Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 1 Corporate Finance and the Financial Manager
1.1 Why Study Finance
1) The Valuation Principle shows how to make the costs and benefits of a decision comparable so that
we can evaluate them properly.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.1 Grasp the importance of financial information in both your personal and business lives
2) Which of the following best describes why the Valuation Principle is a key concept in making
financial decisions?
A) It shows how to assign monetary value to intangibles such as good health and well-being.
B) It allows fixed assets and liquid assets to be valued correctly.
C) It gives a good indication of the net worth of a person, item, or company and can be used to estimate
any changes in that net worth.
D) It shows how to make the costs and benefits of a decision comparable so that we can weigh them
properly.
E) It allows us to produce accurate financial statements.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.1 Grasp the importance of financial information in both your personal and business lives
3) Both personal financial decisions and business financial decisions can best be made by applying the:
A) Internal Ranking Criteria.
B) Best Alternatives Matrix.
C) Valuation Principle.
D) Financial Comparison Analysis.
E) Law of One Price.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.1 Grasp the importance of financial information in both your personal and business lives
1.2 The Three Types of Firms
1) Partnerships are the most common type of business firm in the world.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
2) Corporations have come to dominate the business world through their ability to raise large amounts
of capital by sale of ownership shares to anonymous outside investors.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
3) Which of the following types of firms do not have limited liability?
A) sole proprietorships
B) limited partnerships
C) private corporations
D) public corporations
E) limited liability partnerships
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
4) Over 60% of all Canadian business profit is generated by which type of firm?
A) sole proprietorships
B) partnerships
C) limited partnerships
D) corporations
E) limited liability partnerships
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
5) What is the most common type of firm in Canada and the world?
A) sole proprietorships
B) partnerships
C) limited partnerships
D) corporations
E) limited liability partnerships
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
6) Which of the following is typically the major factor in limiting the growth of a sole proprietorship?
A) The organization of such firms tends to become extremely complicated over time.
B) It is extremely difficult to transfer control of such a firm to a new owner if the present owner dies or
wishes to sell the firm.
C) The amount of money that can be raised by the firm is limited by the fact that the single owner must
make good on all debts.
D) Investors have a great deal of control over the day-to-day running of the firm, leading to confusion
when conflicts in direction arise.
E) The owner's personal reputation is the basis for the business.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
7) Joe is a general partner in a limited partnership firm, while Jane is a limited partner in that same firm.
Which of the following statements regarding their respective relationships to the firm is correct?
A) Joe has no management authority within the partnership.
B) Jane is legally involved in the managerial decision making of the firm.
C) Jane's liability for the firm's debts consists solely of her investment in the firm.
D) Withdrawal of Jane from the partnership will dissolve that partnership.
E) Jane's liability consists of all the firm's outstanding debts.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
8) What is the major way in which the roles and obligations of the owners of a limited liability
partnership differ from the roles and obligations of limited partners in a limited partnership?
A) The owners of a limited liability partnership have personal obligation for debts incurred by the
company.
B) There is no separation between the company and its owners in a limited liability partnership.
C) The owners of a limited liability partnership can withdraw from the company without the company
being dissolved.
D) The owners of a limited liability partnership can take an active role in running the company.
E) The owners of a limited liability partnership are responsible for the negligence of other partners.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
9) In which of the following ways is a limited liability partnership like a corporation?
A) Both types of firm were created and developed first in Canada.
B) Both can choose to be considered a partnership for tax purposes.
C) All of its owners' liability is restricted to their investment in the firm.
D) It is directly managed by the owners of the firm.
E) Owners have unlimited personal liability for the negligence of those whom they supervise.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
10) Why is it possible for a corporation to enter into contracts, acquire assets, incur obligations, and
enjoy protection against the seizure of its property?
A) The number of owners, and hence the spread of risk among these owners, is not limited.
B) Its owners are liable for any obligations it enters into.
C) The province in which the corporation is incorporated provides safeguards against any wrongdoing
by the corporation.
D) It is a legally defined, artificial entity that is separate from its owners.
E) Corporations represent their owners, who have all of those rights.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
11) What is one of the major advantages corporations have over other business entities?
A) It is harder for a corporation to raise capital than other forms of businesses.
B) The owners of the corporation are personally liable for its obligations.
C) Corporations are the only organizational structures not subject to double taxation.
D) There is no limitation on who can own its stock.
E) It is less costly to set up a corporation.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
12) A flow-through entity that holds all the debt and equity securities of a corporation is called
A) an energy trust.
B) a real estate investment trust.
C) a business income trust.
D) a parent corporation.
E) an ownership trust.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
13) The collection of all the outstanding shares of a corporation is known as the
A) Debt.
B) Assets.
C) Liabilities.
D) Equity.
E) Ownership.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
14) Katie owns 12.5% of the stock of the Gimli Corporation. The tax rate on dividend income is 24%. If
Gimli makes a dividend payment of $25,000,000 paid proportionally to its shareholders, how much of
this amount would Katie receive after taxes?
A) $750,000
B) $2,375,000
C) $3,125,000
D) $6,000,000
E) $19,000,000
Answer: B
Explanation: B) Katie will receive 12.5% of the dividend payment proportional to her ownership:
0.125 × 25,000,000 = $3,125,000. She pays taxes at 24%, and receives (3,125,000)(1 - 0.24) = 2,375,000 after
taxes.
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
15) Kuljeet owns 20% of the stock of the Flin Flon Corporation. The tax rate on dividend income is 15%.
If Flin Flon makes a dividend payment of $2,000,000 paid proportionally to its shareholders, how much
of this amount would Kuljeet receive after taxes?
A) $450,000
B) $300,000
C) $60,000
D) $340,000
E) $400,000
Answer: D
Explanation: D) Kuljeet will receive 20% of the dividend payment proportional to her ownership:
0.20 × 2,000,000 = $400,000. She pays taxes at 15%, and receives (400,000)(1 - 0.15) = $340,000 after taxes.
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
16) Saskatoon Smelting is a corporation that earned $4 per share before it paid any taxes. The firm
retained $2 of after-tax earnings for reinvestment, and distributed what remained in dividend
payments. If the corporate tax rate was 25% and dividend earnings were taxed at 15%, what was the
value of the dividend earnings received after tax by a holder of 10,000 shares of Saskatoon Smelting?
A) $7,500
B) $17,000
C) $8,500
D) $10,000
E) $20,000
Answer: C
Explanation: C) Corporate tax paid on $4 earnings = $4 × 0.25 = $1; earnings after tax =4 - 1 = $3;
earnings distributed as dividends = $3 - $2 = $1; taxes paid on dividends by a shareholder = 1 × 0.15 =
0.15; after-tax dividends per share = 1 - 0.15 = $0.85; hence a holder of 10,000 shares receives 0.85 ×
100,000 = $8,500
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
17) Moncton Meats is a corporation that earned $3 per share before it paid any taxes. The firm retained
$1 of after-tax earnings for reinvestment, and distributed what remained in dividend payments. You
hold 20,000 shares of Moncton Meats in a tax-free savings account. If the corporate tax rate was 30% and
dividend earnings were taxed at 20%, what was the value of your dividend earnings received after all
taxes are paid?
A) $40,000
B) $16,000
C) $20,000
D) $17,600
E) $22,000
Answer: E
Explanation: E) Corporate tax paid on $3 earnings = $3 × 0.3 = 0.9; earnings after tax = 3 - 0.9 = $2.1;
earnings distributed as dividends = $2.1 - $1 = $1.1; hence a holder of 20,000 shares in a TFSA receives
1.1 × 20,000 = $$22,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
18) Tofino Toffee is a corporation that earned $5 per share before it paid any taxes. The firm retained
$2.50 of after-tax earnings for reinvestment, and distributed what remained in dividend payments. You
hold 6,000 shares of Tofino Toffee in a tax-free savings account, and 4,000 shares outside of a tax-free
savings account. If the corporate tax rate was 25% and dividend earnings were taxed at 15%, what was
the value of your dividend earnings received after all taxes are paid?
A) $12,500
B) $11,750
C) $10,625
D) $23,500
E) $13,175
Answer: B
Explanation: B) Corporate tax paid on $5 earnings = $5 × 0.25 =1.25; earnings after tax = 5 - 1.25 = $3.75;
earnings distributed as dividends = $3.75 - $2.50 = $1.25;
after-tax dividends = 1.25 × (1 - 0.15) = $1.0625;
Inside TFSA: 1.25 × 6,000 = $7,500
Outside TFSA: 1.0625 × 4,000 = $4,250; Total earnings =7,500 + 4,250 = $11,750
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
19) You are a unit holder in Pembina Properties, a real estate investment trust (REIT). The REIT
announces a profit of $8 per share, of which it retains $3 for reinvestment and distributes the rest as
dividend payments. Given your personal tax rate of 30%, and the tax rate on dividends is 15%, how
much tax must you pay per unit?
A) $0.90
B) $1.20
C) $0.75
D) $0.45
E) $0
Answer: B
Explanation: B) Tax paid by unit holder of a REIT = 5 × 0.3 = $1.50
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
20) You hold 1,000 units of Calgary Commercial Property, a real estate investment trust (REIT). The
REIT announces a profit of $10 per share, of which it retains $4 for reinvestment and distributes the rest
as dividend payments. Given your personal tax rate of 40%, and the tax rate on dividends is 15%, how
much tax must you pay on your holdings?
A) $900
B) $4,000
C) $2,400
D) $1,500
E) $1,600
Answer: C
Explanation: C) Tax paid by unit holder of a REIT = 6 × 0.4 × 1,000 units = $2,400
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
21) You hold 1,000 units of Calgary Commercial Property, a real estate investment trust (REIT). 500 of
those units are held inside a tax-free savings account, the other 500 are outside the tax-free savings
account. The REIT announces a profit of $10 per share, of which it retains $4 for reinvestment and
distributes the rest as dividend payments. Given your personal tax rate of 30%, and the tax rate on
dividends is 15%, how much tax must you pay on your holdings?
A) $900
B) $450
C) $1,800
D) $1,500
E) $1,600
Answer: A
Explanation: A) Tax paid by unit holder of a REIT = 6 × 0.3 × 500 units = $900
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
22) You hold 1,000 units of Calgary Commercial Property, a real estate investment trust (REIT). 500 of
those units are held inside a tax-free savings account, the other 500 are outside the tax-free savings
account. The REIT announces a profit of $10 per share, of which it retains $4 for reinvestment and
distributes the rest as dividend payments. Given your personal tax rate of 30%, and the tax rate on
dividends is 15%, what is your total after-tax income?
A) $6,000
B) $5,100
C) $5,550
D) $4,200
E) $5,000
Answer: B
Explanation: B) Tax paid by unit holder of a REIT = 6 × 0.3 × 500 units = $900
Total dividends = 6 × 1,000 = $6,000. After-tax income = 6,000 - 900 = $5,100
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
23) Red Deer Plumbing Supply Co. earns $4.50 per share before taxes. The corporate tax rate is 30%, the
personal tax rate on dividends is 15%, and the personal tax rate on non-dividend income is 40%. What is
the total amount of taxes paid per share if the company pays a $2.00 dividend?
A) $0.30
B) $2.15
C) $1.35
D) $1.65
E) $0.80
Answer: D
Explanation: D) Corporate tax = $4.50 × 30% = $1.35, Personal tax = $2.00 × 15% = $0.30.
Total = $1.35 + $0.30 = $1.65
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
24) Windsor Windows earns $4.50 per share before taxes. The corporate tax rate is 30%, the personal tax
rate on dividends is 15%, and the personal tax rate on non-dividend income is 40%. What is the total
amount of taxes paid per share if the company pays a $2.00 dividend but all of the shares are held in a
tax-free savings account?
A) $0.30
B) $2.15
C) $1.35
D) $1.65
E) $0.80
Answer: C
Explanation: C) Corporate tax = $4.50 × 30% = $1.35, no personal tax.
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
25) Windsor Windows earns $4.50 per share before taxes and pays a dividend of $2.00 per share. The
corporate tax rate is 30%, the personal tax rate on dividends is 15%, and the personal tax rate on nondividend income is 40%. What is the after-tax amount an individual would receive per share from the
dividend?
A) $2.68
B) $2.15
C) $1.35
D) $1.65
E) $1.70
Answer: E
Explanation: E) Personal tax = $2.00 × 0.15 = $0.30. After-tax income = $2.00 - $0.30 = $1.70.
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
26) You own shares in two different companies, Ace Holdings, and Beta Inc. Ace Holdings earns $6.00
per share before taxes, has a corporate tax rate of 25%, and pays out 50% of its after-tax earnings as
dividends. Beta Inc. earns $4.00 per share before taxes, has a corporate tax rate of 15%, and pays out
100% of its after-tax earnings as dividends. Which company pays you a higher dividend, and by how
much?
A) Beta Inc., by $1.15
B) Beta Inc., by $1.75
C) Ace Holdings, by $0.15
D) Ace Holdings, by $1.10
E) Ace Holdings, by $2.25
Answer: A
Explanation: A) Ace Holdings dividend = $6.00(1 - 0.25)(0.5) = $2.25. Beta Inc. dividend = $4.00(1 - 0.15)
= $3.40. $3.40 - 2.25 = $1.15.
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
27) You own 100 shares in each of two different companies, Ace Holdings, and Beta Inc. Ace Holdings
earns $6.00 per share before taxes, has a corporate tax rate of 25%, and pays out 50% of its after-tax
earnings as dividends. Beta Inc. earns $4.00 per share before taxes, has a corporate tax rate of 15%, and
pays out 100% of its after-tax earnings as dividends. The tax rate on dividend income is 15%. If all of
your shares are held outside a TFSA, what is the total after-tax income you receive from your
dividends?
A) $191.25
B) $289.00
C) $480.25
D) $565.00
E) $739.00
Answer: C
Explanation: C) Ace Holdings dividend = $6.00(1 - 0.25)(0.5) = $2.25. After dividend tax: $2.25(1 - 0.15) =
$1.9125. $1.9125 × 100 shares = $191.25. Beta Inc. dividend = $4.00(1 - 0.15) = $3.40. After dividend tax:
$3.40(1 - 0.15) = $2.89. $2.89 × 100 shares = $289. Total received = $191.25 + $289 = $480.25.
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
28) You own 100 shares in each of two different companies, Ace Holdings, and Beta Inc. Ace Holdings
earns $6.00 per share before taxes, has a corporate tax rate of 25%, and pays out 50% of its after-tax
earnings as dividends. Beta Inc. earns $4.00 per share before taxes, has a corporate tax rate of 15%, and
pays out 100% of its after-tax earnings as dividends. The tax rate on dividend income is 15%. If your
shares of Ace Holdings are held outside of a TFSA, and your shares of Beta Inc. are held inside a TFSA,
what is the total after-tax income you receive from your dividends?
A) $191.25
B) $289.00
C) $480.25
D) $531.25
E) $565.00
Answer: D
Explanation: D) Ace Holdings dividend = $6.00(1 - 0.25)(0.5) = $2.25. After dividend tax: $2.25(1 - 0.15) =
$1.9125. $1.9125 × 100 shares = $191.25. Beta Inc. dividend = $4.00(1 - 0.15) = $3.40. $3.40 × 100 shares =
$340. Total received = $191.25 + $289 = $531.25.
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
29) You own 50 units of a real estate investment trust (REIT) and 50 shares of a public corporation. The
REIT earns $6.00 per unit.The corporation earns $4.00 per share before taxes. The corporate tax rate is
25%, your personal tax rate is 35%, and the tax rate on dividend income is 15%. What is the total aftertax income you receive, if everything is held outside a TFSA?
A) $273.75
B) $318.75
C) $322.50
D) $382.50
E) $450.00
Answer: C
Explanation: C) REIT distribution: $6.00 × 50 = $300.00. After tax: $300.00( 1 - 0.35) = $195.00. Dividends
after corporate taxes: ($4.00 × 50)(1 - 0.25) = $150. After dividend tax: $150(1 - 0.15) = $127.50. Total
income = $195.00 + 127.50 = $322.50
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
30) You own 50 units of a real estate investment trust (REIT) and 50 shares of a public corporation. The
REIT earns $6.00 per unit.The corporation earns $4.00 per share before taxes. The corporate tax rate is
25%, your personal tax rate is 35%, and the tax rate on dividend income is 15%. What is the total aftertax income you receive, if your REIT holdings are outside of a TFSA, and your corporation shares are
held inside a TFSA?
A) $273.75
B) $318.75
C) $322.50
D) $345.00
E) $450.00
Answer: D
Explanation: D) REIT distribution: $6.00 × 50 = $300.00. After tax: $300.00( 1 - 0.35) = $195.00. Dividends
after corporate taxes: ($4.00 × 50)(1 - 0.25) = $150. Total income = $195.00 + 150.00 = $345.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
31) What is the process of double taxation for the stockholders in a corporation?
A) Their shares are taxed when they are both bought and sold.
B) The corporation is taxed on the profits it makes, and the owners are taxed when this profit is
distributed to them.
C) The owners of a corporation are taxed when they receive dividend payments and when they make a
profit from the sale of shares.
D) The corporation must pay taxes on any profits it makes, and the capital raised by the sale of shares is
also subject to taxation.
E) The corporation is taxed on any profits it makes, and owners are taxed when they sell their shares.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
32) Which of the following is an advantage of a sole proprietorship?
A) double taxation
B) ease of setup
C) limited liability
D) separation of ownership and control
E) the ability to raise substantial amounts of capital
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
33) What are the main differences between a partnership and sole proprietorship?
Answer: While a sole proprietor has the same identity as its single owner, a partnership of general
partners has the same identity as its partners. Each general partner is responsible for the decisions taken
by that partner as well as any other general partner.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
34) What are the main differences between a limited partnership and limited liability partnership?
Answer: A limited partnership is required to have at least one general partner. A limited liability
partnership can only be used in the legal and accounting professions. The limitation on a partner's
liability is only in cases related to actions of negligence of other partners or those supervised by other
partners.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
35) How is a corporation different from most of the other forms of business organizations?
Answer: A corporation has a separate legal identity from those of its owners. This separation gives the
owners limited liability for the actions of the corporation. The down side is the process of double
taxation for each dollar earned by the corporation, once when it is earned by the corporation and
subsequently when it is passed on to the owners as a dividend.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.2 Understand the important features of the three main types of firms and see why the advantages of the
corporate form have led it to dominate economic activity
1.3 The Financial Manager
1) The principal goal of the financial manager is to maximize the wealth of the shareholders.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
2) It is generally not the duty of financial managers to ensure that a firm has the cash it needs for day-today transactions.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
3) Which of the following are major duties of a financial manager?
