 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 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 Section: 3.4 AACSB: Analytical Thinking 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 Section: 3.4 301 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 3.4 AACSB: Analytical Thinking 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 Section: 3.4 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 Section: 3.4 AACSB: Analytical Thinking 302 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 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 Section: 3.4 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 Section: 3.4 AACSB: Analytical Thinking 303 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 AACSB: Analytical Thinking 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 Section: 3.4 AACSB: Analytical Thinking 304 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 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 Section: 3.4 AACSB: Analytical Thinking 305 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 AACSB: Analytical Thinking 306 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 AACSB: Analytical Thinking 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 Section: 3.4 AACSB: Analytical Thinking 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 Section: 3.4 AACSB: Analytical Thinking 307 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.4 AACSB: Analytical Thinking 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 Section: 3.4 AACSB: Analytical Thinking 308 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.5 AACSB: Analytical Thinking 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 Section: 3.5 AACSB: Analytical Thinking 309 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3.5 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 310 Copyright © 2015 Pearson Canada, Inc. 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 311 Copyright © 2015 Pearson Canada, Inc. 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 312 Copyright © 2015 Pearson Canada, Inc. 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 313 Copyright © 2015 Pearson Canada, Inc. 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 314 Copyright © 2015 Pearson Canada, Inc. 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 315 Copyright © 2015 Pearson Canada, Inc. 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. 316 Copyright © 2015 Pearson Canada, Inc. 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 = -$7,171 317 Copyright © 2015 Pearson Canada, Inc. Diff: 2 Section: 1.3 Tax Impact of Salvage AACSB: Analytical Thinking 318 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 319 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 320 Copyright © 2015 Pearson Canada, Inc. 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 321 Copyright © 2015 Pearson Canada, Inc. 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 322 Copyright © 2015 Pearson Canada, Inc. 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 323 Copyright © 2015 Pearson Canada, Inc. 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 324 Copyright © 2015 Pearson Canada, Inc. 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 325 Copyright © 2015 Pearson Canada, Inc. 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 326 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 327 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 328 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 329 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 330 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 331 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 332 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 333 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 334 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 335 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 336 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 337 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 338 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 339 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 340 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 344 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 345 Copyright © 2015 Pearson Canada, Inc. 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 346 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 = $353,250 348 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 $410,000 350 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 $335,600 353 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 359 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 + + = âˆ†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 362 Copyright © 2015 Pearson Canada, Inc. 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 363 Copyright © 2015 Pearson Canada, Inc. 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 $26,775 364 Copyright © 2015 Pearson Canada, Inc. 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 365 Copyright © 2015 Pearson Canada, Inc. 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 + + = âˆ†Net Salvage Decrease in Net Working Capital Terminal cash flow $100,080 $5,000 $105,080 366 Copyright © 2015 Pearson Canada, Inc. 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 367 Copyright © 2015 Pearson Canada, Inc. 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 + + = âˆ†Net Salvage Decrease in Net Working Capital Terminal cash flow $72,000 $0 $72,000 368 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 + + = âˆ†Net Salvage Decrease in Net Working Capital Terminal cash flow $72,000 $0 $72,000 370 Copyright © 2015 Pearson Canada, Inc. 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 371 Copyright © 2015 Pearson Canada, Inc. 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 372 Copyright © 2015 Pearson Canada, Inc. 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 373 Copyright © 2015 Pearson Canada, Inc. 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 374 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 = 0.532 376 Copyright © 2015 Pearson Canada, Inc. 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 377 Copyright © 2015 Pearson Canada, Inc. 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 378 Copyright © 2015 Pearson Canada, Inc. 