I. To make investment decisions
II. To make financing decisions
III. To manage cash flow from operating activities
A) I only
B) I and II only
C) I and III only
D) II and III only
E) I, II and III
Answer: E
Diff: 3 Type: MC
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
4) Why in general do financial managers make financial decisions in a corporation, rather than the
owners making these decisions themselves?
A) It is best for the control of the finances of a corporation to be in the hands of a disinterested third
party.
B) The interests of the various owners may conflict with each other.
C) The owners may not be Canadian citizens or residents.
D) There are often many owners, and they can often change as they buy and sell stock.
E) The owners will make decisions for their own self-interest rather than the corporation's interests.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
5) What is the most important duty of a financial manager?
A) to ensure that the firm has enough cash on hand to meet its commitments at any given time
B) to decide how to pay for investments
C) to manage working capital
D) to make investment decisions
E) to minimize taxes
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
6) The financial manager of a well-regarded book publishing firm wishes to buy a small Internet
publishing company to provide an avenue for sale of its materials online. In order to raise the funds to
make this purchase, the financial manager decides to sell more stock in the company. How is the
financial manager raising funds in this case?
A) by increasing the debt burden carried by the company
B) by raising the company's equity by encouraging new owners to take a stake in the company
C) by decreasing the ratio of equity to debt held by the company
D) by increasing the value of shares held by the existing owners of the company
E) by adding a new revenue stream from the Internet publishing company
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
7) A company that produces racing motorbikes has several models that sell well within the motorcycle
racing community and that are very profitable for the company. Despite having a profitable product,
why must this company take care to ensure that it has sufficient cash on hand to meet its obligations?
A) Profits from the sales of popular models will be lost when returned to the shareholders in the form of
dividends.
B) New models will require a lot of money to develop and bring to market before they generate any
revenue.
C) The company will have built up debts which must be repaid in order to bring the current models to
market.
D) Equity must be raised to finance the development of new models to replace the existing models.
E) This will enable the company to maintain a high share price for its stock.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
8) A typical company has many types of shareholders, from individuals holding a few shares, to large
institutions that hold very large numbers of shares. How does a financial manager ensure that the
priorities and concerns of such disparate stockholders are met?
A) The financial manager should seek to make investments that do not harm the interests of the
stockholders.
B) The decisions taken by the financial manager should be solely influenced by the benefit to the
company since, by maximizing its fitness, he or she will also maximize the benefits of that company to
the shareholders.
C) The financial manager should consider the interests and concerns of large shareholders a priority, so
the needs of those who hold a controlling interest in the company are met.
D) In general, all shareholders will agree that they are better off if the financial manager works to
maximize the value of their investment.
E) The financial manager will consider the priorities of all the shareholders at the annual shareholders'
meeting.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
9) Whose interests should a financial manager consider paramount when making a decision?
A) the stockholders who have risked their money to become owners of the company
B) the employees and associated stakeholders who are employed by the company
C) the public who consume the company's goods and services
D) the senior management and associated colleagues at the executive level within the company
E) the financial manager's own interests
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
10) What is the principal guiding factor for the financial manager?
Answer: Maximizing shareholder wealth is the paramount guiding factor for the financial manager.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 1.3 Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the
three main types of decisions a financial manager makes
1.4 The Financial Manager's Place in the Corporation
1) In most corporations the owners exercise direct control of the corporation.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
2) How do the shareholders of most corporations exercise their control of that corporation?
A) by voting on issues that concern them
B) by electing members of a board of directors
C) by vetting the decisions of the board of directors
D) by providing oversight of the day-to-day running of the corporation
E) by hiring other shareholders to run the corporation
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
3) Who is typically responsible for the day-to-day running of a corporation?
A) the shareholders
B) the board of directors
C) the management team
D) the sole proprietor
E) the limited partner
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
4) What are the responsibilities of the board of directors?
A) make rules on how the corporation is run, set policy, and monitor the performance of the company
B) oversee the day-to-day running of the corporation.
C) making investment decisions
D) risk management
E) implementing the rules and policies set by the CEO
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
5) Which of the following would be more typically the responsibility of a controller rather than a
treasurer?
A) overseeing accounting and tax functions
B) capital budgeting
C) managing credit
D) making investment decisions
E) managing risk
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
6) Which of the following would be best considered to be a principal-agent problem in the behaviour of
the following financial managers?
A) Bill chooses to pursue a risky investment for the company's funds, because his compensation will
substantially rise if it succeeds.
B) Sue instructs her staff to skip safety inspections in one of the company's factories, knowing that it will
likely fail the inspection and incur significant costs to fix.
C) James ignores an opportunity for his company to invest in a new drug to fight Alzheimer's disease,
judging the drug's chances of succeeding as low.
D) Michael chooses to enhance his firm's reputation at some cost to its shareholders by sponsoring a
team of athletes for the Special Olympics.
E) Tara treats her staff to a free lunch at the company's expense to increase morale.
Answer: A
Diff: 3 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
7) A factory owner wants his workers to produce as many widgets as they can, so he pays his workers
based on how many widgets they produce. However, in order to make sure that the workers do not
rush and produce a large number of poorly made widgets, he checks the widgets at random at various
stages of their manufacture. If a defect is found in a widget, the pay of the entire section of the factory
responsible for that defect is docked. How is this factory owner seeking to solve the principal-agent
problem in this case?
A) by supplying incentives so the agents act in the way principal desires
B) by ensuring that all workers co-operate to maximize the gains of their section
C) by making the agents into principals themselves
D) by maximizing the information that the principal obtains about the behaviour of the agents
E) by using quality control techniques
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
8) What is the most common way that principal-agent problems are addressed in most corporations?
A) by minimizing the number of decisions that a manager makes where there is a conflict between the
managers interests and those of the shareholders
B) by terminating the employment of employees who are found to have put their own interests above
those of the company
C) by using disinterested outside bodies to adjudicate between managers and shareholders when such
conflicts arise
D) by prosecuting managers who have been found to have illegally used company moneys for their
own benefit
E) by paying the managers high salaries to encourage them to act in the company's interests.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
9) A company's board of directors chooses to provide a comprehensive health care plan for the families
of all employees, despite the large cost. They argue that this will not only increase the number of
employees who stay with the firm, and thus reduce some costs involved in employee turnover, but also
increase the employees' diligence and industry. What general principle is being argued by the board of
directors?
A) In a conflict between stakeholders in a company, the most important stakeholder is not always the
stockholders.
B) Some activities that decrease shareholders' wealth may have intangible benefits which increase the
strength of the company overall.
C) When a conflict of interest arises between shareholders and other stakeholders, in general, the correct
solution is the one that creates the greatest good for the greatest number of stakeholders.
D) Ethical decisions should be assessed on their moral value, not on their value in dollars and cents.
E) Decisions involving employees must take fairness into account.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
10) Why is the stock price of a company an indication of the performance of that company's senior
managers?
A) Well-run companies are invariably highly profitable, which leads to a higher share price.
B) In general, people want to invest in a well-managed corporation, which will drive up the price of
shares.
C) Investors who can see that a company is well-run will hold on to their shares, even if the company
faces temporary setbacks, since they know that the stock price will likely rise again.
D) Larger companies tend to be better run and so have higher stock prices.
E) Managers who perform well get paid well, and can afford to buy more shares of their own company,
driving up the share price.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
11) A corporate raider gains a controlling fraction of the shares of a poorly managed company and
replaces the board of directors. How does the corporate raider hope to make a profit in this case?
A) by the sale of the assets held by the company that hold most of its value
B) by the rise in the value of the stock held by the raider when the new board of directors is judged to be
superior to the ousted board of directors
C) by motivating the board of directors and other stakeholders in the company to make difficult shortterm decisions that will increase the long-term viability of the company
D) by removing the employees' expectations of the continued poor performance of the company
E) by paying itself a large portion of the firm's cash flows
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
12) A ________ is when a rich individual or organization purchases a large fraction of the stock of a
poorly performing firm and in doing so gets enough votes to replace the board of directors and the
CEO.
A) shareholder proposal
B) leveraged buyout
C) shareholder action
D) hostile takeover
E) merger
Answer: D
Diff: 2 Type: MC
Skill: Definition
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
13) Briefly discuss the issues in the principal-agent problem.
Answer: The principal-agent problem arises out of the principal-agent relationship existing between
the shareholders and managers of a corporation. Although managers are required to put the
shareholders interest ahead of their own, in practice they tend to put their own interest ahead of the
shareholders' interests.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
14) Explain some of the measures taken to reduce the principal-agent problem.
Answer: The principal-agent problem can be reduced by taking measures that align the managers'
interests with those of the shareholders. For example, incentive-based compensation such as employee
stock options help align the interests of these two constituents.
Diff: 2 Type: SA
Skill: Analytical
Objective: 1.4 Know how a corporation is managed and controlled, the financial manager's place in it, and some of
the ethical issues financial managers face
1.5 The Stock Market
1) The shares of private corporations are traded on a stock market.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
2) Stock markets provide liquidity for a firm's shares.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
3) If a broker will buy a share of stock from you at $3.85 and sell it to you at $3.87, the ask price would
be $3.85.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
4) Which of the following need be true for an asset to be considered liquid?
A) It pays regular dividends.
B) It can be bought and sold at an organized stock market or bourse.
C) It is offered for sale on both primary and secondary markets.
D) It can be easily bought and sold and the selling price is very close to the buying price at a given point
in time.
E) Buyers and sellers are anonymous.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
5) Why is it in general difficult to determine the market price of a private corporation's shares at any
point in time?
A) It is difficult to obtain enough information to accurately value such a company.
B) The price of its shares is fixed by the owners.
C) It has a limited number of owners.
D) There is no organized market for its shares.
E) Buyers do not wish to reveal their bid price.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
6) Which of the stock markets listed below is the smallest, as judged by trading volume?
A) Shanghai Stock Exchange
B) London Stock Exchange
C) NASDAQ
D) NYSE Euronext (US)
E) TMX Group
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
7) Why is a stock exchange like NASDAQ considered a secondary market?
A) It trades the second-largest volume of shares in the world.
B) Shares sold on it are exchanged between investors without any involvement of the issuing
corporation.
C) The exchange has rules that attempt to ensure that bid and ask prices do not get too far apart.
D) NASDAQ is called a secondary market because NYSE is considered a primary market.
E) Smaller companies are listed on the NASDAQ.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
8) On August 19, 2004, Google IPO offered 19,605,052 shares at a price of U.S. $85 per share, which were
sold in an online auction in a bid to make the shares more widely available. Which of the following
statements best describes why these are considered a primary market transaction?
A) The transaction was between the corporation and investors.
B) Shares of Google from this time onward could be traded between investors on a stock exchange.
C) The shares were the first to be publicly issued by Google.
D) Google was at the time a recently founded company seeking capital with which to expand.
E) The share price was above the threshold required to be known as a primary market transaction.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
9) What is the bid-ask spread?
A) the difference between the lowest price being quoted to sell a stock and the highest price being
quoted to buy that stock
B) all of the costs and fees that a stock exchange charges in order to process a transaction
C) the rise or fall in the value of a stock between the time it is acquired by an investor and sold by that
investor
D) the difference in the selling price of a stock between different exchanges
E) the change in the price of a stock from the market's open to the market's close
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
10) Stella places a market order with her broker to buy 1000 shares of OneWorld Corp. The broker buys
1000 shares at $15.40 each, and sells them to Stella at $15.55 each. He also charges a commission of
$12.00. What is bid-ask spread in this case?
A) $15,400
B) $15,562
C) $172
D) $150
E) $162
Answer: D
Explanation: D) (15.55 - 15.40) × 1000 = $150
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
11) Why do many Canadian companies list on the NYSE in addition to the TSX?
A) To raise funds in $US.
B) As a signal of their higher quality.
C) To avoid Canadian taxes.
D) They have grown too big for the TSX.
E) It is the first step in moving their operations to the US.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
Use the figure for the question(s) below.
12) Using the above information, how much would you pay for a share of BHP Billiton stock?
A) $41.91
B) $41.93
C) $41.65
D) $41.59
E) $41.54
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
Use the figure for the question(s) below.
13) Using the above information, how much would you receive if you sold a share of Washington Post
stock?
A) $683.00
B) $677.62
C) $678.50
D) $677.64
E) $679.00
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
kelihood that auditing relationships becom
Use the figure for the question(s) below.
14) Based on the information shown above, what would it cost to buy 1000 shares of the above stock?
A) $91,110
B) $91,300
C) $91,320
D) $91,650
E) $91,350
Answer: D
Diff: 1 Type: MC
Skill: Analytical
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
re dealt with around the worldon(s) below.
Use the figure for the question(s) below.
15) Based on the information shown above, how much would you receive from selling 2000 shares of
the above stock?
A) €40,840
B) €40,740
C) €41,000
D) €42,560
E) €41,650
Answer: B
Explanation: B) 2000 shares × €20.37 = 40,740
Diff: 1 Type: MC
Skill: Analytical
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
ne who gets ure for the question(s) below.
Use the figure for the question(s) below.
16) What is the bid-ask spread on the stock shown above?
A) 1 cent
B) 3 cents
C) 6 cents
D) 12 cents
E) 4 cents
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
y, the CEO of Movin On Up Company, was gra
Use the figure for the question(s) below.
17) How much money would a stock exchange make from buying and selling 500 shares of the stock
under the conditions shown above?
A) $250
B) $3,000
C) $5,875
D) $210,375
E) $210,625
Answer: A
Explanation: A) (421.25 - 420.75) × 500 = $250
Diff: 2 Type: MC
Skill: Analytical
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
18) Companies that attract the interest of just a few investors are said to be
A) thinly traded.
B) penny stocks.
C) liquid.
D) unpopular.
E) bad investments.
Answer: A
Diff: 2 Type: MC
Skill: Definition
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
19) What are the terms for the two types of prices quoted for a stock on an exchange?
Answer: The two quotes associated with a stock quoted on the exchange are bid price and ask price.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
쁌@셼@쌠@쌢@쌮@쌰@쌼@쌾@썊@썌@썘@썚@썦@써@썼@쏊@쓸@욚@욜@욨@욪@욶@울@웄@웆@웒@월@웞@웠@웴@은@쩰@첼@췬@퍲@풠@�@�
20) What is the general relation of the two types of prices quoted for a stock on a exchange?
Answer: The two prices are bid price and ask price. The ask price is higher than the bid price to deter a
buyer from buying a stock and selling it back immediately, assuming everything else remains
unchanged.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
21) What is the term for the applicable price that I will pay, if I have to buy a stock?
Answer: The buyer of a stock pays the ask price when he buys the stock.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
22) What is the term for the applicable price that the seller gets when he sells a stock on the exchange?
Answer: The seller gets the bid price when he sells a stock on the exchange.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
23) What are the main differences between the TSX and the TSX Venture Exchange?
Answer: The TSX has more stringent listing standards than the TSX Venture Exchange, and bid-ask
spreads tend to be lower. The TSX Venture Exchange is an exchange for relatively small company
stocks.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 1.5 Understand the importance of financial markets, such as stock markets, to a corporation and the
financial manager's role as liaison to those markets
1.6 Financial Institutions
1) Raising new capital by issuing bonds is an example of a commercial banking activity.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 1.6 Recognize the role that financial institutions play in the financial cycle of the economy
2) Put the following steps of the financial cycle in the correct order:
I. Money flows to companies who use it to fund growth through new products.
II. People invest and save their money.
III. Money flows back to savers and investors.
A) I, II, III
B) II, I, III
C) III, II, I
D) II, III, I
E) I, III, II
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 1.6 Recognize the role that financial institutions play in the financial cycle of the economy
3) Which type of financial institution receives money in the form of deposits and loans it out to people
and businesses?
A) Banks and credit unions
B) Insurance companies
C) Mutual funds
D) Pension funds
E) Hedge funds
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 1.6 Recognize the role that financial institutions play in the financial cycle of the economy
4) Which type of financial institution receives money in the form of investments by wealthy individuals
and endowments and invests in any kind of investment with an attempt to maximize returns for
relatively low risk?
A) Mutual funds
B) Pension funds
C) Hedge funds
D) Venture capital funds
E) Private equity funds
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 1.6 Recognize the role that financial institutions play in the financial cycle of the economy
5) Which type of financial institution receives money in the form of investments by wealthy individuals
and endowments and purchases whole companies by using a small amount of equity and borrowing
the rest?
A) Mutual funds
B) Pension funds
C) Hedge funds
D) Venture capital funds
E) Private equity funds
Answer: E
Diff: 1 Type: MC
Skill: Definition
Objective: 1.6 Recognize the role that financial institutions play in the financial cycle of the economy
6) Which type of financial institution is involved in many different aspects of the financial cycle,
brokering many of the transactions that take place between institutions?
A) Banks and credit unions
B) Mutual funds
C) Investment banks
D) Hedge funds
E) Private equity funds
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 1.6 Recognize the role that financial institutions play in the financial cycle of the economy
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 2 Introduction to Financial Statement Analysis
2.1 Firms' Disclosure of Financial Information
1) In Canada, publicly traded companies can choose whether or not they wish to release periodic
financial statements.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
2) Financial statements are accounting reports issued periodically by a firm that present information on
the past performance of the firm, a summary of the firm's assets and the financing of those assets, and a
prediction of the firm's future performance.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
3) International Financial Reporting Standards are taking root throughout the world. However, it is
unlikely that the Canada will report according to IFRS before the second half of the twenty-first century.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
4) What is the main reason that it is necessary for public companies to follow the rules and format set
out in the Generally Accepted Accounting Principles (GAAP) when creating financial statements?
A) It is easier to find specific information in such a report if it is laid out in a clear and consistent
manner.
B) It ensures that information on the performance of private companies is readily available to the public.
C) It ensures that important information is not omitted and superfluous information is not included.
D) It makes it easier to compare the financial results of different firms.
E) To make sure they satisfy the auditor.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
5) Which of the following best describes why firms produce financial statements?
A) to use as a tool when planning future investments within the firm
B) to provide a means of enticing new investors to a firm
C) to provide interested parties, both inside and outside the company, with an overview of the shortand long-term financial condition of a business
D) to show what activities the company has undertaken in the previous financial year, and what
activities are planned for the near future
E) to determine managerial performance
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
6) The third party who checks annual financial statements to ensure that they are prepared according to
Generally Accepted Accounting Principles (GAAP) and verifies that the information reported is reliable
is the
A) TSX Enforcement Board.
B) Accounting Standards Board.
C) provincial securities commission.
D) auditor.
E) GAAP commission.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
7) What is the role of an auditor in financial statement analysis?
Answer: Key points:
1. to ensure that the annual financial statements are prepared accurately
2. to ensure that the annual financial statements are prepared according to Generally Accepted
Accounting Principles (GAAP)
3. to verify that the information used in preparing the annual financial statements is reliable
Diff: 2 Type: ES
Skill: Conceptual
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
8) What are the four financial statements that all public companies must produce?
Answer:
1. statement of financial position (or balance sheet)
2. statement of comprehensive income
3. statement of cash flows
4. statement of changes in equity
Diff: 2 Type: ES
Skill: Conceptual
Objective: 2.1 Know why the disclosure of financial information through financial statements is critical to investors
2.2 The Statement of Financial Position or Balance Sheet
1) The statement of financial position shows the assets, liabilities, and stockholders' equity of a firm over
a given length of time.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
2) Shareholders' equity is the difference between a firm's assets and liabilities, as shown on the
statement of financial position.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
3) Which of the following amounts would be included on the right side of a statement of financial
position?
A) the value of government bonds held by the company
B) the cash held by the company
C) the amount of deferred tax liability held by the company
D) the amount of money owed to the company by customers who have not yet paid for goods and
services they have received
E) the value of inventories held by the company
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
4) Which of the following best describes why the left and right sides of a statement of financial position
are equal?
A) In a properly run business, the value of liabilities will not exceed the assets held by the company.
B) By definition, the assets plus the liabilities will be the same as the stockholders' equity.
C) The assets must equal liabilities plus stockholders' equity, because stockholders' equity is the
difference between the assets and the liabilities.
D) By accounting convention, the assets of a company must be equal to the liabilities of that company.
E) Assets must always exceed liabilities or the company will be bankrupt.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
5) A company that produces drugs is preparing a statement of financial position. Which of the following
would be most likely to be considered a long-term asset on this statement of financial position?
A) commercial paper held by the company
B) the inventory of chemicals used to produce the drugs made by the company
C) a patent for a drug held by the company
D) the cash reserves of the company
E) money owed to the firm by customers who have purchased goods on credit
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
6) A delivery company is creating a statement of financial position. Which of the following would most
likely be considered a short-term liability on this statement of financial position?
A) the depreciation over the last year in the value of the vehicles owned by the company
B) revenue received for the delivery of items that have not yet been delivered
C) a loan which must paid back in two years' time
D) prepaid rent on the offices occupied by the company
E) money owed to the firm by customers who have purchased goods on credit
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
7) A small company has current assets of $112,000 and current liabilities of $117,000. Which of the
following statements about that company is most likely to be true?
A) Since net working capital is negative, the company will not have enough funds to meet its
obligations.
B) Since net working capital is high, the company will likely have little difficulty meeting its obligations.
C) Since net working capital is very high, the company will have ample money to invest after it meets
its obligations.
D) Since net working capital is nearly zero, the company is well run and will have little difficulty
attracting investors.
E) Since net working capital is negative, the company will likely have little difficulty meeting its
obligations.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
8) What is the main problem in using a statement of financial position to provide an accurate
assessment of the value of a company's equity?
A) Valuable assets such as the company's reputation, the quality of its work force, and the strength of its
management are not captured on the statement of financial position.
B) The statement of financial position does not accurately represent the book value of assets held by the
company.
C) The equity shown on the statement of financial position does not reflect the market capitalization of
the company.
D) Knowing at a single point in time what assets a firm possesses and the liabilities a firm owes does
not give any indication of what those assets can produce in the future.
E) The statement of financial position does not provide enough detail about the company's equity.
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
9) The major components of shareholders' equity are
A) cash, common stock, and paid-in surplus.
B) common stock, paid-in surplus, and net income.
C) common stock, paid-in surplus, and retained earnings.
D) common stock, liabilities, and retained earnings.
E) cash, paid-in surplus, and retained earnings.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
Use the table for the question(s) below.
Statement of Financial Position
Assets
Current Assets
Cash
50
Accounts receivable
22
Inventories
17
Total current assets
89
Long-Term Assets
Net property, plant,
and equipment
Total long-term assets
121
121
Total Assets
210
Liabilities
Current Liabilities
Accounts payable
Notes payable/short-term debt
42
7
Total current liabilities
49
Long-Term Liabilities
Long-term debt
Total long-term liabilities
Total Liabilities
Shareholders' Equity
Total Liabilities and
Shareholders' Equity
128
128
177
33
210
10) The above diagram shows a statement of financial position for a certain company. All quantities
shown are in millions of dollars. What is the company's net working capital?
A) $7 million
B) $32 million
C) $33 million
D) $40 million
E) $20 million
Answer: D
Explanation: D) Net working capital = total current assets - total current liabilities, which = 89 - 49 = $40
million as all quantities are expressed in millions of dollars on the table.
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
11) The above diagram shows a statement of financial position for a certain company. All quantities
shown are in millions of dollars. How would the balance sheet change if the company's long-term assets
were judged to depreciate at an extra $5 million per year?
A) Net property, plant, and equipment would rise to $126 million, and Total Assets and Stockholders'
Equity would be adjusted accordingly.
B) Net property, plant, and equipment would fall to $116 million, and Total Assets and Stockholders'
Equity would be adjusted accordingly.
C) Long-Term Liabilities would rise to $182 million, and Total Liabilities and Stockholders' Equity
would would be adjusted accordingly.
D) Long-Term Liabilities would fall to $172 million, and Total Liabilities and Stockholders' Equity
would be adjusted accordingly.
E) Net property, plant, and equipment would be unchanged, and Total Assets and Stockholders' Equity
would also remain the same.
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
12) The above diagram shows a statement of financial position for a certain company. All quantities
shown are in millions of dollars. If the company has 4 million shares outstanding, and these shares are
trading at a price of $8.24 per share, what does this tell you about how investors view this firm's book
value?
A) Investors consider that the firm's market value is worth very much less than its book value.
B) Investors consider that the firm's market value is worth less than its book value.
C) Investors consider that the firm's market value and its book value are roughly equivalent.
D) Investors consider that the firm's market value is worth more than its book value.
E) Investors consider that the firm's market value is worth much more than its book value.
Answer: C
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
13) Which of the following statement of financial position equations is correct?
A) Assets - Liabilities = Shareholders' Equity
B) Assets + Liabilities = Shareholders' Equity
C) Assets - Current Liabilities = Long Term Liabilities
D) Assets + Current Liabilities = Long Term Liabilities + Shareholders' Equity
E) Assets + Current Liabilities = Long Term Liabilities - Shareholders' Equity
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
Use the table for the question(s) below.
Luther Corporation
Consolidated Statement of Financial Position
December 31, 2015 and 2014 (in $ millions)
Assets
Current Assets
Cash
2015
2014
63.6
58.5
Accounts receivable
55.5
39.6
45.9
6.0
171.0
42.9
3.0
144.0
Inventories
Other current assets
Total current assets
Liabilities and
Stockholders' Equity
Current Liabilities
Accounts payable
Notes payable /
short-term debt
Current maturities of longterm debt
Other current liabilities
Total current liabilities
Long-Term Liabilities
Long-term debt
Capital lease obligations
Total Debt
2015
2014
87.6
73.5
10.5
9.6
39.9
6.0
144.0
36.9
12.0
132.0
239.7
--239.7
168.9
--168.9
22.8
22.2
Long-Term Assets
Land
Buildings
Equipment
Less accumulated
depreciation
Net property, plant, and
equipment
Goodwill
Other long-term assets
Total long-term assets
66.6
109.5
119.1
62.1
91.5
99.6
(56.1)
(52.5)
Deferred taxes
239.1
60.0
63.0
362.1
200.7
-42.0
242.7
Other long-term liabilities
Total long-term liabilities
Total liabilities
Shareholders' Equity
--262.5
406.5
126.6
--191.1
323.1
63.6
Total Assets
533.1
386.7
Total liabilities and
Shareholders' Equity
533.1
386.7
14) Refer to the statement of financial position above. What is Luther's net working capital in 2014?
A) $12 million
B) $27 million
C) $39 million
D) $45 million
E) $63.6 million
Answer: A
Explanation: A) NWC = Current assets - Current liabilities = 144 - 132 = $12 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
15) In general, a successful firm will have a market-to-book ratio that is substantially greater than 1.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
16) A public company has a book value of $128 million. They have 20 million shares outstanding, with a
market price of $4 per share. Which of the following statements is true regarding this company?
A) Investors may consider this firm to be a growth company.
B) Investors believe the company's assets are not likely to be profitable since its market value is worth
less than its book value.
C) The firm's market value is more than its book value.
D) The value of the firm's assets are greater than their liquidation value.
E) The firm's market-to-book ratio is greater than 1.
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
17) A stock has 94 million shares outstanding, with a current share price of $3.53 per share. If the firm's
book value of equity is $120 million, what is its market-to-book ratio?
A) 2.77
B) 0.38
C) 1.28
D) 0.78
E) 3.53
Answer: A
Explanation: A) Market-to-book = (94 × 3.53)/120 = 2.77
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
18) Ivanhoe Energy Inc has 36 million shares outstanding, with a current share price of $21.45 per share.
If the firm's book value of equity is $80 million, what is its market-to-book ratio?
A) 0.45
B) 2.22
C) 9.65
D) 0.10
E) 3.73
Answer: C
Explanation: C) Market-to-book = (36 × 21.45)/80 = 9.65
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
19) Secure Energy Services has 20 million shares outstanding, with a current share price of $12.15 per
share. If the firm's market-to-book ratio is 4.5, what is the firm's book value of equity?
A) $7.4 million
B) $54 million
C) $20 million
D) $90 million
E) $243 million
Answer: B
Explanation: B) Market-to-book = Market cap / book value of equity
Book value of equity = (20 × 12.15)/4.5 = 54 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
20) CIBC has 110 million shares outstanding, with a current share price of $94.50 per share. If the firm's
market-to-book ratio is 7.85, what is the firm's book value of equity?
A) $5.6 billion
B) $0.9 billion
C) $10.4 billion
D) $1.3 billion
E) $2.75 billion
Answer: D
Explanation: D) Market-to-book = Market cap / book value of equity
Book value of equity = (110 × 94.5)/7.85 = $1.3 billion
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
21) MTS has 83 million shares outstanding with a current share price of $19.25. The firm has a marketto-book ratio of 4.17 and a book debt-equity ratio of 1.59. If MTS currently has $24 million in cash, what
is its enterprise value?
A) $0.968 billion
B) $4.115 billion
C) $1.598 billion
D) $2.183 billion
E) $1.013 billion
Answer: D
Explanation: D) Market value of equity = 83 million × 19.25 = 1.598 billion
Book value of equity = 1.598/4.17 = 383 million
Debt = 383 × 1.59 = 609 million.
Enterprise value = 1.598 billion + 609 million - 24 million = $2.183 billion
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
22) A firm has 12 million shares outstanding with a current share price of $8.50. The firm has a marketto-book ratio of 3.55 and a book debt-equity ratio of 0.8. If the firm currently has $4 million in cash, what
is its enterprise value?
A) $121 million
B) $83 million
C) $180 million
D) $102 million
E) $125 million
Answer: A
Explanation: A) Market value of equity = 12 million × 8.50 = 102 million
Book value of equity = 102/3.55 = 29 million
Debt = 29 × 0.8 = 23 million
Enterprise value = 102 + 23 - 4 = $121 million.
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
23) A firm has 41 million shares outstanding with a current share price of $4.30 The firm has a marketto-book ratio of 8.5 and a book debt-equity ratio of 2.2. If the firm currently has $18 million in cash, what
is its enterprise value?
A) $176 million
B) $204 million
C) $148 million
D) $49 million
E) $240 million
Answer: B
Explanation: B) Market value of equity = 41 million × 4.3 = 176 million
Book value of equity = 176/8.5 = 21 million
Debt = 21 × 2.2= 46 million
Enterprise value = 176 + 46 - 18 = $204 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
Use the table for the question(s) below.
Luther Corporation
Consolidated Statement of Financial Position
December 31, 2015 and 2014 (in $ millions)
Assets
Current Assets
Cash
2015
2014
63.6
58.5
Accounts receivable
55.5
39.6
45.9
6.0
171.0
42.9
3.0
144.0
Inventories
Other current assets
Total current assets
Liabilities and
Stockholders' Equity
Current Liabilities
Accounts payable
Notes payable /
short-term debt
Current maturities of longterm debt
Other current liabilities
Total current liabilities
Long-Term Liabilities
Long-term debt
Capital lease obligations
Total Debt
2015
2014
87.6
73.5
10.5
9.6
39.9
6.0
144.0
36.9
12.0
132.0
239.7
--239.7
168.9
--168.9
22.8
22.2
Long-Term Assets
Land
Buildings
Equipment
Less accumulated
depreciation
Net property, plant, and
equipment
Goodwill
Other long-term assets
Total long-term assets
66.6
109.5
119.1
62.1
91.5
99.6
(56.1)
(52.5)
Deferred taxes
239.1
60.0
63.0
362.1
200.7
-42.0
242.7
Other long-term liabilities
Total long-term liabilities
Total liabilities
Shareholders' Equity
--262.5
406.5
126.6
--191.1
323.1
63.6
Total Assets
533.1
386.7
Total liabilities and
Shareholders' Equity
533.1
386.7
24) Refer to the statement of financial position above. If in 2015 Luther has 10.2 million shares
outstanding and these shares are trading at $16 per share, then Luther's market-to-book ratio would be
closest to:
A) 0.39
B) 0.76
C) 1.29
D) 2.57
E) 0.31
Answer: C
Explanation: C) MTB = market cap / book value of equity = (10.2 million × 16) / 126.6 = 163.2 / 126.6 =
1.29
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
25) Refer to the statement of financial position above. If in 2015 Luther has 10.2 million shares
outstanding and these shares are trading at $16 per share, then Luther's stock would be considered to be
A) undervalued.
B) overvalued.
C) a growth stock.
D) a value stock.
E) worthless.
Answer: D
Explanation: D) MTB = market cap / book value of equity = (10.2 million × 16) / 126.6 = 163.2 / 126.6 =
1.29. This is a low market-to-book ratio, and thus it would be considered a value stock.
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
26) Refer to the statement of financial position above. If in 2015 Luther has 10.2 million shares
outstanding and these shares are trading at $16 per share, then what is Luther's enterprise value?
A) -$63.3 million
B) $353.1 million
C) $389.7 million
D) $516.9 million
E) $163.2 million
Answer: C
Explanation: C) Enterprise value = MVE + Debt - Cash = 10.2 × $16 + 290.1 - 63.6 = 389.7
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
27) Refer to the statement of financial position above. If on December 31, 2014 Luther has 8 million
shares outstanding trading at $15 per share, then what is Luther's market-to-book ratio?
Answer: market-to-book = market value of equity / book value of equity
market-to-book = 8 million × $15 / $63.6 = 1.89
Diff: 2 Type: ES
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
28) Refer to the statement of financial position above. If on December 31, 2014 Luther has 8 million
shares outstanding trading at $15 per share, then what is Luther's enterprise value?
Answer: Enterprise value = Market value of equity + Debt - Cash
Market value of equity = 8 million × $15 = $120 million
Debt = Notes payable + Current maturities of long-term debt + Long-term debt
Debt = 9.6 + 36.9 + 168.9 = 215.4
Cash = 58.5
So, enterprise value = $120 + 215.4 - 58.5 = $276.90.
Diff: 2 Type: ES
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
29) How does a firm select the date for preparation of its statement of financial position?
Answer: The statement of financial position is prepared on the fiscal closing date for the accounts of a
firm that may or may not coincide with the calendar year-end of December 31st.
Diff: 3 Type: SA
Skill: Analytical
Objective: 2.2 Understand the function of the statement of financial position
30) What will be the effect on the statement of financial position if a firm buys a new processing plant
through a new loan?
Answer: The Assets side will increase under Net property, plant, and equipment with the net effect of
the new processing plant while the Liabilities side will correspondingly show the new debt that was
incurred in paying for the plant.
Diff: 3 Type: SA
Skill: Conceptual
Objective: 2.2 Understand the function of the statement of financial position
2.3 The Statement of Comprehensive Income and Income Statement
1) The income statement reports the firm's revenues and expenses, and it computes the firm's bottom
line of net income, or earnings.
Answer: TRUE
Diff: 1 Type: TF
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
2) What is a firm's net income?
A) earnings before interest and taxes are deducted
B) the third line of an income statement that represents the difference between sales revenues and costs
C) a measure of the firm's profitability over a given period
D) net sales less cost of sales
E) earnings after interest is deducted but before taxes are deducted
Answer: C
Diff: 3 Type: MC
Skill: Conceptual
Objective: 2.3 Understand how the income statement is used
3) What is a firm's gross profit?
A) the difference between the sales and other income generated by the firm, and all costs, taxes, and
expenses incurred by the firm in a given period
B) the difference between sales revenues and the costs associated with those sales
C) the difference between sales revenues and cash expenditures associated with those sales
D) earnings before interest and taxes are deducted
E) earnings after interest is deducted but before taxes are deducted
Answer: B
Diff: 3 Type: MC
Skill: Conceptual
Objective: 2.3 Understand how the income statement is used
4) Gross profit is calculated as
A) Total sales - Cost of sales - Selling, general, and administrative expenses - Depreciation and
amortization.
B) Total sales - Cost of sales - Selling, general, and administrative expenses.
C) Total sales - Cost of sales.
D) Total sales - Cost of sales - Interest expense.
E) Total sales - Cost of sales - Interest expense -Taxes.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.3 Understand how the income statement is used
5) A firm has EBIT of $4.5 million, interest expense of $400,000, and pays taxes of $1.2 million. If the firm
has 2 million shares outstanding, what is the firm's EPS?
A) $1.45
B) $2.25
C) $1.65
D) $0.69
E) $1.00
Answer: A
Explanation: A) Net income = EBIT - interest expense - taxes
Net income = 4.5 - 0.4 - 1.2 = 2.9 million.
EPS = 2.9/2 = $1.45
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
6) A firm has EBIT of $29 million, interest expense of $4.5 million, and pays taxes of $8 million. If the
firm has 15 million shares outstanding, what is the firm's EPS?
A) $1.93
B) $1.10
C) $1.40
D) $1.63
E) $0.91
Answer: B
Explanation: B) Net income = EBIT - interest expense - taxes
Net income = 29 -4.5 - 8 = 16.5 million
EPS = 16.5/15 = 1.10
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
7) A firm has gross profit of $45 million, EBIT of $20 million, and net income of $8.5 million. If the firm
has 5 million shares outstanding, what is the firm's EPS?
A) $9.00
B) $4.00
C) $1.70
D) $2.30
E) $5.00
Answer: C
Explanation: C) EPS = net income/shares outstanding = 8.5/5 = $1.70
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
8) A firm has gross profit of $142 million, EBIT of $94 million, and net income of $55 million. If the firm
has 28 million shares outstanding, what is the firm's EPS?
A) $1.39
B) $3.36
C) $1.71
D) $2.30
E) $1.96
Answer: E
Explanation: E) EPS = net income/shares outstanding = 55/28 = $1.96
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
Use the table for the question(s) below.