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 379 Copyright © 2015 Pearson Canada, Inc. 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 380 Copyright © 2015 Pearson Canada, Inc. 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 381 Copyright © 2015 Pearson Canada, Inc. 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 382 Copyright © 2015 Pearson Canada, Inc. 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 383 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 398 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 399 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 AACSB: Analytical Thinking 402 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 403 Copyright © 2015 Pearson Canada, Inc. 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: 2.1 404 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 405 Copyright © 2015 Pearson Canada, Inc. 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 406 Copyright © 2015 Pearson Canada, Inc. 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 407 Copyright © 2015 Pearson Canada, Inc. 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 408 Copyright © 2015 Pearson Canada, Inc. 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 409 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 410 Copyright © 2015 Pearson Canada, Inc. 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 411 Copyright © 2015 Pearson Canada, Inc. 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: 4 412 Copyright © 2015 Pearson Canada, Inc. 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: 3 413 Copyright © 2015 Pearson Canada, Inc. Section: 2.1 AACSB: Analytical Thinking 414 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 415 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 416 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 417 Copyright © 2015 Pearson Canada, Inc. 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 418 Copyright © 2015 Pearson Canada, Inc. 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 419 Copyright © 2015 Pearson Canada, Inc. 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 420 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 422 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 423 Copyright © 2015 Pearson Canada, Inc. 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 424 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 425 Copyright © 2015 Pearson Canada, Inc. 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 426 Copyright © 2015 Pearson Canada, Inc. 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 427 Copyright © 2015 Pearson Canada, Inc. 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 428 Copyright © 2015 Pearson Canada, Inc. 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 429 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 430 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3 Determine the Optimal Capital Structure AACSB: Analytical Thinking 431 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3 Determine the Optimal Capital Structure AACSB: Analytical Thinking 432 Copyright © 2015 Pearson Canada, Inc. 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 433 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 434 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 435 Copyright © 2015 Pearson Canada, Inc. 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 436 Copyright © 2015 Pearson Canada, Inc. 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 437 Copyright © 2015 Pearson Canada, Inc. 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 438 Copyright © 2015 Pearson Canada, Inc. 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 439 Copyright © 2015 Pearson Canada, Inc. 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 440 Copyright © 2015 Pearson Canada, Inc. 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 441 Copyright © 2015 Pearson Canada, Inc. 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 442 Copyright © 2015 Pearson Canada, Inc. 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 443 Copyright © 2015 Pearson Canada, Inc. 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 444 Copyright © 2015 Pearson Canada, Inc. 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 445 Copyright © 2015 Pearson Canada, Inc. 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 446 Copyright © 2015 Pearson Canada, Inc. 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 447 Copyright © 2015 Pearson Canada, Inc. 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 448 Copyright © 2015 Pearson Canada, Inc. 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 449 Copyright © 2015 Pearson Canada, Inc. 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 450 Copyright © 2015 Pearson Canada, Inc. 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 451 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 452 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. Collections in January = $550 + $500 = $1,050 Diff: 2 Section: 2 AACSB: Analytical Thinking 454 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 455 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 456 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 457 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 458 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 459 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 460 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 461 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 462 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 463 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 464 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 465 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 466 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 467 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 468 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 469 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 470 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 471 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 472 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 473 Copyright © 2015 Pearson Canada, Inc. 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 474 Copyright © 2015 Pearson Canada, Inc. 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: 2 475 Copyright © 2015 Pearson Canada, Inc. 