Income Statement for Xenon Manufacturing:
Total sales
Cost of sales
Gross Profit
Selling, general, and
administrative expenses
Research and development
Depreciation and amortization
Operating Income
Other income
Earnings before interest
and taxes (EBIT)
Interest income (expense)
Pretax income
Taxes
Net Income
2014
202
-148
54
2015
212
-172
40
-22
-8
-4
20
4
-20
-7
-3
10
6
24
-7
14
-4
10
16
-4
12
-3
9
9) Consider the above Income Statement for Xenon Manufacturing. All values are in millions of dollars.
If Xenon Manufacturing has 25 million shares outstanding, what is its EPS in 2015?
A) $0.36
B) $0.40
C) $0.63
D) $0.84
E) $0.64
Answer: A
Explanation: A) EPS = Net income/# shares outstanding = 9/25 = 0.36
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
Use the table for the question(s) below.
Income Statement for CharmCorp:
Total sales
Cost of sales
Gross Profit
Selling, general, and
administrative expenses
Research and development
Depreciation and amortization
Operating Income
Other income
Earnings before interest
and taxes (EBIT)
Interest income (expense)
Pretax income
Taxes
Net Income
2014
600
-532
68
2015
540
-488
52
-36
-4
-5
23
1
-21
-5
-5
21
5
24
-7
14
-4
10
26
-7
19
-5
14
10) Consider the above Income Statement for CharmCorp. All values are in millions of dollars. If
CharmCorp has 6 million shares outstanding, and its managers and employees have stock options for 1
million shares, what is its diluted EPS in 2015?
A) $1.42
B) $1.67
C) $2.00
D) $2.33
E) $3.71
Answer: C
Explanation: C) Diluted EPS = Net income / (# shares outstanding + # options) = 14 / (6 + 1)
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
11) How does a firm select the dates for preparation of its income statement?
Answer: The income statement is prepared on the fiscal closing date for the accounts of a firm that may
or may not coincide with the calendar year-end of December 31st. Typically the income statement spans
the flow between two adjacent balance sheets.
Diff: 3 Type: SA
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
12) What will be the effect on the income statement if a firm buys a new processing plant through a new
loan?
Answer: The effect on the income statement will be in the form of a depreciation expense for the first
year on the new processing plant.
Diff: 3 Type: SA
Skill: Conceptual
Objective: 2.3 Understand how the income statement is used
Use the table for the question(s) below.
Luther Corporation
Consolidated Income Statement
Year ended December 31 (in $ millions)
2015
Total sales
610.1
Cost of sales
(500.2)
Gross profit
109.9
Selling, general, and
administrative expenses
(40.5)
Research and development
(24.6)
Depreciation and amortization
(3.6)
Operating income
41.2
Other income
--Earnings before interest and taxes (EBIT)
41.2
Interest income (expense)
(25.1)
Pretax income
16.1
Taxes
(5.5)
Net income
10.6
Price per share
Shares outstanding (millions)
Stock options outstanding (millions)
Shareholders' Equity
Total Liabilities and Shareholders' Equity
2014
578.3
(481.9)
96.4
(39.0)
(22.8)
(3.3)
31.3
--31.3
(15.8)
15.5
(5.3)
10.2
$16
10.2
0.3
$15
8.0
0.2
126.6
533.1
63.6
386.7
13) Refer to the income statement above. For the year ending December 31, 2015 Luther's earnings per
share are closest to:
A) $1.01
B) $1.04
C) $1.58
D) $4.04
E) $10.77
Answer: B
Explanation: B) EPS = Net income / Shares outstanding = $10.6 / 10.2 = $1.04
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
14) Refer to the income statement above. Assuming that Luther has no convertible bonds outstanding,
then for the year ending December 31, 2015 Luther's diluted earnings per share are closest to:
A) $1.01
B) $1.04
C) $1.53
D) $3.92
E) $4.04
Answer: A
Explanation: A) Diluted EPS = Net income / (Shares outstanding + Options contracts outstanding +
Shares possible from convertible bonds outstanding) = 10.6 / (10.2 + 0.3 + 0.0) = $1.01
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
15) Refer to the income statement above. Luther has convertible bonds outstanding that would allow
bondholders to convert their bonds into 700,000 shares of Luther stock. For the year ending December
31, 2015 Luther's diluted earnings per share are closest to:
A) $0.95
B) $1.01
C) $1.04
D) $1.53
E) $3.92
Answer: A
Explanation: A) Diluted EPS = Net income / (Shares outstanding + Options contracts outstanding +
Shares possible from convertible bonds outstanding) = 10.6 / (10.2 + 0.3 + 0.7) = $0.95
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
16) Price-earnings ratios tend to be high for fast-growing firms.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.3 Understand how the income statement is used
Use the table for the question(s) below.
Luther Corporation
Consolidated Income Statement
Year ended December 31 (in $ millions)
2015
2014
Total sales
610.1
578.3
Cost of sales
(500.2) (481.9)
Gross profit
109.9
96.4
Selling, general, and
administrative expenses
(40.5)
(39.0)
Research and development
(24.6)
(22.8)
Depreciation and amortization
(3.6)
(3.3)
Operating income
41.2
31.3
Other income
----Earnings before interest and taxes (EBIT)
41.2
31.3
Interest income (expense)
(25.1)
(15.8)
Pretax income
16.1
15.5
Taxes
(5.5)
(5.3)
Net income
10.6
10.2
Price per share
Shares outstanding (millions)
Stock options outstanding (millions)
Shareholders' Equity
Total Liabilities and Shareholders' Equity
$16
10.2
0.3
$15
8.0
0.2
126.6
533.1
63.6
386.7
17) Refer to the income statement above. Luther's earnings before interest, taxes, depreciation, and
amortization (EBITDA) for the year ending December 31, 2015 is closest to:
A) $10.6 million
B) $19.7 million
C) $37.6 million
D) $41.2 million
E) $44.8 million
Answer: E
Explanation: E) EBITDA = EBIT + Depreciation and amortization = 41.2 + 3.6 = $44.8 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.3 Understand how the income statement is used
2.4 The Statement of Cash Flows
1) The firm's statement of cash flows uses the balance sheet and the income statement to determine the
amount of cash a firm has generated and how it has used that cash during a given period.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
2) Which of the following is a way that the Operating Activity section of the statement of cash flows
adjusts Net Income from the balance sheet?
A) It subtracts all expenses and costs related to the firm's operating activities.
B) It adds all non-cash entries related to the firm's operating activities.
C) It adds the cash that flows from investors to the firm.
D) It removes the cash used for investment purposes.
E) It adds cash received from investments.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
3) Allen Company bought a new copy machine to be depreciated straight line for three years for use by
sales personnel. Where would this purchase be reflected on the Statement of Cash Flows?
A) It would be an expense on the income statement, so it would be reflected in operating cash flows.
B) It would be an addition to property, plant and equipment, so it would be an investing activity.
C) It would be an addition to cash, so would be reflected in the change in cash.
D) It would be an increase in borrowing, so would be reflected in financing activities.
E) It would be a change in inventory, so would be reflected in operating activities.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
4) A printing company prints a brochure for a client, and then bills them for this service. At the time the
printing company's financial disclosure statements are prepared, the client has not yet paid the bill for
this service. How will this transaction be recorded?
A) The sale will be added to Net Income on the income statement and retained in Net Income on the
statement of cash flows.
B) The sale will be added to Net Income on the income statement but deducted from Net Income on the
statement of cash flows.
C) The sale will not be added to Net Income on the income statement but added to Net Income on the
statement of cash flows.
D) The sale will neither be added to Net Income on the income statement nor used to adjust Net Income
on the statement of cash flows.
E) The sale will be deducted from Net Income on the income statement but added to Net Income on the
statement of cash flows.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
5) A manufacturer of plastic bottles for the medical trade purchases a new compression blow moulder
for its bottle production plant. How will the cost to the company of this piece of equipment be
recorded?
A) It will be depreciated over time on the income statement and subtracted as a capital expenditure on
the statement of cash flows.
B) It will be depreciated over time on the income statement and subtracted as Inventory on the
statement of cash flows.
C) It will be depreciated over time on the income statement and therefore not be recorded separately on
the statement of cash flows.
D) It will be subtracted from Gross Profit on the income statement and therefore not be recorded
separately on the statement of cash flows.
E) It will be depreciated over time on the income statement and added as accounts payable on the
statement of cash flows.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
6) A software company acquires a smaller company in order to acquire the patents that it holds. Where
will the cost of this acquisition be recorded on the statement of cash flows?
A) as an outflow under Operating Activities
B) as an outflow under Investment Activities
C) as an outflow under Financial Activities
D) The acquisition would not be recorded on the statement of cash flows.
E) as an inflow under Financial Activities
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
7) Farhan's Fences has retained earnings of $2.5 million, after paying dividends of $1.5 million. What
was the firm's payout ratio?
A) 0.38
B) 0.60
C) 0.63
D) 1.50
E) 1.67
Answer: A
Explanation: A) Net income = Retained Earnings + Dividends = 2.5 + 1.5 = 4 million
Payout ratio = Dividends/Net income = 1.5/4 = 0.38
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.4 Interpret a statement of cash flows
8) Solid State Software has retained earnings of $42 million, after paying dividends of $10 million. What
was the firm's payout ratio?
A) 0.24
B) 0.81
C) 0.19
D) 0.62
E) 4.20
Answer: C
Explanation: C) Net income = Retained Earnings + Dividends = 42 + 10 = 52 million
Payout ratio = Dividends/Net income = 10/52 = 0.19
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.4 Interpret a statement of cash flows
Use the table for the question(s) below.
AOS Industries Statement of Cash Flows for 2015
Operating activities
Net Income
Depreciation and amortization
Cash effect of changes in
Accounts receivable
Accounts payable
Inventory
Cash from operating activities
-2.1
1.1
-0.8
2.8
Investment activities
Capital expenditures
Acquisitions and other investing activity
Cash from investing activities
2.2
-0.4
2.6
Financing activities
Dividends paid
Sale or purchase of stock
Increase in short-term borrowing
Increase in long-term borrowing
Cash from financing activities
Change in Cash and Cash Equivalents
-1.5
2.1
1.4
3.2
5.2
5.4
3.2
1.4
9) Consider the above statement of cash flows. If all amounts shown above are in millions of dollars,
what was AOS Industries' change in retained earnings for 2015?
A) $1.3 million
B) $1.7 million
C) $2.1 million
D) $5.4 million
E) $3.2 million
Answer: B
Explanation: B) 3.2 - 1.5 = $1.7 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.4 Interpret a statement of cash flows
10) Consider the above statement of cash flows. What were AOS Industries' major means of raising
money in 2015?
A) from investment activities
B) by sale of stock
C) from its operations
D) by issuing debt
E) from short-term bank loans
Answer: D
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.4 Interpret a statement of cash flows
11) Consider the above statement of cash flows. Which of the following is true of AOS Industries'
operating cash flows?
A) It collected more cash from its customers than they charged.
B) It sold more inventory than it bought.
C) It charged more on its accounts payable than it paid back.
D) It charged less on its accounts payable than it paid back.
E) It used $1.4 million of its cash on depreciation and amortization.
Answer: C
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.4 Interpret a statement of cash flows
12) Consider the above statement of cash flows. In 2015, AOS Industries had contemplated buying a
new warehouse for $2 million, the cost of which would be depreciated over 10 years. If AOS Industries
has a tax rate of 25%, what would be the impact on the amount of cash held by AOS at the the end of the
2015?
A) It would have $2,00,000 less cash at the end of 2015.
B) It would have $1,950,000 less cash at the end of 2015.
C) It would have $150,000 less cash at the end of 2015.
D) It would have an additional $50,000 in cash at the end of 2015.
E) It would have $1,800,000 less cash at the end of 2015.
Answer: B
Explanation: B) -$2,000,000 +200,000 × 0.25 = -$1,950,000
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.4 Interpret a statement of cash flows
13) How can we cross check the statement of cash flows?
Answer: The last item in the statement of cash flows should equal the difference in cash balances
between two adjacent balance sheets.
Diff: 3 Type: SA
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
14) What will be the effect on the statement of cash flows if a firm buys a new processing plant through
a new loan?
Answer: The new loan entry should show as a cash inflow for the firm in financing activities, while the
payment for the new processing plant will be entered as a cash outflow in investing activities.
Diff: 3 Type: SA
Skill: Conceptual
Objective: 2.4 Interpret a statement of cash flows
2.5 Other Financial Statement Information
1) The management of public companies are not legally required to disclose any off balance sheet
transactions.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.5 Know what management's discussion and analysis and the statement of shareholders' equity are
2) A firm whose primary business is in a line of regional grocery stores would be most likely to have to
include which of the following facts, if true, in the firm's management discussion and analysis
(MD&A)?
A) that a large number of funds were allocated to advertising to increase awareness of the firm's brand
in new areas it had expanded into this year
B) that some senior members of the management team have retired in this financial year
C) that the company has lost a class action suit brought against the firm by its employees and is
expected to have to pay a large amount of damages
D) that the firm has plans to expand into the organic food business in the next financial year by
purchasing several small organic food retailers
E) that food prices have increased, increasing the firm's costs
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.5 Know what management's discussion and analysis and the statement of shareholders' equity are
3) Which type of transactions must be disclosed in the management discussion and analysis?
A) transactions that significantly affect the firm's leverage
B) off balance sheet transactions
C) off income statement transactions
D) very large transactions
E) transactions that reduce the firm's net income
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.5 Know what management's discussion and analysis and the statement of shareholders' equity are
4) What is the need for the notes to the financial statements when the firm's operations are already
documented in the financial statements?
Answer: Not all actions of the firm can be directly converted to an entry on the financial statements. For
example, the firm may be involved in off balance sheet transactions, which have to be reported through
notes to the financial statements.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 2.5 Know what management's discussion and analysis and the statement of shareholders' equity are
2.6 Financial Statement Analysis
Use the table for the question(s) below.
Luther Corporation
Consolidated Income Statement
Year ended December 31 (in $ millions)
2015
2014
Total sales
610.1 578.3
Cost of sales
(500.2) (481.9)
Gross profit
109.9
96.4
Selling, general, and
administrative expenses
(40.5) (39.0)
Research and development
(24.6) (22.8)
Depreciation and amortization
(3.6)
(3.3)
Operating income
41.2
31.3
Other income
----Earnings before interest and taxes (EBIT)
41.2
31.3
Interest income (expense)
(25.1) (15.8)
Pretax income
16.1
15.5
Taxes
(5.5)
(5.3)
Net income
10.6
10.2
Price per share
Shares outstanding (millions)
Stock options outstanding (millions)
Shareholders' Equity
Total Liabilities and Shareholders' Equity
$16
10.2
0.3
$15
8.0
0.2
126.6
533.1
63.6
386.7
1) Refer to the income statement above. Luther's operating margin for the year ending December 31,
2014 is closest to:
A) 1.8%
B) 2.7%
C) 5.4%
D) 6.8%
E) 16.7%
Answer: C
Explanation: C) Operating margin = Operating income / Sales
OM = 31.3 / 578.3 = 0.054 or 5.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
2) Refer to the income statement above. Luther's net profit margin for the year ending December 31,
2014 is closest to:
A) 1.8%
B) 2.7%
C) 5.4%
D) 16.7%
E) 18.3%
Answer: A
Explanation: A) Net profit margin = Net income / Total sales = 10.2 / 578.3 = 0.018 or 1.8%
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
3) Refer to the income statement above. Luther's return on equity (ROE) for the year ending December
31, 2015 is closest to:
A) 2.0%
B) 6.5%
C) 8.4%
D) 12.7%
E) 32.5%
Answer: C
Explanation: C) ROE = Net income / Shareholders' equity = 10.6 / 126.6 = 0.084 or 8.4%
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
4) Refer to the income statement above. Luther's return on assets (ROA) for the year ending December
31, 2015 is closest to:
A) 2.0%
B) 6.5%
C) 8.4%
D) 12.7%
E) 32.5%
Answer: A
Explanation: A) ROA = Net income / Total assets.
This is a little tricky in that Total Assets are not given in the problem. The student must remember the
basic balance sheet equation A = L + SE. Total Liabilities and Shareholders' Equity is given and this is
the same as Total Assets. So, ROA = 10.6 / 533.1 = 0.020 or 2.0%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
Use the table for the question(s) below.
Income Statement for Xenon Manufacturing:
Total sales
Cost of sales
Gross Profit
Selling, general, and
administrative expenses
Research and development
Depreciation and amortization
Operating Income
Other income
Earnings before interest
and taxes (EBIT)
Interest income (expense)
Pretax income
Taxes
Net Income
2014
2015
202
212
-148
-172
54
40
-22
-8
-4
20
4
-20
-7
-3
10
6
24
-7
14
-4
10
16
-4
12
-3
9
5) Consider the above Income Statement for Xenon Manufacturing. All values are in millions of dollars.
Calculate the operating margin for 2014 and 2015. What does the change in the operating margin
between these two years imply about the company?
A) The efficiency of Xenon Manufacturing has significantly risen between 2014 and 2015.
B) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of
producing them rose between 2014 and 2015.
C) The efficiency of Xenon Manufacturing has significantly fallen between 2014 and 2015.
D) The leverage of Xenon Manufacturing fell slightly between 2014 and 2015.
E) The revenues available to equity holders fell slightly between 2014 and 2015.
Answer: C
Explanation: C) 24 / 202 = 0.12; 16 / 212 = 0.08
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
6) Consider the above Income Statement for Xenon Manufacturing. All values are in millions of dollars.
Calculate the gross margin for 2014 and 2015. What does the change in the gross margin between these
two years imply about the company?
A) The efficiency of Xenon Manufacturing has significantly risen between 2014 and 2015.
B) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of
producing them rose between 2014 and 2015.
C) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of
producing them fell between 2014 and 2015.
D) The leverage of Xenon Manufacturing fell slightly between 2014 and 2015.
E) The revenues available to equity holders fell slightly between 2014 and 2015.
Answer: C
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
7) Consider the above Income Statement for Xenon Manufacturing. All values are in millions of dollars.
Calculate the gross margin for 2014 and 2015. What does the change in the net profit margin between
these two years imply about the company?
A) The efficiency of Xenon Manufacturing has significantly risen between 2014 and 2015.
B) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of
producing them rose between 2014 and 2015.
C) The ability of Xenon Manufacturing to sell its goods and services for more than the costs of
producing them fell between 2014 and 2015.
D) The leverage of Xenon Manufacturing fell slightly between 2014 and 2015.
E) The revenues available to equity holders fell slightly between 2014 and 2015.
Answer: E
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
8) A firm has total sales of $53 million. It has gross profit of $12 million, operating income of $8.5
million, and net income of $4 million. What is the firm's net profit margin?
A) 7.5%
B) 16%
C) 22.6%
D) 33.3%
E) 47%
Answer: A
Explanation: A) Net profit margin = net income/sales = 4/53 = 7.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
9) A firm's net profit margin increased from 3.2% to 3.8% from 2014 to 2015. If total sales increased from
$312 million in 2014 to $345 million in 2015, what was the increase in net income?
A) $19 million
B) $21 million
C) $3 million
D) $2 million
E) $13 million
Answer: C
Explanation: C) Net profit margin = net income/sales
2014: Net income = 0.032 × 312 = $10 million
2015: Net income = 0.038 × 345 = $13 million
Increase in net income = 13 -10 = $3 million.
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
10) A firm's net profit margin increased from 8.1% to 8.3% from 2014 to 2015. If net income increased
from $4.5 million to $5.6 million, what was the change in the firm's sales?
A) $55 million
B) $21 million
C) $0.1 million
D) $11.9 million
E) $1.1 million
Answer: D
Explanation: D) Net profit margin = net income/sales
2014: Sales = 4.5/0.081 = $55.56 million
2015: Sales = 5.6/0.083 = $67.47 million
Increase in sales = 67.47 - 55.56 = $11.9 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
11) A firm has $10 million in cash, $4.5 million in accounts receivable, and inventory of $8 million. The
firm's accounts payable is $6.2 million and the firm has no short-term debt. What is the firm's current
ratio?
A) 3.63
B) 1.05
C) 5.38
D) 2.90
E) 2.34
Answer: A
Explanation: A) Current ratio = current assets/current liabilities = (10 + 4.5 + 8)/6.2 = 3.63
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
12) A firm has $6 million in cash, $1.5 million in accounts receivable, and inventory of $4.2 million. The
firm's accounts payable is $7.4 million and the firm has no short-term debt. What is the firm's quick
ratio?
A) 0.81
B) 1.58
C) 1.01
D) 0.45
E) 0.77
Answer: C
Explanation: C) Quick ratio = (current assets - inventory)/current liabilities = (6 + 1.5)/7.4 = 1.01
Diff: 1 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
13) A firm's current assets increase from 1.4 million in 2014 to 1.7 million in 2015. If the firm's current
liabilities are unchanged at $1.1 million, and inventory remains unchanged, what is the change in the
firm's quick ratio?
A) increase of 0.28
B) no change
C) increase of 0.30
D) cannot be determined
E) increase of 1.27
Answer: A
Explanation: A) Initial current ratio = 1.4/1.1 = 1.27
Final current ratio = 1.7/1.1 = 1.55
Since current liabilities and inventory do not change, change in quick ratio = change in current ratio =
1.55 - 1.27 = 0.28
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
14) A firm has EBIT of $15 million, interest expense of $1 million, and pays taxes of $4 million. The firm
has a market-to-book ratio of 5.75. If the firm has 30 million shares outstanding at a current price of $12
per share, what is its ROE?
A) 24%
B) 2.8%
C) 16%
D) 4.2%
E) 18%
Answer: C
Explanation: C) Net income = 15 - 1 - 4 = $10 million.
Book value of equity = (30 × 12)/5.75 = 62.61
ROE = Net income/Book value of equity = 10/62.61 = 16%
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
15) A firm has EBIT of $24 million and has a corporate tax rate of 25%. The firm has total debt of $40
million, and excess cash of $8 million. If the firm's book value of equity is $72 million, what is the firm's
return on invested capital (ROIC)?
A) 6%
B) 17%
C) 16%
D) 15%
E) 23%
Answer: B
Explanation: B) ROIC = EBIT(1 - tax rate)/(Book value of equity + Net debt)
ROIC = 24(1 - 0.25)/(72 + 40 - 8) = 18/104 = 17%
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
16) A firm has ROE of 15% and a net profit margin of 4.5%. If the firm has 6.5 dollars in assets per dollar
of equity, what is the firm's asset turnover ratio?
A) 0.5
B) 2
C) 1
D) 1.5
E) 2.5
Answer: A
Explanation: A) ROE = net profit margin × asset turnover × equity multiplier
Asset turnover = 15/(4.5 × 6.5) = 0.5
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
17) A firm has an asset turnover ratio of 1.6 and a net profit margin of 1.3%. If the firm has 5 dollars in
assets per dollar of equity, what is the firm's ROE?
A) 4.1%
B) 6.5%
C) 6.2%
D) 10.4%
E) 1.3%
Answer: D
Explanation: D) ROE = net profit margin × asset turnover × equity multiplier
ROE = 1.3 × 1.6 × 5 = 10.4%
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
18) A firm has ROE of 5.5% and an asset turnover ratio of 1.2. If the firm has 10 dollars in assets per
dollar of equity, what is the firm's net profit margin?
A) 1.2%
B) 0.66%
C) 5.5%
D) 6.6%
E) 0.46%
Answer: E
Explanation: E) ROE = net profit margin × asset turnover × equity multiplier
Net profit margin = 5.5/(1.2 × 10) = 0.46%
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
19) A firm has ROE of 18.5%, net profit margin of 3.2% and an asset turnover ratio of 0.7. What is the
firm's equity multiplier?
A) 4.0
B) 8.3
C) 13.0
D) 4.6
E) 5.8
Answer: B
Explanation: B) ROE = net profit margin × asset turnover × equity multiplier
Equity multiplier = 18.5/(3.2 × 0.7) = 8.3
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
20) In 2015, an agricultural company introduced a new cropping process which reduced the cost of
growing some of its crops. If sales in 2014 and 2015 were steady at $25 million, but the gross margin
increased from 2.3% to 3.4% between those years, by what amount was the cost of sales reduced?
A) $275,000
B) $325,000
C) $425,000
D) $575,000
E) $850,000
Answer: A
Explanation: A) (25 × 0.034 - 25 × 0.023) × 1,000,000 = $275,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
21)
Firm A:
Assets
Current assets
Fixed assets
Total assets
Firm A:
Total sales
Cost of sales
Gross Profit
4
10
14
Firm B:
Assets
Current assets
Fixed assets
Total assets
7
7
14
12
-5
7
Firm B:
Total sales
Cost of sales
Gross Profit
12
-7
5
Above are portions of the balance sheet and income statement for two companies in 2015. Based upon
this information, which of the following statements is most likely to be true?
A) Asset turnover ratios indicate that firm A is generating greater revenue per dollar of assets than firm
B.
B) Fixed asset turnover ratios indicate that firm A generating fewer sales for the assets they employ than
firm B.
C) Both asset turnover ratios and fixed asset turnover ratios indicate that firm A is generating greater
revenue per dollar of assets than firm B.
D) Fixed asset turnover ratios indicate that firm A generating more sales for the assets they employ than
firm B.
E) Asset turnover ratios indicate that firm A is generating less revenue per dollar of assets than firm B.
Answer: B
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
Use the tables for the question(s) below.
Balance Sheet
Assets
Current Assets
Cash
Accounts receivable
Inventories
Total current assets
50
22
17
89
Long-Term Assets
Net property, plant,
and equipment
Total long-term assets
121
121
Total Assets
210
Liabilities
Current Liabilities
Accounts payable
Notes payable/short-term debt
42
7
Total current liabilities
49
Long-Term Liabilities
Income Statement
Total sales
Cost of sales
Gross Profit
Selling, general, and
administrative expenses
Research and development
Depreciation and amortization
Operating Income
Other income
Earnings before interest
and taxes (EBIT)
Interest income (expense)
Pretax income
Taxes
Net Income
Long-term debt
Total long-term liabilities
Total Liabilities
Shareholders' Equity
Total Liabilities and
Shareholders' Equity
128
128
177
33
210
312
-210
102
-34
-10
-5
53
53
-20
33
-8
25
22) The balance sheet and income statement of a particular firm are shown above. What does the
accounts receivable days ratio tell you about this company?
A) It takes on average about 4 weeks to collect payment from its customers.
B) It takes on average about 6 weeks to collect payment from its customers.
C) It takes on average about 7 weeks to collect payment from its customers.
D) It takes on average about 8 weeks to collect payment from its customers.
E) It takes on average about 11 weeks to collect payment from its customers.
Answer: A
Explanation: A) 22 / (312 / 365) = 25.7 days, or approximately 4 weeks
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
23) The balance sheet and income statement of a particular firm are shown above. What does the
accounts payable days ratio tell you about this company?
A) It takes on average about 4 weeks to pay its suppliers.
B) It takes on average about 6 weeks to pay its suppliers.
C) It takes on average about 7 weeks to pay its suppliers.
D) It takes on average about 8 weeks to pay its suppliers.
E) It takes on average about 10 weeks to pay its suppliers.
Answer: E
Explanation: E) 42 / (210 / 365) = 73 days, or approximately 10 weeks
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
24) Which of the following firms would be expected to have a high ROE based on that firm's high
operating efficiency?
A) a medical supply company that provides very precise instruments at a high price to large medical
establishments such as hospitals
B) a high-end fashion retailer that has a very high mark-up on all items it sells
C) a brokerage firm that has high levels of leverage
D) a grocery store chain that has very high turnover, selling many multiples of its assets per year
E) a mining firm that is mostly engaged in exploration for new deposits
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
25) Which of the following firms would be expected to have a high ROE based on that firm's high
profitability?
A) a medical supply company that provides very precise instruments at a high price to large medical
establishments such as hospitals
B) a low-end retailer that has a low mark-up on all items it sells
C) a brokerage firm that has high levels of leverage
D) a grocery store chain that has very high turnover, selling many multiples of its assets per year
E) a mining firm that is mostly engaged in exploration for new deposits
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
26) Manufacturer A has a profit margin of 2.0%, an asset turnover of 1.7, and an equity multiplier of 4.9.
Manufacturer B has a profit margin of 2.3%, an asset turnover of 1.1, and an equity multiplier of 4.7.
How much asset turnover should manufacturer B have to match manufacturer A's ROE?
A) 1.54
B) 3.00
C) 3.09
D) 4.77
E) 1.10
Answer: A
Explanation: A) ROEa = 2 × 1.7 × 4.9 = 16.66; ROEb = 2.3 × 1.1 × 4.7 = 11.891; 16.66 / (2.3 × 4.7) = 1.54
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
27)
Net Income
Market Capitalization
Earnings per share
Firm A
$34.1
million
$310 million
$4.10
Firm B
$5.7
million
$53 million
$4.05
Firm C
Firm D
Firm E
$31.1
$13.2
million
million
$23 million
$280 million $112 million $198 million
$6.75
$12.70
$7.85
The above data is for five regional trucking firms. Based on price-earnings ratios, which firm's stock is
the best value?
A) Firm A
B) Firm B
C) Firm C
D) Firm D
E) Firm E
Answer: B
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
28) Why must care be taken when comparing a firm's share price to its operating income?
A) Both share price and operating income are related to the whole firm.
B) Share price is a quantity related to the entire firm, while operating income is an amount that is
related solely to equity holders.
C) Both share price and operating income are related solely to equity holders.
D) Share price is a quantity related to equity holders, while operating income is an amount that is
related to the whole firm.
E) Share price is a quantity related to the enterprise value of the firm, while operating income is related
to the equity holders.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
29) A company has a share price of $24.50 and 118 million shares outstanding. Its market-to-book ratio
is 4.2, its book debt-equity ratio is 3.2, and it has cash of $800 million. How much would it cost to take
over this business assuming you pay its enterprise value?
A) $1.5 billion
B) $2.8 billion
C) $3.6 billion
D) $4.3 billion
E) $2.9 billion
Answer: D
Explanation: D) Market cap = 24.5 × 118 = $2.891 billion; Book value = 2.891 / 4.2 = 0.688;
Debt = 0.688 × 3.2 = 2.203; Enterprise value = 2.891 + 2.203 - 0.800 = 4.3 billion
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
30) Which ratio would you use to measure the financial health of a firm by assessing that firm's
leverage?
A) debt-equity or equity multiplier ratio
B) market-to-book ratio
C) market debt-equity ratio
D) current or quick ratio
E) price-to-book ratio
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
31) Company A has current assets of $42 billion and current liabilities of $31 billion. Company B has
current assets of $2.7 billion and current liabilities of $1.8 billion. Which of the following statements is
correct, based on this information?
A) Company A is less likely than Company B to have sufficient working capital to meet its short-term
needs.
B) Company A has greater leverage than Company B.
C) Company A has less leverage than Company B.
D) Company A and Company B have roughly equivalent enterprise values.
E) Company A is more likely than Company B to have sufficient working capital to meet its short-term
needs.
Answer: A
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
Use the table for the question(s) below.
Luther Corporation
Consolidated Statement of Financial Position
December 31, 2015 and 2014 (in $ millions)
Assets
Current Assets
Cash
2015
2014
63.6
58.5
Accounts receivable
55.5
39.6
45.9
6.0
171.0
42.9
3.0
144.0
Inventories
Other current assets
Total current assets
Liabilities and
Stockholders' Equity
Current Liabilities
Accounts payable
Notes payable /
short-term debt
Current maturities of longterm debt
Other current liabilities
Total current liabilities
Long-Term Liabilities
Long-term debt
Capital lease obligations
Total Debt
2015
2014
87.6
73.5
10.5
9.6
39.9
6.0
144.0
36.9
12.0
132.0
239.7
--239.7
168.9
--168.9
22.8
22.2
Long-Term Assets
Land
Buildings
Equipment
Less accumulated
depreciation
Net property, plant, and
equipment
Goodwill
Other long-term assets
Total long-term assets
66.6
109.5
119.1
62.1
91.5
99.6
(56.1)
(52.5)
Deferred taxes
239.1
60.0
63.0
362.1
200.7
-42.0
242.7
Other long-term liabilities
Total long-term liabilities
Total liabilities
Shareholders' Equity
--262.5
406.5
126.6
--191.1
323.1
63.6
Total Assets
533.1
386.7
Total liabilities and
Shareholders' Equity
533.1
386.7
32) Refer to the statement of financial position above. Luther's quick ratio for 2014 is closest to:
A) 0.77
B) 1.31
C) 1.09
D) 0.92
E) 0.87
Answer: A
Explanation: A) quick ratio = (current assets - inventory) / current liabilities
quick ratio = (144.0 - 42.9) / 132 = 0.77
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
33) Refer to the statement of financial position above. The change in Luther's quick ratio from 2014 to
2015 is closest to:
A) a decrease of 0.10
B) an increase of 0.10
C) a decrease of 0.15
D) an increase of 0.15
E) being unchanged
Answer: B
Explanation: B) quick ratio in 2011 = (171.0 - 45.9) / 144 = 0.87
quick ratio 2010 = (144.0 - 42.9) / 132 = 0.77
So, the quick ratio increased by 0.87 - 0.77 = 0.10.
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
34) Refer to the statement of financial position above. When using the book value of equity, the debtequity ratio for Luther in 2015 is closest to:
A) 2.21
B) 2.29
C) 2.98
D) 3.03
E) 4.39
Answer: B
Explanation: B) D/E = Total debt / Total equity
Total debt = Notes payable (10.5) + Current maturities of long-term debt (39.9) + Long-term debt (239.7)
= 290.1 million
Total equity = 126.6, so D/E = 290.1 / 126.6 = 2.29
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
35) Refer to the statement of financial position above. If in 2015 Luther has 10.2 million shares
outstanding and these shares are trading at $16 per share, then using the market value of equity, the
debt-equity ratio for Luther in 2015 is closest to:
A) 1.71
B) 1.78
C) 2.31
D) 2.35
E) 2.29
Answer: B
Explanation: B) D/E = Total debt / Total equity
Total Debt = Notes payable (10.5) + Current maturities of long-term debt (39.9) + Long-term debt (239.7)
= 290.1 million
Total equity = 10.2 × $16 = 163.2, so D/E = 290.1 / 163.2 = 1.78
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
36) Refer to the statement of financial position above. Luther's current ratio for 2015 is closest to:
A) 0.84
B) 0.87
C) 1.15
D) 1.19
E) 0.77
Answer: D
Explanation: D) current ratio = current assets / current liabilities = 171 / 144 = 1.19
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
Use the table for the question(s) below.
Statement of Financial Position
Assets
Current Assets
Cash
Accounts receivable
Inventories
Total current assets
2014 2015
50
22
17
89
46
12
38
96
Long-Term Assets
Net property, plant,
and equipment
Total long-term assets
121
121
116
116
Total Assets
210
212
Liabilities
2014 2015
Current Liabilities
Accounts payable
42
48
Notes payable/short-term debt
7
5
Total current liabilities
49
53
128
128
177
33
136
136
189
23
210
212
Long-Term Liabilities
Long-term debt
Total long-term liabilities
Total Liabilities
Shareholders' Equity
Total Liabilities and
Shareholders' Equity
37) If the above statement of financial position is for a retail company, what indications about this
company would best be drawn from the changes in the statement of financial position between 2014
and 2015?
A) The company is having difficulties selling its product.
B) The company has reduced its debt.
C) The company has added a major new asset in terms of plant and equipment.
D) The company has experienced a significant rise in its market value.
E) The company has reduced its net working capital.
Answer: A
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
38) If the above statement of financial position is for a retail company, what indications about this
company would best be drawn from the changes in quick ratio between 2014 and 2015?
A) The company has eliminated the risk that it will experience a cash shortfall in the near future.
B) The company has reduced the risk that it will experience a cash shortfall in the near future.
C) The risk that the company will experience a cash shortfall in the near future is unchanged.
D) The company has increased the risk that it will experience a cash shortfall in the near future.
E) The company has greatly reduced the risk that it will experience a cash shortfall in the near future.
Answer: D
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
39) If the above statement of financial position is for a retail company, how has the company's leverage
changed between 2014 and 2015?
A) The company has experienced a very significant decrease in its leverage.
B) The company has experienced a significant decrease in its leverage.
C) The company has experienced no significant change in its leverage.
D) The company has experienced a significant increase in its leverage.
E) The company has experienced a slight decrease in its leverage.
Answer: D
Diff: 3 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
40) If the above statement of financial position is for a retail company, what indications about this
company would best be drawn from the changes in leverage between 2014 and 2015?
A) The company's risk has decreased.
B) The company's risk is unchanged.
C) The company may have a problem in meeting borrowing obligations in the future.
D) The company has excellent growth prospects.
E) The company is bankrupt.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
41) If the above statement of financial position is for a retail company, what indications about this
company would best be drawn from the changes in shareholders' equity between 2014 and 2015?
A) The company is very profitable because it is obviously collecting receivables faster.
B) The company is selling its property, plant, and equipment, which may result in a long-term
deficiency in production capacity.
C) The company's net income in 2015 was negative.
D) The company's enterprise value declined.