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: 2 476 Copyright © 2015 Pearson Canada, Inc. 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 477 Copyright © 2015 Pearson Canada, Inc. 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 478 Copyright © 2015 Pearson Canada, Inc. 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 479 Copyright © 2015 Pearson Canada, Inc. 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 480 Copyright © 2015 Pearson Canada, Inc. 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 481 Copyright © 2015 Pearson Canada, Inc. 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 482 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 484 Copyright © 2015 Pearson Canada, Inc. 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 486 Copyright © 2015 Pearson Canada, Inc. 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 488 Copyright © 2015 Pearson Canada, Inc. 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 489 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 490 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 491 Copyright © 2015 Pearson Canada, Inc. 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 492 Copyright © 2015 Pearson Canada, Inc. 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 $882,891 Diff: 4 Section: 3 AACSB: Analytical Thinking 493 Copyright © 2015 Pearson Canada, Inc. 6) Blockbuster is a video rental and retail chain. Blockbuster is forecasting its financial statements for Year 3. Selected financial information for Year 2 is provided in the table. What is Retained Earnings for Year 3? Selected Financial Information Blockbuster Inc. ($ '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 = $-607,976 Diff: 2 Section: 3 AACSB: Analytical Thinking 494 Copyright © 2015 Pearson Canada, Inc. 7) Blockbuster is a video rental and retail chain. Blockbuster is forecasting its financial statements for Year 7. Selected financial information for Year 6 is provided in the table. What is long term debt (the plug variable) for the forecasted year? To forecast current liabilities payable use the percentage of sales method based on Year 6 figures. Assume that no dividends are paid in Year 7. Selected Financial Information Blockbuster Inc. ($ '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 495 Copyright © 2015 Pearson Canada, Inc. 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: 3 496 Copyright © 2015 Pearson Canada, Inc. 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 = $308 Diff: 2 497 Copyright © 2015 Pearson Canada, Inc. Section: 3 AACSB: Analytical Thinking 12) Blockbuster is a video rental and retail chain. Blockbuster is forecasting its financial statements for Year 3. Selected financial information for Years 1 and 2 is provided in the table. What is the interest expense for Blockbuster in Year 3? (Assume that Blockbuster's average cost of debt is 7.50%.) Selected Financial Information Blockbuster Inc. ($ '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) = $72,054 Diff: 2 Section: 3 AACSB: Analytical Thinking 13) Cadbury plc is a global confectionery company. Cadbury is forecasting its financial statements for Year 9. Selected financial information for Years 7 and 8 is provided in the table. What is the interest expense for Year 9? (Assume that Cadbury's average cost of debt is 3%.) Selected Financial Information Cadbury Inc. (£ millions) Year 7 Year 8 Short Term Debt £2,562 £1,189 Long Term Debt 2,551 1,973 Interest Expense 153 A) £36 B) £59 C) £63 D) £95 E) £110 Answer: D Explanation: D) Interest Expense9 = kd × (Short-term Debt8 + Long-term Debt8) Interest Expense9 = 0.03 × (£1,189 + £1,973) = £95 Diff: 2 Section: 3 AACSB: Analytical Thinking 498 Copyright © 2015 Pearson Canada, Inc. 14) Polaris Industries is forecasting its financial statements for Year 6. Selected financial information for Year 5 is provided in the table. What is the interest expense for Polaris Industries in Year 6? (Assume that Polaris Industries average cost of debt is 11.76%.) Selected Financial Information Polaris Industries Inc. ($ '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 499 Copyright © 2015 Pearson Canada, Inc. 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 500 Copyright © 2015 Pearson Canada, Inc. 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 = $184 Diff: 2 Section: 3 AACSB: Analytical Thinking 501 Copyright © 2015 Pearson Canada, Inc. 20) Outlaws is a general goods retail chain in the High Plains region. Outlaws is forecasting its financial statements for Year 3. Selected financial information for Years 1 and 2 is provided in the table. What is Retained Earnings for Year 3? Selected Financial Information Outlaws Inc. ($ 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 502 Copyright © 2015 Pearson Canada, Inc. 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 503 Copyright © 2015 Pearson Canada, Inc. 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 504 Copyright © 2015 Pearson Canada, Inc. 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) = $788 Retained Earnings9 = £2,498 + £788 - £315 = £2,971 Diff: 2 Section: 3 AACSB: Analytical Thinking 505 Copyright © 2015 Pearson Canada, Inc. 24) Outlaws is a general goods retail chain in the High Plains region. Outlaws is forecasting its financial statements for Year 7. Selected financial information for Year 6 is provided in the table. What is long term debt, the plug variable, for the forecasted year? To calculate forecasted current liabilities use the percentage of sales method based on Year 6 figures. Assume that no dividends are paid in Year 7. Selected Financial Information Outlaws Inc. ($ 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 506 Copyright © 2015 Pearson Canada, Inc. 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 507 Copyright © 2015 Pearson Canada, Inc. 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 508 Copyright © 2015 Pearson Canada, Inc. 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 509 Copyright © 2015 Pearson Canada, Inc. 