E) The company has experienced a significant rise in its market value.
Answer: C
Diff: 2 Type: MC
Skill: Analytical
Objective: 2.6 Use financial statement information to analyze a company's profitability, liquidity, asset efficiency,
working capital, interest coverage, leverage, valuation, and operating returns
2.7 Financial Reporting in Practice
1) Use of Generally Accepted Accounting Principles (GAAP) and auditors have eliminated the danger
of inadvertent or deliberate fraud in financial statements.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
2) One way Enron manipulated its financial statements was to sell assets at inflated prices to other
firms, while giving a promise to buy back those assets at a later date. The incoming cash was recorded
as revenue, but the promise to buy back the assets was not disclosed. Which of the following is one of
the ways that such a transaction is deceptive?
A) The assets should have been listed on the balance sheet as long-term assets.
B) Cash raised by selling assets should not be recorded as revenue.
C) The cash raised should have been recorded as short-term loans.
D) The off balance sheet promises to repurchase assets should have been disclosed in management
discussion and analysis (MD&A) or notes to the financial statement.
E) The promise to buy back the assets should have been listed under accounts payable.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
3) Which of the following is one of the ways that the Sarbanes-Oxley Act sought to improve the
accuracy of information given to both boards and shareholders?
A) by reducing the penalties to firms for providing false information
B) by increasing the independence of auditors and clients
C) by increasing the non-audit fees that an auditor can receive from a client
D) by forcing CEOs and CFOs to certify the accuracy of their firm's financial statements
E) by removing the requirement that firms include outside directors on audit committees
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
4) Which of the following describes why Canada's regulation changes following the Enron scandal were
less strict than those in the United States?
A) Canada has a national securities commission that can monitor firms more closely than the SEC in the
United States.
B) The same scale of corporate fraud had yet to be experienced in Canada.
C) Canadian firms tend to have higher market capitalizations than U.S. firms, and the reporting costs of
increased regulation place a greater burden on larger firms.
D) Canada has a much larger percentage of public firms with a controlling shareholder, and these firms
require less oversight than firms without concentrated ownership.
E) Since Canadian firms report according to IFRS, their financial statements are likely to be more
accurate.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
5) Which of the following is the main lesson that analysts and investors should take from the case of
Enron?
A) The usefulness of financial statements to investors is entirely dependent on the ethics of those
constructing them.
B) It is not possible to effectively evaluate a company unless all the financial statements are fully and
correctly prepared.
C) The information in financial statements should be viewed extremely critically.
D) Readers of even fraudulent financial statements can spot signs of a firm's financial health if those
statements are read fully and with care.
E) Financial statements are too easily manipulated and cannot be taken at face value.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
6) What role do external auditors play in the firm's financial reporting process?
Answer: As the name implies, external auditors act as third party monitors to the firms' financial
reporting process.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
7) What role does Generally Accepted Accounting Principles (GAAP) play in the accounting process?
Answer: All firms quoted on a Canadian exchange are required to use GAAP in their financial
reporting process. This standardization process makes it easier to adjust and/or compare the financial
figures across different firms.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
8) According to the text, did Enron follow Generally Accepted Accounting Principles (GAAP) in its
financial reporting process?
Answer: Many of Enron's problems were kept hidden from boards and shareholders until it was too
late. People felt that the accounting statements of the company, while often remaining true to the letter
of GAAP, did not present an accurate picture of the financial health of the company.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 2.7 Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other
financial scandals
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 3 The Valuation Principle: The Foundation of Financial Decision Making
3.1 Cost-Benefit Analysis
1) In general, if an action increases a firm's value by providing benefits with a value greater than any
costs involved, then that action is good for the firm's investors.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
2) To enable costs and benefits to be compared, they are typically converted into cash value at the time
the benefit is received.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
3) Costs and benefits must be put in common terms if they are to be compared.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
4) Which of the following is the overarching principle that a financial manager should follow when
making decisions?
A) Decisions should generate the greatest benefits for the firm.
B) Decisions should provide benefit to the firm without incurring costs greater than those benefits to
others.
C) Decisions should be on behalf of the firm's owners that give the greatest benefit to those owners, the
firm's employees, and the firm's other stakeholders.
D) Decisions should increase the value of the firm to its investors.
E) Decisions should be in the strategic competitive interests of the firm.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
5) A firm that provides tax services to the public intends to offer a premium tax-return service at a
higher price than their current services. The managers of the company ask experts in marketing to
determine how much an effective ad campaign for such a service would cost, and by how much sales
would be increased. They consult experts in economics to calculate the increases in revenue from the
success of the campaign, experts in operations to determine the cost of offering the service, and experts
in strategy to anticipate possible counter-moves by competitors. This example illustrates which of the
following points about the role of financial managers?
A) Real-world decisions are complex and require information from many sources if the decisions are to
be valid.
B) Determining the costs associated with making a decision is easier than determining the potential
benefits of the decision.
C) All of the costs and benefits associated with a decision can never be fully identified.
D) Ultimately the decision whether to take a certain course of action rests with the financial managers of
a company.
E) A financial manager's job is to make decisions on behalf of the firm's investors.
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
Use the information for the question(s) below.
Alaska North Slope Crude Oil (ANS)
West Texas Intermediate Crude Oil (WTI)
$71.75/Bbl
$73.06/Bbl
As an oil refiner, you are able to produce $76 worth of unleaded gasoline from one barrel of Alaska
North Slope (ANS) crude oil. Because of its lower sulfur content, you can produce $77 worth of
unleaded gasoline from one barrel of West Texas Intermediate (WTI) crude.
6) Another oil refiner is offering to trade you 10,150 Bbls of Alaska North Slope (ANS) crude oil for
10,000 Bbls of West Texas Intermediate (WTI) crude oil. Assuming you currently have 10,000 Bbls of
WTI crude, the added benefit (cost) to you if you take the trade is closest to:
A) ($1400)
B) $1400
C) ($3908)
D) $3908
E) $2508
Answer: B
Explanation: B) Total Benefits
No trade and refine WTI crude (base case)
10,000 Bbls × $77 of gasoline/Bbl = $770,000
Trade WTI for ANS crude
10,150 Bbls × $76 of gasoline/Bbl = $771,400
Added Benefits = Total Benefits - Base Case
Trade WTI for ANS crude
= $771,400 - $770,000 = $1400
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
7) Assuming you currently have 10,000 Bbls of WTI crude, the added benefit (cost) to you if you were to
sell the 10,000 Bbls of WTI crude and use the proceeds to purchase and refine ANS crude is closest to:
A) ($1400)
B) $1400
C) ($3908)
D) $3908
E) $2508
Answer: D
Explanation: D) Total Benefits
No trade and refine WTI crude (base case)
10,000 Bbls × $77 of gasoline/Bbl = $770,000
Sell WTI and use proceeds to buy ANS
10,000 Bbls WTI × $73.06/Bbl = $730,600
Buy ANS crude
$730,600 / $71.75/Bbl ANS = 10,182.57 or approx 10,183 Bbls ANS
10,183 Bbls × $76 of gasoline/Bbl = $773,908
Added Benefits = Total Benefits - Base Case
Sell WTI and use proceeds to buy ANS
= $773,908 - $770,000 = $3908
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
8) Assuming you just purchased 10,000 Bbls of WTI crude at the current market price, the total benefit
(cost) to you if you were to refine this crude oil and sell the unleaded gasoline is closest to:
A) $730,600
B) $770,000
C) $771,400
D) $773,908
E) $775,000
Answer: B
Explanation: B) Total Benefits
No trade and refine WTI crude (base case)
10,000 Bbls × $77 of gasoline/Bbl = $770,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
9) Another oil refiner is offering to trade you 10,150 Bbls of Alaska North Slope (ANS) crude oil for
10,000 Bbls of West Texas Intermediate (WTI) crude oil. Assuming you just purchased 10,000 Bbls of
WTI crude at the current market price, the total benefit (cost) to you if you take the trade is closest to:
A) $730,600
B) $770,000
C) $771,400
D) $773,908
E) $775,000
Answer: C
Explanation: C) Total Benefits
Trade WTI for ANS crude
10,150 Bbls × $76 of gasoline/Bbl = $771,400
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
10) Assuming you currently have 10,000 Bbls of WTI crude, the total benefits to you if you were to sell
the 10,000 Bbls of WTI crude and use the proceeds to purchase and refine ANS crude is closest to:
A) $730,600
B) $770,000
C) $771,400
D) $773,908
E) $775,000
Answer: D
Explanation: D) Total Benefits
Sell WTI and use proceeds to buy ANS
10,000 Bbls WTI × $73.06/Bbl = $730,600
Buy ANS crude
$730,600 / $71.75/Bbl ANS = 10,182.57 or approx 10,183 Bbls ANS
10,183 Bbls × $76 of gasoline/Bbl = $773,908
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
11) Another oil refiner is offering to trade you 10,150 Bbls of Alaska North Slope (ANS) crude oil for
10,000 Bbls of West Texas Intermediate (WTI) crude oil. Assuming you currently have 10,000 Bbls of
WTI crude, what should you do?
A) Sell 10,00 Bbls WTI crude on the market and use the proceeds to purchase and refine ANS crude.
B) Do nothing, refine the 10,000 Bbls of WTI crude.
C) Trade the 10,000 Bbls WTI crude with the other refiner and refine the 10,150 Bbls of ANS crude.
D) Trade the 10,000 Bbls WTI crude with the other refiner and then sell the 10,150 Bbls of ANS crude.
E) Purchase 10,150 Bbls of ANS on the market and refine both the ANS and WTI crude.
Answer: A
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
12) Steve is offered an investment where for every $1.00 invested today, he will receive $1.10 at the end
of each of the next five years. Steve concludes that in five years time he will have $1.10 for every $1.00
invested and that this investment will increase his personal value. What is Steve's major error in
reasoning when making this decision?
A) Costs and benefits must be in the same terms to be compared.
B) There may be other investments that he can make that will offer even bigger benefits.
C) The investment may have hidden costs that will reduce the amount of benefit he receives.
D) The value of the cash he has today is greater than the value of the cash he may have in the future.
E) Whether he has enough spare cash with which to invest.
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
13) In a trade with the government of an oil-producing nation, a manufacturer will deliver 14
Caterpillar D9 tractors, with a value of $350,000 per tractor, and receive 45,000 barrels of oil, valued at
$115 per barrel. What is the net benefit of this trade to the manufacturer?
A) $158,000
B) $275,000
C) $1,750,000
D) $4,900,000
E) $5,175,000
Answer: B
Explanation: B) -14 × 350,000 + 115 × 45,000 = -4,900,000 + 5,175,000 = $275,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
14) A wholesale food retailer is offered $14 per two-layer carton for 5000 cartons of peaches. The
wholesaler can buy peaches from its growers at $12.50 per carton. Shipping costs $1.50 per carton, for
the first 1000 cartons, and $1.00 per carton for every carton over that. Will taking this opportunity
increase the value of the wholesale food retailer?
A) No. The costs are $1,200 more than the benefits.
B) No. The costs and the benefits are the same.
C) Yes. The costs are $1,000 less than the benefits.
D) Yes. The costs are $2,000 less than the benefits.
E) Yes. The costs are $1,500 less than the benefits.
Answer: D
Explanation: D) 0.50 × 4000 = $2000
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
15) Heavy Duty Inc., a manufacturer of power tools, decides to offer a rebate of $100 on its 16-inch midrange chain saw, which currently has a retail price $470. Heavy Duty's marketers estimate that, as a
result of the rebate, sales of this model will increase from 50,000 to 80,000 units next year. The profit
margin for Heavy Duty before the rebate is $150. Based on the given information, is the decision to give
the rebate a wise one?
A) No, since costs are $5.0 million more than benefits.
B) No, since costs are $3.5 million more than benefits.
C) Yes, since the benefits are $0.2 million more than the costs.
D) Yes, since the benefits are $1.5 million more than the costs.
E) Yes, since the benefits are $0.5 million more than the costs.
Answer: B
Explanation: B) 150 × 50,000 = $7,500,000; 50 × 80,000 = $4,000,000;
$7,500,000 - $4,000,000 = $3,500,000
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
Country
Australia
Abalone Cost AUD 93,500
Exchange
Rate: $1 U.S. = 1.1 AUD
Chile
Iceland
CLP 50,990,000 ISK 5,400,000
New Zealand
NZD 104,000
South Africa
ZAR 640,000
585 CLP
1.3 NZD
7.8 ZAR
61 ISK
16) Refer to the table above. An international seafood supplier is offered 9.45 million yen today for 1000
pounds of abalone frozen in the shell. The abalone can be sourced from various countries at the prices
shown above. The current market exchange rates between the United States and the other relevant
currencies are also shown. In addition, $1 U.S. = 105 yen. What is the value of the best deal the
international seafood supplier can make, in U.S. dollars?
A) $5,000
B) $7,000
C) $8,000
D) $10,000
E) $9,450
Answer: D
Explanation: D) 9.45 million / 105 YEN = $90,000; cost = 104,000 / 1.3 NZD = $80,000
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
17) A metal fabrication company is pricing raw supplies of aluminium.The following are the costs to the
company to receive one tonne of aluminium from various sources. Which source offers the best price for
aluminium per tonne?
A) 3,012 Canadian dollars per tonne
B) 3,206 Australian dollars per tonne, with $0.942 CAD = 1 AUD
C) 4,998 Brazilian reals per tonne, with $0.6000 CAD = 1 BRL
D) 121,756 Indian rupees per tonne, with $0.025 CAD = 1 INR
E) 3,000 U.S. dollars per tonne, with $1.015 CAD = 1 US
Answer: C
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
18) You own 1000 shares of Newstar Financial stock, currently trading for $57 per share. You are offered
a deal where you can exchange these stocks for 900 shares of Amback Financial Group stock, currently
trading at $63 per share. What is the value of this trade, if you choose to make it?
A) -$540
B) -$480
C) -$300
D) $280
E) $600
Answer: C
Explanation: C) -57 × 1000 + 900 × 63 = -$300
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
19) A company intends to install new management software for its warehouse. The software will cost
$50,000 to buy and will cost an additional $150,000 to install and implement. It is anticipated that it will
save the company $45,000 through reductions in staff and $65,000 in general inventory costs in the first
year after installation. What is the benefit to the company in the first year if they choose to install the
software?
A) $45,000
B) $90,000
C) $110,000
D) $180,000
E) $65,000
Answer: C
Explanation: C) $45,000 + $65,000 = $110,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
20) You have a used CD store. At an estate sale, you can purchase 260 compact discs for $400. You
believe you could sell the CDs for an average of $2.50 each. What is the net benefit of buying the CDs at
the estate sale and selling them in your store?
A) $650
B) $400
C) $1050
D) $250
E) $900
Answer: D
Explanation: D) ($2.50 × 260) - $400 = $650 - $400 = $250
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
21) What is one of the main obstacles in cost benefit analysis?
Answer: One of the main obstacles in cost benefit analysis is that not all benefits that are expected to
occur in the future can be stated in dollar terms.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
22) How can we perform cost benefit analysis in case they are occurring in different currencies?
Answer: We need to convert costs and benefits occurring in different currencies to one base currency
before performing any time value computation.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
Use the information for the question(s) below.
Low-Grade Copper Ore
High-Grade Copper Ore
$571 per Ton
$843 per Ton
Coloma Cooper Incorporated is able to produce $640 worth of copper from one ton of low-grade copper
ore. Because of its higher copper content, Coloma can produce $940 worth of copper from one ton of
high-grade copper ore.
23) A mining company is offering to trade you 7250 tons of low-grade copper ore for 5000 tons of highgrade copper ore. Assuming you currently have 5000 tons of high-grade ore, what should you do?
Answer: Don't trade. Coloma should keep the high grade ore and refine it.
See below:
Total Benefits
No trade and refine high-grade ore (base case)
5000 tons × $940 of copper/ton = $4,700,000
Trade high-grade for low-grade
7250 tons × $640 of copper/ton = $4,640,000
Diff: 2 Type: ES
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
24) A company that manufactures copper piping is offering to trade you 5925 tons of low-grade copper
ore for 4000 tons of high-grade copper ore. Assuming you currently have 4000 tons of high-grade ore,
what are the total benefits and added benefits of taking the trade?
Answer: Total Benefits
No trade and refine high-grade ore (base case)
4000 tons × $940 of copper/ton = $3,760,000
Trade high-grade for low-grade
5925 tons × $640 of copper/ton = $3,792,000 (total benefits)
Added Benefits = Total Benefits - Base Case
= $3,792,000 - $3,760,000 = $32,000 (added benefit)
Diff: 2 Type: ES
Skill: Analytical
Objective: 3.1 Identify the role of financial managers in decision making
25) Explain the role played by some of the other management disciplines in financial decision making.
Answer: The role played by some of the other management disciplines include:
∙ Economics: to determine the effect of a price reduction on net income.
∙ Marketing: to determine the increase in revenues resulting from an advertising campaign.
∙ Strategy: to determine a competitor's response to a price decrease.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 3.1 Identify the role of financial managers in decision making
3.2 Market Prices and the Valuation Principle
1) Whenever a good trades in a competitive market, the price the good trades for determines the value
of the good.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
2) Whenever a good trades in a competitive market, the ________ determines the value of the good.
A) supply
B) price
C) demand
D) cost
E) quantity
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
3) Which of the following best explains why market prices are useful to a financial manager when
performing a cost-benefit analysis?
A) They can be used to determine how much an asset can be sold for.
B) They can be used to convert different services and commodities into equivalent cash values which
can be compared.
C) They allow all commodities and services to be assigned a fixed and unchanging value.
D) They can be evaluated to determine whether the market in which the manager exchanges goods and
services offers true value.
E) They can be used to determine the correct value for assets to be purchased.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
4) A coin collector treasures his 1969-S Lincoln cent with a doubled die obverse because he found it in
his pocket change, rather than purchasing it. He can sell it on the open market for $35,000, but would
only sell it for at least twice that price, due to its sentimental value to him. It is anticipated that the coin
will increase in market value in the foreseeable future. What is the value of the coin?
A) Nothing, since he paid nothing to obtain the coin.
B) $35,000, since this is the price that the coin would fetch on the open market.
C) At least $35,000, since he could replace the coin for $35,000, but the coin he owns has additional
intangible value due to its sentimental value.
D) At least $35,000, since the value of the coin will increase in the future.
E) $0.01 since this is the face value of the coin.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
5) What is a competitive market?
A) a market in which goods can be bought at the ask price and sold at bid price
B) a market in which a good can be bought and sold at the same price
C) a market in which a good is sold at a lower price than that for which it can be bought
D) a market in which a good is bought for a lower price than that for which it can be sold
E) a market in which buyers do not have to shop around for the cheapest price
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
6) An elderly relative offers to sell you her used 1958 Cadillac Eldorado for $50,000. You note that very
similar cars are selling on the open market for $90,000. You don't care for classic cars and would rather
buy a new Ford Explorer for $35,000. What is the net value of buying the Cadillac?