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) = $329,750 Diff: 2 Section: 3 AACSB: Analytical Thinking 510 Copyright © 2015 Pearson Canada, Inc. LO4: Learn How to Manage Additional Funds Needed 1) Q9 Networks is a leading provider of outsourced data centre infrastructure such as web-servers and data storage. Use the equation approach and the financial data in the table to calculate additional funds needed (AFN) in Year 6. Selected Financial Statement Values and Ratios Q9 Networks As of December 31, Year 5 ($ 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 = $6,702 Diff: 2 Section: 4 AACSB: Analytical Thinking 511 Copyright © 2015 Pearson Canada, Inc. 2) Q9 Networks is a leading provider of outsourced data centre infrastructure such as web-servers and data storage. Use the financial information in the table to calculate Q9's maximum internal growth rate. Selected Ratios Q9 Networks Year 5 ROE 0.10% ROA 0.09% Net Profit Margin 0.27% Total Asset Turnover 0.33 Dividend Payout Rate 0% A) 0.09% B) 0.10% C) 0.13% D) 0.16% E) 0.20% Answer: A Explanation: A) MIGR = MIGR = = 0.09% Diff: 2 Section: 4 AACSB: Analytical Thinking 512 Copyright © 2015 Pearson Canada, Inc. 3) Q9 Networks is a leading provider of outsourced data centre infrastructure such as web-servers and data storage. Use the financial information in the table to calculate Q9's maximum sustainable growth rate. Selected Ratios Q9 Networks Year 5 ROE 0.10% ROA 0.09% Net Profit Margin 0.27% Total Asset Turnover 0.33 Dividend Payout Rate 0% A) 0.09% B) 0.10% C) 0.11% D) 0.12% E) 0.13% Answer: B Explanation: B) MSGR = MSGR = = 0.10% Diff: 2 Section: 4 AACSB: Analytical Thinking 513 Copyright © 2015 Pearson Canada, Inc. 4) Outlaws is a general goods retail chain in the High Plains region. Use the equation approach and Outlaws financial information for Year 6 to calculate additional funds needed (AFN) in Year 7. Selected Financial Statement Values and Ratios Outlaws Inc. As of December 31, Year 6 ($ 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 $91 million. Diff: 3 Section: 4 AACSB: Analytical Thinking 514 Copyright © 2015 Pearson Canada, Inc. 5) CN Railways is North America's fifth largest railway. Use the equation approach and CN's financial information for Year 10 to calculate additional funds needed (AFN) in Year 11. Selected Financial Statement Values and Ratios CN Railway Company As of December 31, Year 10 ($ 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 515 Copyright © 2015 Pearson Canada, Inc. 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 516 Copyright © 2015 Pearson Canada, Inc. 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 517 Copyright © 2015 Pearson Canada, Inc. 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 518 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 521 Copyright © 2015 Pearson Canada, Inc. 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 522 Copyright © 2015 Pearson Canada, Inc. 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 523 Copyright © 2015 Pearson Canada, Inc. 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 524 Copyright © 2015 Pearson Canada, Inc. 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 525 Copyright © 2015 Pearson Canada, Inc. 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 526 Copyright © 2015 Pearson Canada, Inc. 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 527 Copyright © 2015 Pearson Canada, Inc. 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) 86 528 Copyright © 2015 Pearson Canada, Inc. 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 529 Copyright © 2015 Pearson Canada, Inc. 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 530 Copyright © 2015 Pearson Canada, Inc. 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 531 Copyright © 2015 Pearson Canada, Inc. 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 532 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 533 Copyright © 2015 Pearson Canada, Inc. 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 534 Copyright © 2015 Pearson Canada, Inc. 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 535 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 538 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 540 Copyright © 2015 Pearson Canada, Inc. 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 541 Copyright © 2015 Pearson Canada, Inc. 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 542 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 545 Copyright © 2015 Pearson Canada, Inc. 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 546 Copyright © 2015 Pearson Canada, Inc. 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 547 Copyright © 2015 Pearson Canada, Inc. 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 548 Copyright © 2015 Pearson Canada, Inc. 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 549 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 552 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 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 Section: 5 AACSB: Analytical Thinking 553 Copyright © 2015 Pearson Canada, Inc. Corporate Finance Online (McNally) 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 554 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 555 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 556 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 557 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 558 Copyright © 2015 Pearson Canada, Inc. 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 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 Section: 1 AACSB: Analytical Thinking 559 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 AACSB: Analytical Thinking 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 Section: 2 AACSB: Analytical Thinking 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 Section: 2 AACSB: Analytical Thinking 560 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 AACSB: Analytical Thinking 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 Section: 2 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 AACSB: Analytical Thinking 561 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 562 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 563 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 AACSB: Analytical Thinking 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 Section: 2 AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 564 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 565 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 AACSB: Analytical Thinking 566 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 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 Section: 2 AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 567 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 568 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 569 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 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. Diff: 1 570 Copyright © 2015 Pearson Canada, Inc. Section: 3 AACSB: Analytical Thinking 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 571 Copyright © 2015 Pearson Canada, Inc. 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 572 Copyright © 2015 Pearson Canada, Inc. 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 573 Copyright © 2015 Pearson Canada, Inc. 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 574 Copyright © 2015 Pearson Canada, Inc. 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 575 Copyright © 2015 Pearson Canada, Inc. 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: 576 Copyright © 2015 Pearson Canada, Inc. 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 582 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 Copyright © 2015 Pearson Canada, Inc. 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 589 Copyright © 2015 Pearson Canada, Inc. 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 = 54,484.32 594 Copyright © 2015 Pearson Canada, Inc. 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 - 36,883.15 596 Copyright © 2015 Pearson Canada, Inc. 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 601 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 603 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 604 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 605 Copyright © 2015 Pearson Canada, Inc. 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 606 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 607 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 608 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 609 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 610 Copyright © 2015 Pearson Canada, Inc. 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 611 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 612 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 613 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 614 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 615 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 616 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 617 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 618 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 619 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 620 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 621 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 622 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 623 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 624 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 625 Copyright © 2015 Pearson Canada, Inc. 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 Section: 3. DCF 626 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 627 Copyright © 2015 Pearson Canada, Inc. 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 628 Copyright © 2015 Pearson Canada, Inc. 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 629 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 631 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 = 137.5 633 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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) 636 Copyright © 2015 Pearson Canada, Inc. 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) 638 Copyright © 2015 Pearson Canada, Inc. 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 639 Copyright © 2015 Pearson Canada, Inc. 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 641 Copyright © 2015 Pearson Canada, Inc. 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 = $2,335.13 642 Copyright © 2015 Pearson Canada, Inc. 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 643 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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% 646 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 = $29,428.57 653 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 672 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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? 676 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Futures Contracts 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 Section: 2 Futures Contracts 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 679 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Futures Contracts 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 Section: 2 Futures Contracts 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 Section: 2 Futures Contracts 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 Section: 2 Futures Contracts 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 680 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 2 Futures Contracts 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 Section: 2 Futures Contracts 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 681 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 682 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Futures Contracts 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 Section: 2 Futures Contracts 683 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 2 Futures Contracts 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 Section: 2 Futures Contracts AACSB: Analytical Thinking 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 Section: 2 Futures Contracts 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: 1 684 Copyright © 2015 Pearson Canada, Inc. Section: 2 Futures Contracts AACSB: Analytical Thinking 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 685 Copyright © 2015 Pearson Canada, Inc. 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 686 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Futures Contracts AACSB: Analytical Thinking 687 Copyright © 2015 Pearson Canada, Inc. 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 688 Copyright © 2015 Pearson Canada, Inc. 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 689 Copyright © 2015 Pearson Canada, Inc. 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 = $1,500 690 Copyright © 2015 Pearson Canada, Inc. 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 691 Copyright © 2015 Pearson Canada, Inc. 