A) $90,000, since the Cadillac could be sold for this price.
B) $50,000, since the Cadillac could be bought for this price.
C) $40,000, since this is the difference between purchase and resale price of the Cadillac.
D) $35,000, since this is the value of the car that you really want to buy.
E) -$15,000, since this would cost that much more than the car that you really want to buy.
Answer: C
Explanation: C) Net value = $90,000 - $50,000 = $40,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
7) A company decides to close down its plastics division. It has on hand 20 tons of styrene monomer, a
raw material that has a market price of $700 per ton, which had been originally purchased at $650 per
ton. Given that the company has no use for the styrene monomer, and that it would cost the company
$5000 to store it, what is the value of the 20 tons of styrene monomer to the company?
A) -$5000
B) $0
C) $13,000
D) $14,000
E) $19,000
Answer: D
Explanation: D) Value of 20 tons monomer = 20 × 700 = $14,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
8) A firm has contracted to supply 500,000 gallons of propane fuel for $1.49 million to the local
municipality. The municipality wants to break the contract. What does the minimum current market
price of propane need to be in order for the firm to benefit from breaking the contract?
A) greater than $2.97 per gallon
B) greater than $2.98 per gallon
C) greater than $2.99 per gallon
D) greater than $3.00 per gallon
E) greater than $3.01 per gallon
Answer: B
Explanation: B) The firm should benefit as long as it gets a price higher than the contract price;
contract price = $1,490,000 / 500,000 = $2.98.
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
9) A manufacturer of breakfast cereals has the opportunity to purchase barley at $3.00 a bushel for
10,000 bushels, if it also buys 5,000 bushels of wheat at $16.00 per bushel. However, the manufacturer
does not use any barley in its products, and currently needs 20,000 bushels of wheat. If the current
market price of barley is $3.80 per bushel, and wheat is $15.80 per bushel, should this opportunity be
taken, and why?
A) Because the company has no need of barley, the opportunity should not be taken.
B) Because the opportunity does not meet the company's need for wheat, the opportunity should not be
taken.
C) Because the value of the opportunity is positive, the opportunity should be taken.
D) Because the value of the opportunity is negative the opportunity should not be taken.
E) Because the company will have to pay more for wheat, the opportunity should not be taken.
Answer: C
Explanation: C) 0.8 × 10,000 - 0.2 × 5000 = 8000 - 1000 = $7000
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
10) Which of the following is the best statement of the Valuation Principle?
A) It is not possible to compare costs and benefits that occur at different points in time, in different
currencies, or with different risks.
B) The value of a commodity or an asset to the firm or its investors is determined by its competitive
market price. When the value of the benefits exceeds the value of the costs in terms of market prices, the
decision will increase the market value of the firm.
C) The rate at which we can exchange money today for money in the future by borrowing or investing
is the current market interest rate and is same across all banks.
D) If equivalent goods or securities trade simultaneously in different markets across the world, they will
trade for the same price.
E) The value of a commodity or an asset is determined by assessing its use to the firm.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
11) Which of the following best explains why you cannot use the price of rolled oats at a local
supermarket as the competitive market value of rolled oats?
A) You can buy the oats at the price posted by the store, but the store will not buy oats from you for the
same price.
B) The posted prices of oats can vary widely between grocery stores, even within the same local area.
C) Grocery stores mark up the prices of their oats up to make a profit.
D) Grocery stores typically sell oats in different packaging, which results in different prices within the
same store.
E) You can only by the oats in the quantities specified by the grocery store.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
12) Like other metals, uranium 308 is traded in competitive markets like the New York Metals
Exchange. Which of the following would most likely value a given weight of uranium 308 the most?
A) a power station that uses uranium 308 to produce electrical energy
B) a metals trader who stockpiles and sells actual physical quantities of uranium 308
C) a speculator who buys and sells uranium 308 on the market without ever using the metal
D) a uranium mining company
E) All buyers and sellers would have the same value for 250 pounds of uranium.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
13) The Law of One Price states that if equivalent goods or securities are traded simultaneously in
different competitive markets, they will trade for the same price in each market.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
14) If an arbitrage opportunity exists, an investor can act quickly in the hope of making a risk-free profit.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
15) Which of the following is an example of arbitrage?
A) An inventor of a new hydrocarbon cracking technology based on palladium buys this metal knowing
that its price will rise when the technology is adopted.
B) A metals merchant is offered $108,000 in one year for $100,000 of palladium today, when the interest
rate is 10%.
C) An investor, seeing that the price of palladium on the metals exchange in two different countries is
slightly different, buys on one and sells on the other to make a profit.
D) A firm buys $250,000 of palladium today, with an option to sell it at $275,000 in one year if interest
rates rise above 10%.
E) An investor buys palladium today hoping the price will increase and it can be sold for a profit.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
16) Why are arbitrage opportunities short-lived?
A) Federal regulations will kick in to restrict trade and effectively shut the opportunity down.
B) Prices will fluctuate up and down as traders take advantage of the opportunity, resulting in the net
present value (NPV) fluctuating between positive and negative values.
C) Once investors take advantage of the opportunity, prices will respond so that the buying and selling
price become equal.
D) Arbitrage opportunities need a lot of information processing, which is very slow to arrive.
E) Investors will stop taking advantage of them for fear of being caught by regulators.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
17) Sellers can make typographical errors when listing items on the online auction site eBay. These items
often attract very few bidders. For example, someone listing a Nokia phone as a Nokya phone would
have very few potential buyers sent to the incorrectly listed item by eBay's search engines. Some buyers
look for items that are mislisted, buy them for a low price, then immediately list them for resale under
the correct listing. Why does an arbitrage opportunity exist in this case?
A) eBay's search engine makes it a fundamentally non-competitive market, since sellers do not have the
same advantages as buyers.
B) Buyers with a greater knowledge of the market than sellers can purchase goods for a discount.
C) The same item can be bought and sold on what are essentially two different markets, a market of
mislisted items where they sell low and a market of correctly listed items where they sell high.
D) The items are, in effect, not equivalent, since the item listed incorrectly will sell, in general, for a
lower price than the correctly listed item.
E) Sellers deliberately change the spelling to avoid getting caught selling stolen goods.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
18) The State Bank offers an interest rate of 5.5% on savings and 6% on loans, while the Colonial Bank
offers 6.5% on savings and 7% on loans. Which of the following is the likely outcome of such a
situation?
A) The State Bank would experience a surge in demand for deposits.
B) The Colonial Bank would experience a surge in demand for deposits.
C) The Colonial Bank would experience a fall in demand for deposits.
D) The Colonial Bank would experience a surge in demand for loans.
E) The State bank would experience a fall in demand for loans.
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
19) Which of the following statements regarding the Law of One Price is most accurate?
A) At any point in time, the price of two equivalent goods trading in different competitive markets is
expected to be different.
B) One consequence of the Law of One Price is that when evaluating costs and benefits to compute a net
present value (NPV), we must check the price in all possible markets.
C) If equivalent goods or securities trade simultaneously in different competitive markets, then they
will trade for the same price in both markets.
D) An important property of the Law of One Price is that it holds even in markets where arbitrage is not
possible.
E) Different goods trading simultaneously in the same competitive market will trade for different prices.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
Use the table for the question(s) below.
Consider the following prices from a McDonald's Restaurant:
Big Mac Sandwich
Large Coke
Large Fry
$2.99
$1.39
$1.09
20) A McDonald's Big Mac value meal consists of a Big Mac sandwich, large Coke, and a large fry.
Assuming that there is a competitive market for McDonald's food items, at what price must a Big Mac
value meal sell to ensure the absence of an arbitrage opportunity and uphold the Law of One Price?
A) $4.08
B) $4.38
C) $5.47
D) $5.77
E) $5.00
Answer: C
Explanation: C) 2.99 + 1.39 + 1.09 = 5.47
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
21) A McDonald's Big Mac value meal consists of a Big Mac sandwich, large Coke, and a large fry.
Assume that there is a competitive market for McDonald's food items and that McDonald's sells the Big
Mac value meal for $4.79. Does an arbitrage opportunity exists and if so how would you exploit it and
how much would you make on one value meal?
A) Yes, buy a value meal and then sell the Big Mac, Coke, and fries to make arbitrage profit of $0.68.
B) No, no arbitrage opportunity exists.
C) Yes, buy a Big Mac, Coke, and fries, then sell a value meal to make arbitrage profit of $1.09.
D) Yes, buy a Big Mac, Coke, and fries, then sell a value meal to make arbitrage profit of $0.68.
E) Yes, buy a value meal and then sell the Big Mac, Coke, and fries to make arbitrage profit of $1.09.
Answer: A
Explanation: A) Buy a value meal and sell the Big Mac, Coke and fries.
-4.79 + 2.99 + 1.39 + 1.09 = 0.68 (so arbitrage exists)
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
22) Walgreen Company (NYSE: WAG) is currently trading at $48.75 on the NYSE. Walgreen Company
is also listed on NASDAQ and assume it is currently trading on NASDAQ at $48.50. Does an arbitrage
opportunity exist and, if so, how would you exploit it and how much would you make on a block trade
of 100 shares?
A) No, no arbitrage opportunity exists.
B) Yes, buy on NASDAQ and sell on NYSE, make $25.
C) Yes, buy on NYSE and sell on NASDAQ, make $25.
D) Yes, buy on NASDAQ and sell on NYSE, make $250.
E) Yes, buy on NYSE and sell on NASDAQ, make $250.
Answer: B
Explanation: B) Yes, buy 100 shares × 48.50 and sell 100 shares × 48.75 = $25.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
23) If the exchange rates, after fees, in Tokyo are ¥1000 = €6 = $9 and the exchange rates in Paris are €1 =
$1.5 = ¥171, which of the following would you expect to occur?
A) a surge in conversion of dollars to yen in Tokyo
B) a surge in conversion of euros to yen in Tokyo
C) a surge in conversion of euros to dollars in Paris
D) a surge in conversion of euros to yen in Paris
E) a drop in conversion of euros to dollars in Tokyo
Answer: D
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
24) The exchange rates in New York are ¥1000 = $9 and the exchange rates in Tokyo are ¥171 = $1.5. You
incur a transaction fee of 0.1% when buying and selling in each market. You have $1 million dollars
with which to purchase foreign currency. What is your maximum potential profit from exploiting the
arbitrage opportunity?
A) $0
B) $0.024 million
C) $0.026 million
D) -$0.024 million
E) -$0.026 million
Answer: B
Explanation: B) Buy Yen in Tokyo: $1 million × (¥171 / $1.5) = ¥114 million; after fees: ¥114 million ×
0.999 = ¥113.886 million; Sell Yen in New York: 113.886 million × ($9 / ¥1000) = $1.024974 million; after
fees: $1.024974 million × 0.999 = $1.024 million. Profit = 0.024 million.
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
25) A backhoe can dig 150 feet of trench per hour and costs $500 per hour to hire and operate. A ditch
digger can dig six feet of trench per hour. Based on this information, what is the most a ditch digger can
charge per hour when digging ditches?
A) $20 per hour
B) $25 per hour
C) $3.33 per hour
D) $83.33 per hour
E) $500 per hour
Answer: A
Explanation: A) To be competitive, the ditch digger could not charge more than backhoe costs;
cost per foot of ditch for backhoe = $500 / 150 = $3.33;
charge per hour by ditch digger = $3.33 × 6 = $20
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
26) "If equivalent investment opportunities trade simultaneously in different competitive markets, then
they must trade for the same price in both markets."
What do we call the above statement?
A) the Net Present Value rule
B) the Law of One Price
C) the Valuation Principle
D) the time value of money
E) an arbitrage opportunity
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
27) On Commodity Exchange A it is possible to buy and sell crude oil at $117 per barrel, while on
Commodity Exchange B crude oil can be bought and sold at $118 per barrel. If there are transaction
costs of 1% when buying or selling on either exchange, what is the net effect of buying a barrel of oil on
Exchange A and selling it on Exchange B?
A) -$1.35
B) -$0.17
C) $0.99
D) $1.01
E) $1.00
Answer: A
Explanation: A) -$117 × 1.01 = -$118.17; $118 × 0.99 = $116.82;
cash out = -$118.17; cash in = $116.82
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
28) Suppose the price of gold in New York is $1750 per ounce, while the price of gold in London is
$1760. If there are transaction costs of 0.5% when buying or selling in either market, what is the net
effect of buying one ounce of gold in New York and selling it in London?
A) $1.25
B) $1.20
C) -$7.55
D) -$1.25
E) $10.00
Answer: C
Explanation: C) -$1750 × 1.005 = $1758.75; $1760 × .995 = $1751.20;
Net effect = -1758.75 + 1751.20 = -$7.55
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
29) You see on Kijiji that a used XBOX One sells for $100 and a new XBOX One sells for $300. Is this an
arbitrage opportunity?
A) No., because the market for a used XBOX One is not the same as the market for a new XBOX One.
B) No, because the market for a used XBOX One is a competitive market.
C) Yes, because the market for a used XBOX One is a competitive market.
D) Yes, because the market for a used XBOX One is not the same as the market for a new XBOX One.
E) No, because Kijiji is not a competitive market.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
30) Diwali Airlines has a contract that gives them the opportunity to purchase up to 10,000,000 gallons
of jet fuel at $2.00 per gallon. The current market price of jet fuel is $2.26 per gallon. Diwali believes they
will only need 6,000,000 gallons of jet fuel. What is the value of this opportunity?
A) $1,560,000
B) $2,600,000
C) $1,040,000
D) $9,040,000
E) $12,000,000
Answer: B
Explanation: B) 10,000,000 × ($2.26 - $2.00) = $2,600,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
31) Suppose that Bondi Inc. is a holding company that owns both Pizza Hut and KFC franchised
restaurants. If the value of Bondi is $130 million, and the Pizza Hut franchises are worth $70 million,
then what is the value of the KFC franchises?
A) $60 million
B) $70 million
C) $130 million
D) $200 million
E) $50 million
Answer: A
Explanation: A) value KFC = value of Bondi - value of Pizza Hut = 130 - 70 = $60 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
32) Which of the following statements best describes the effect of transaction costs on arbitrage and the
Law of One Price?
A) As long as the market is competitive, transaction costs will have no effect.
B) When there are transaction costs, there will never be arbitrage opportunities.
C) Prices can deviate but not by more than the amount of the transaction costs.
D) Prices will be different in different competitive markets, and this difference usually exceeds the
amount of the transaction costs.
E) Arbitrage possibilities increase in the presence of transaction costs.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
33) How does arbitrage help the Law of One Price?
Answer: Any arbitrage opportunity will exploit any mispricing to restore the Law of One Price.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
34) What role do transaction costs play in establishing the Law of One Price?
Answer: Transaction costs play a negative role in establishing the Law of One Price. Thus for arbitrage
opportunities to be exploited, the divergence in prices should be high enough to recover the transaction
costs.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
35) You are watching TV late one night and see an ad from Ronco for the Dial-o-matic food slicer. You
learn that the Dial-o-matic sells for $29.95. But wait, there's more! Ronco is also including in this deal a
set of Ginsu steak knives worth $10.95 and another free gift worth $7.95. Assuming that there is a
competitive market for Ronco items, at what price must Ronco be selling this three item Dial-o-matic
deal to ensure the absence of an arbitrage opportunity and uphold the Law of One Price?
Answer: 29.95 + 10.95 + 7.95 = $48.85
Diff: 1 Type: ES
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
36) Advanced Micro Devices (NYSE: AMD) is currently trading at $20.75 on the NYSE. Advanced Micro
Devices is also listed on NASDAQ and assume it is currently trading on NASDAQ at $20.50. Does an
arbitrage opportunity exist and, if so, how would you exploit it and how much would you make on a
block trade of 1000 shares?
Answer: Yes, buy 1000 shares × 20.50 and sell 1000 shares × 20.75 = $250.00.
Diff: 1 Type: ES
Skill: Analytical
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
37) What is one of the prerequisite conditions for the Valuation Principle to work?
Answer: The availability of competitive market prices is a prerequisite for the Valuation Principle to be
effective and efficient.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 3.2 Recognize the role competitive markets play in determining the value of a good
3.3 The Time Value of Money and Interest Rates
1) Dollar amounts received at different points in time cannot be compared in absolute terms.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
2) The one-year discount factor is the discount at which we can purchase money in the future.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
3) Why is it usually necessary to use the time value of money when performing a cost-benefit analysis?
A) For an investment project to be considered, costs must have a higher dollar value than benefits.
B) In most investment projects costs are incurred up front, but benefits are provided in the future.
C) For practical purposes, a dollar today may be considered to be equal to a dollar at some future time.
D) Although costs and benefits generally occur concurrently, the benefits will accrue value over time,
due to interest.
E) Since money is worth more in the future, if the time value of money is not considered, profitable
investments will be passed up.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
4) How can we convert the value of money from one point in time to another?
A) using the current exchange rate
B) using a cost benefit analysis
C) using the Valuation Principle
D) using the current interest rate
E) using competitive market prices
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
5) If the risk-free rate of interest (rf) is 6%, then you should be indifferent between receiving $250 in one
year or
A) $235.85 today.
B) $250.00 today.
C) $265.00 today.
D) $244.00 today.
E) $256.00 today.
Answer: A
Explanation: A) Benefit = $250.00 / ($1.06 in one year / $1.00 today) = $235.85
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
6) If the risk-free rate of interest (rf) is 6%, then you should be indifferent between receiving $250 today
or
A) $235.85 in one year.
B) $250.00 in one year.
C) $265.00 in one year.
D) $244.00 in one year.
E) $256.00 in one year.
Answer: C
Explanation: C) $250.00 × (1.06) = $265.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
7) You decide to deposit $5000 in a bank account paying 3.5% interest. What is the value of your savings
in one year?
A) $5,175
B) $4,831
C) $5,000
D) $5,500
E) $5,350
Answer: A
Explanation: A) 5000 × 1.035 = $5,175
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
8) You decide to deposit your money in a bank account paying 6% interest. If the value of your savings
grows to $3,180 in one year's time, how much money did you deposit?
A) $3,180
B) $3,371
C) $3,000
D) $3,100
E) $3,080
Answer: C
Explanation: C) 3,180/1.06 = $3,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
9) You decide to $10,000 in a bank account. If the value of your savings grows to $10,200 in one year's
time, what is the interest rate on your savings?
A) 5%
B) 4%
C) 3%
D) 2%
E) 1%
Answer: D
Explanation: D) 10,200/10,000 -1 = 2%
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
10) You have made an investment which will pay you $10,485 in one year's time. If the discount factor is
0.9728, what is the present value of your investment?