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 = $1,000 692 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 693 Copyright © 2015 Pearson Canada, Inc. 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 Section: 2 Futures Contracts 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 AACSB: Analytical Thinking 694 Copyright © 2015 Pearson Canada, Inc. 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 695 Copyright © 2015 Pearson Canada, Inc. 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 696 Copyright © 2015 Pearson Canada, Inc. 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 697 Copyright © 2015 Pearson Canada, Inc. 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 698 Copyright © 2015 Pearson Canada, Inc. 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 699 Copyright © 2015 Pearson Canada, Inc. 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 700 Copyright © 2015 Pearson Canada, Inc. 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 701 Copyright © 2015 Pearson Canada, Inc. 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 702 Copyright © 2015 Pearson Canada, Inc. 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 703 Copyright © 2015 Pearson Canada, Inc. 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 704 Copyright © 2015 Pearson Canada, Inc. 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 705 Copyright © 2015 Pearson Canada, Inc. 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 706 Copyright © 2015 Pearson Canada, Inc. 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 707 Copyright © 2015 Pearson Canada, Inc. 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 = $4.20 708 Copyright © 2015 Pearson Canada, Inc. 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 709 Copyright © 2015 Pearson Canada, Inc. 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 710 Copyright © 2015 Pearson Canada, Inc. 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 711 Copyright © 2015 Pearson Canada, Inc. 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 712 Copyright © 2015 Pearson Canada, Inc. 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 713 Copyright © 2015 Pearson Canada, Inc. 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 714 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits 715 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 716 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 717 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 718 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 719 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 720 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 721 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 722 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 723 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits 724 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 725 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 726 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 727 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 728 Copyright © 2015 Pearson Canada, Inc. 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 729 Copyright © 2015 Pearson Canada, Inc. For the Google put option with the strike price of $200: Maximum Loss = -$200 + $19.80 Maximum Loss = -$180.2 Diff: 2 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 730 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits AACSB: Analytical Thinking 731 Copyright © 2015 Pearson Canada, Inc. 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 Section: 5 Option Payoffs and Profits 732 Copyright © 2015 Pearson Canada, Inc. AACSB: Analytical Thinking 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 AACSB: Analytical Thinking 733 Copyright © 2015 Pearson Canada, Inc. 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 Section: 6 Option Pricing AACSB: Analytical Thinking 734 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 735 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 736 Copyright © 2015 Pearson Canada, Inc. 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 Section: 6 Option Pricing AACSB: Analytical Thinking 737 Copyright © 2015 Pearson Canada, Inc. 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 Section: 6 Option Pricing AACSB: Analytical Thinking 738 Copyright © 2015 Pearson Canada, Inc. 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 AACSB: Analytical Thinking 739 Copyright © 2015 Pearson Canada, Inc. 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 740 Copyright © 2015 Pearson Canada, Inc. 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 741 Copyright © 2015 Pearson Canada, Inc. 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 742 Copyright © 2015 Pearson Canada, Inc. 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 743 Copyright © 2015 Pearson Canada, Inc. 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 744 Copyright © 2015 Pearson Canada, Inc. 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 745 Copyright © 2015 Pearson Canada, Inc. 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 746 Copyright © 2015 Pearson Canada, Inc. 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 747 Copyright © 2015 Pearson Canada, Inc. 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 748 Copyright © 2015 Pearson Canada, Inc. 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 749 Copyright © 2015 Pearson Canada, Inc. 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 750 Copyright © 2015 Pearson Canada, Inc. 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 751 Copyright © 2015 Pearson Canada, Inc. 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 752 Copyright © 2015 Pearson Canada, Inc. 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 753 Copyright © 2015 Pearson Canada, Inc. 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 754 Copyright © 2015 Pearson Canada, Inc. 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 755 Copyright © 2015 Pearson Canada, Inc. 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 756 Copyright © 2015 Pearson Canada, Inc. 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 757 Copyright © 2015 Pearson Canada, Inc. 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 758 Copyright © 2015 Pearson Canada, Inc. 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.