A) $10,200
B) $10,000
C) $10,485
D) $10,778
E) $10,400
Answer: A
Explanation: A) PV = 10,485 × 0.9728 = 10,200
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
11) Owen expects to receive $20,000 at the end of next year from a trust fund. If a bank loans money at
an interest rate of 7.5%, how much money can he borrow from the bank on the basis of this information?
A) $11,428
B) $15,000
C) $18,605
D) $21,500
E) $20,000
Answer: C
Explanation: C) $20,000 / 1.075 = $18,605
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
12) Stella deposits $5000 in a savings account at a bank that offers interest of 5.5% on such accounts.
What is the value of the money in her savings account in one year's time?
A) $4739
B) $5135
C) $5275
D) $7750
E) $5000
Answer: C
Explanation: C) $5,000 × 1.055 = $5,275
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
13) An investment will pay $205,000 at the end of next year for an investment of $183,000 at the start of
the year. If the market interest rate is 8% over the same period, should this investment be made?
A) No, because the investment will yield $6240 less than putting the money in a bank.
B) Yes, because the investment will yield $2360 more than putting the money in a bank.
C) Yes, because the investment will yield $4280 more than putting the money in a bank.
D) Yes, because the investment will yield $7360 more than putting the money in a bank.
E) Yes, because the investment will yield $14,640 more than putting the money in a bank.
Answer: D
Explanation: D) $183,000 × 1.08 = $197,640; $205,000 - $197,640 = $7360
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
14) If $476 invested today yields $500 in one year's time, what is the discount factor?
A) 0.05
B) 0.95
C) 1.05
D) 1.50
E) 0.24
Answer: B
Explanation: B) $476 / $500 = 0.95
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
15) If $476 invested today yields $500 in one year's time, what is the discount rate?
A) 0.05
B) 0.95
C) 1.05
D) 1.50
E) 0.24
Answer: A
Explanation: A) 1 / (476 / 500) -1 = 0.05
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
16) A vintner is deciding when to release a vintage of sauvignon blanc. If it is bottled and released now,
the wine will be worth $2.2 million. If it is barrel aged for a further year, it will be worth 20% more,
though there will be additional costs of $500,000, realized at the end of the year. If the interest rate is 7%,
what is the difference in the benefit the vintner will realize if he releases the wine after barrel aging it for
one year or if he releases the wine now?
A) He will earn $600,000 less if he releases the wine now.
B) He will earn $200,000 more if he releases the wine now.
C) He will earn $107,000 less if he releases the wine now.
D) He will earn $80,000 more if he releases the wine now.
E) He will earn $500,000 less if he releases the wine now.
Answer: B
Explanation: B) PV of releasing now = $2.2 million
PV of aging one year: $2.2 million × 1.2 = $2.64 million; $2.64 million - $500,000 = $2.14 million; 2.14/1.07
= $2 million.
Difference = $2.2 million - $2 million = $200,000.
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
17) Samantha has holdings of 250 troy ounces of platinum, currently valued at $815 dollars per ounce.
She estimates that the price of platinum will rise to $850 per ounce in the next year. If the interest rate is
8%, should she sell the platinum today?
A) Yes, as the difference between selling now and selling in one year is $7550 dollars one year from
now.
B) Yes, as the difference between selling now and selling in one year is $6991 dollars one year from now.
C) Yes, as the difference between selling now and selling in one year is $5513 dollars one year from
now.
D) No, as the difference between selling now and selling in one year is -$6988 dollars one year from
now.
E) No, the difference between selling now and selling in one year is -$8750 dollars one year from now.
Answer: A
Explanation: A) $815 × 250 = $203,750; $203,750 × 1.08 = $220,050;
$850 × 250 = $212,500; $220,050 - $212,500 = $7550
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
18) You are scheduled to receive $10,000 in one year. An increase in the interest rate will have what
effect on the present value of this cash flow?
A) It will cause the present value to fall.
B) It will cause the present value to rise.
C) It will have no effect on the present value.
D) The effect cannot be determined with the information provided.
E) It will cause the present value to rise significantly.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
19) You are scheduled to receive $10,000 in one year. An decrease in the interest rate will have what
effect on the present value of this cash flow?
A) It will cause the present value to fall.
B) It will cause the present value to rise.
C) It will have no effect on the present value.
D) The effect cannot be determined with the information provided.
E) It will cause the present value to fall significantly.
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
20) You are scheduled to receive $10,000 in one year. An increase in the interest rate will have what
effect on the future value of this cash flow?
A) It will cause the future value to fall.
B) It will cause the future value to rise.
C) It will have no effect on the future value.
D) The effect cannot be determined with the information provided.
E) It will cause the future value to fall significantly.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
21) If the interest rate is 5%, the one-year discount factor is equal to:
A) 0.050
B) 1.050
C) 0.952
D) 1.045
E) 0.950
Answer: C
Explanation: C) 1/(1.05) = 0.952
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
22) If the one-year discount factor is equal to 0.90909, the interest must be equal to:
A) 5.0%
B) 9.1%
C) 9.5%
D) 10.0%
E) 10.5%
Answer: D
Explanation: D) 1/(1 + r) = 0.90909
1 = (1 + r) × 0.90909
1 = 0.90909 + 0.90909r
1 - 0.90909 = 0.90909r
0.09091 = 0.90909r
r = 0.09091/0.90909 = .10 = 10%
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
23) Explain why a dollar today is worth more than a dollar tomorrow.
Answer: A dollar today can be invested to earn interest, which will make it worth more than a dollar
tomorrow.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
24) How can we take a financial decision with cash flows occurring at different points in time?
Answer: We need to transform the cash flows to a single point in time either through present value
(PV) computations or through future value (FV) computations, thus bringing all of them at the same
point in time to perform simple algebraic computation.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 3.3 Understand the Valuation Principle and how it can be used to identify decisions that increase the value
of the firm
3.4 Valuing Cash Flows at Different Points in Time
1) A dollar today and a dollar in one year may be considered to be equivalent.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
2) The rule of 72 tells you approximately how long it takes for money invested at a given rate of
compound interest to double in value.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
3) To calculate a cash flow's present value (PV), you must compound it.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
4) What is the present value (PV) of $85,000 received 15 years from now, assuming the interest rate is
3% per year?
A) $54,558
B) $85,000
C) $82,524
D) $132,427
E) $5,502
Answer: A
Explanation: A) Calculate the PV with FV = $85,000, interest = 3%, and N =15, PV = $54,558
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
5) What is the present value (PV) of $1 million received 100 years from now, assuming the interest rate
is 5% per year?
A) $10,000
B) $7,604
C) $9,524
D) $11,114
E) $112
Answer: B
Explanation: B) Calculate the PV with FV = $1,000,000, interest = 5%, and N =100, PV = $7,604
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
6) What is the present value (PV) of $66,000 received 7 years from now, assuming the interest rate is 9%
per year?
A) $60,550
B) $60,000
C) $66,000
D) $36,104
E) $8,650
Answer: D
Explanation: D) Calculate the PV with FV = $66,000, interest = 9%, and N =7, PV = $36,104
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
7) What is the future value (FV) of $10,000 in 50 years, assuming the interest rate is 4% per year?
A) $100,804
B) $52,000
C) $520,000
D) $20,000
E) $71,067
Answer: E
Explanation: E) Calculate the FV with PV = $10,000, interest = 4%, and N = 50, FV = $71,067
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
8) What is the future value (FV) of $100 in 30 years, assuming the interest rate is 8% per year?
A) $102
B) $3,240
C) $1,800
D) $1,006
E) $1,080
Answer: D
Explanation: D) Calculate the FV with PV = $100, interest = 8%, and N = 30, FV = $1,006
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
9) What is the future value (FV) of $72,000 in 25 years, assuming the interest rate is 5.5% per year?
A) $1.9 million
B) $274,564
C) $171,000
D) $1.8 million
E) $144,000
Answer: B
Explanation: B) Calculate the FV with PV = $72,000, interest = 5.5%, and N = 25, FV = $274,564
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
10) If $1 million is invested at 6% per year, in approximately how many years will the investment
double?
A) 10.1
B) 11.9
C) 12.9
D) 15
E) 8.7
Answer: B
Explanation: B) Calculate the N with FV = $2 million, PV = $1 million, and interest = 6%, N = 11.9
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
11) If money is invested at 8% per year, after approximately how many years will the interest earned be
equal to the original investment?
A) 5 years
B) 6 years
C) 9 years
D) 12 years
E) 8 years
Answer: C
Explanation: C) Calculate the N using the rule of 72.
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
12) If the future value (FV) in two years of $100,000 invested in a certain fund that compounds it at a
fixed rate annually is $116,640, at what rate has it been compounded?
A) 8.00%
B) 11.66%
C) 16.00%
D) 24.20%
E) 10.00%
Answer: A
Explanation: A) Calculate the interest with FV = $116,640, PV = $100,000, and N = 2, which = 8%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
13) Jeff has the opportunity to receive lump-sum payments either now or in the future. Which of the
following opportunities is the best, given that the interest rate is 7% per year?
A) one that pays $1,000 now
B) one that pays $1,200 in two years
C) one that pays $1,500 in five years
D) one that pays $1,800 in ten years
E) one that pays $5,000 in 25 years
Answer: C
Explanation: C) It has the highest Present Value. Calculate with FV = $1500, and interest = 7%, and
number of years = 5, which gives PV = $1,069.479.
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
14) Michelle is saving for a new car. She wants to have $25,000 in her account in 3 years. If her account
pays 11% interest, how much money will she need to put in her account now, to ensure that she has
$25,000 in 3 years?
A) $18,280
B) $25,000
C) $20,000
D) $18,060
E) $18,000
Answer: A
Explanation: A) Calculate the PV with FV = $25000, N =3, and interest = 11%, PV = 18,280
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
15) On the day Justine was born, her grandparents put $10,000 into a savings account that pays interest
of 6% per year. How much money will Justine have in her account when she turns 18?
A) $20,800
B) $190,800
C) $28,543
D) $20,000
E) $18,000
Answer: C
Explanation: C) Calculate the FV with PV = $10000, interest = 6%, and N = 18, FV = $28,543
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
16) Helen is saving to start a business. If she invests $10,000 in a savings account now, which of the
following is the minimum interest rate required to ensure that she has $25,000 in her account in ten
years time?
A) 2.5%
B) 6.4%
C) 9.6%
D) 10.2%
E) 8.7%
Answer: C
Explanation: C) Calculate the interest rate FV = $25,000 with PV = $10,000 and N = 10, which = 9.6%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
17) Which of the following statements is correct?
A) The process of moving a value or cash flow forward in time is known as discounting.
B) The effect of earning interest on interest is known as compound interest.
C) It is possible to compare or combine values at different points in time.
D) A dollar in the future is worth more than a dollar today.
E) Calculating the value of a future cash flow at an earlier point in time is known as compounding.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
18) Consider the following timeline:
If the current market rate of interest is 9%, then the present value (PV) of this timeline as of year 0 is
closest to:
A) $492
B) $637
C) $600
D) $400
E) $463
Answer: A
Explanation: A) PV = FV(1 + r)n
100 / (1.09)1 = 91.74
200 / (1.09)2 = 168.34
300 / (1.09)3 = 231.66
Sum = 491.74, which is approximately $492.
Diff: 3 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
ions with an exercise price of $55.00
19) Consider the following timeline:
If the current market rate of interest is 12%, then the value of the cash flows in year 0 and year 2 as of
year 1 is closest to:
A) $257.29
B) -$96.57
C) $78.71
D) $1.29
E) -$38.71
Answer: B
Explanation: B) This is a two-part problem involving both present and future values.
FV of year 0 c/f = FV = PV(1 + r)n = -150(1.12)1 = -$168
PV of year 2 c/f = PV = FV/(1 + r)n = 80/(1.12)1 = $71.43
So, the answer is -$168 + $71.43 = -96.57
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
o privately approach the board.eline:
20) Consider the following timeline:
If the current market rate of interest is 8%, then the value as of year 1 is closest to:
A) $0
B) $1003
C) $540
D) $77
E) $40
Answer: D
Explanation: D) Two-part problem:
FV = PV(1 + r)n = 500(1.08)1 = $540
PV = FV/(1 + r)n = -500 / (1.08)1 = -$463
So, the answer is $540 + -$463 = $77.
Diff: 2 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
21) To compute the future value of a cash flow, you must
A) discount it.
B) compound it.
C) double it.
D) arbitrage it.
E) first find the present value.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
22) An investment will pay you $100 in one year and $200 in two years. If the interest rate is 5%, what is
the present value of these cash flows?
A) $305.00
B) $285.71
C) $276.65
D) 258.32
E) $272.11
Answer: C
Explanation: C) 100/(1.05) + 200/(1.052) = 95.24 + 181.41 = 276.65
Diff: 1 Type: MC
Skill: Analytical
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
23) When computing a present value, which of the following is TRUE?
A) You should adjust the discount rate to match the time period of the cash flows.
B) You should adjust the future value to match the present value.
C) You should adjust the time period to match the present value.
D) You should adjust the cash flows to match the time period of the discount rate.
E) You should adjust the time period to match the future value.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
24) If an analyst mistakenly adds cash flows occurring at different points in time, what is the implied
assumption in the process?
Answer: Cash flows occurring at different points in time cannot be added because a dollar today is
worth more than a dollar tomorrow. In other words, these cash flows are not in the same units. The
compounding and discounting effect causes these cash flows to be different across time. However, this
is only valid for nonzero interest rates. Hence, the implied assumption in adding cash flows across time
is that interest rate is zero.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
25) Why should interest rates be generally positive?
Answer: An investor should be compensated for forgoing current consumption and, everything else
remaining the same, a positive interest rate serves to compensate the investor.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
26) What are the the three rules of valuing cash flows at different points in time?
Answer: 1. It is only possible to compare or combine values at the same point in time.
2. To calculate a cash flow's future value, you must compound it.
3. To calculate the value of a future cash flow at an earlier point in time, we must discount it.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
27) In order to distinguish between inflows and outflows, different colours are assigned to each of these
cash flows when constructing a timeline.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
28) A lender lends $10,000, which is to be repaid in annual payments of $2,000 for 6 years. Which of the
following shows the timeline of the loan from the lender's perspective?
A)
Year 1
-$10,000
Year 2
$2000
Year 3
$2000
Year 4
$2000
Year 5
$2000
B)
Year 1
0
Year 2
$2000
Year 3
$2000
Year 4
$2000
Year 5
$2000
Year 6
$2000
Year 6
$2000
C)
Year 0 Year 1
-$10,000 $2000
Year 2
$2000
Year 3
$2000
Year 4
$2000
Year 5
$2000
Year 6
$2000
D)
Year 0 Year 1
-$10,000 $2000
Year 2
$4000
Year 3
$6000
Year 4
$8000
Year 5
$10,000
Year 6
$12,000
E)
Year 0 Year 1 Year 2
$10,000 -$2000 -$2000
Year 3
-$2000
Year 4
-$2000
Year 5
-$2000
Year 6
-$2000
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
29) A tenant wants to lease a building for $48,000 per year. She signs a five-year rental agreement that
states that she will pay $24,000 every six months for the next five years. Which of the following is the
timeline for her rental payments, assuming she makes the first payment immediately?
A)
Date
(years)
Cash Flows
(thousands)
0
1
2
3
4
5
-$48
-$48
-$48
-$48
-$48
-$48
1
2
3
4
5
$48
$48
$48
$48
$48
B)
Date
(years)
0
Cash Flows
(thousands) $48
C)
Date
(years)
0
Cash Flows
(thousands) $24
1
2
3
4
5
6
3 1/2 4
4 1/2 5
$24
$24
$24
$24
$24
$24
$24
$24
1 1/2 2
D)
Date
(years)
Cash Flows
(thousands)
0
1/2
$24 -$24
1
E)
Date
(years)
Cash Flows
(thousands)
0
1/2
$24 -$24
1
-$24 -$24
-$24 -$24
1 1/2 2
-$24 -$24
2 1/2 3
-$24 -$24
3 1/2 4
-$24 -$24
2 1/2 3
$24
-$24 -$24
4 1/2 5
-$24 -$24
3 1/2 4
$24
0
4 1/2 5
-$24 -$24
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
-$24
30) Samantha enters a rent-to-own agreement for living room furniture. She will pay $60 per month for
one year. Which of the following shows the timeline for her payments if the first payment is one month
from now?
A)
Date
(Months) 1
2
3
Cash
Flows
$60 -$60 -$60
4
B)
Date
(Months) 0
1
Cash
Flows
$60 -$60
2
3
4
5
6
7
8
9
10
11
12
-$60
-$60
-$60
-$60
-$60
-$60
-$60
-$60
-$60
-$60
-$60
C)
Date
(Months) 0
Cash
Flows
0
2
3
1
-$60 -$60
5
-$60 -$60
4
-$60 -$60
6
7
-$60 -$60
5
6
-$60 -$60
8
9
10
-$60 -$60
7
8
-$60 -$60
11
-$60 -$60
9
10
-$60 -$60
12
-$60
11
12
-$60 -$60
D)
Date
(Months) 0
1
2
3
4
5
6
7
8
9
10
11
12
Cash
Flows
$60 $120 $180 $240 $300 $360 $480 $540 $600 $660 $720 $780 $840
E)
Date
(Months) 0
1
2
Cash
Flows
$60 -$60 -$60
3
4
-$60 -$60
5
6
-$60 -$60
7
8
-$60 -$60
9
10
-$60 -$60
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
11
12
-$60 0
31) The timeline shown below best describes the cash flow of which of the following people?
Date
(years)
Cash
Flows
0
1
2
3
4
-$3500
$1000
$1000
$1000
$1000
A) Joe, who puts down $3500 to buy a car, and then makes annual payments of $1000
B) Harry, who borrows $3500, and then receives an annual payment of $1000
C) Karen, who loans a friend $3500, which the friend then pays back in four annual installments of
$1000
D) Leo, who borrows $3500, and then pays back the loan in four annual payments of $1000
E) Michelle, who contributes $3500 to an RRSP and makes four annual contributions of $1000
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
32) The timeline shown below best describes which of the following situations?
Date
(Months) 0
Cash
Flows
-$250
1
2
3
4
5
-$250
-$250
-$250
-$250
-$250
A) You make payments of $250 per month for six months.
B) You receive payments of $250 per month for six months.
C) You make payments of $250 per month for five months.
D) You receive payments of $250 per month for five months.
E) You make payments of $250 per year for five years.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
33) Why should you approach every problem by drawing a timeline?
A) Timelines allow you to quickly sum cash flows over time.
B) Timelines eliminate the majority of flawed financial decisions.
C) Timelines can be used to schedule events which are yet to occur.
D) Timelines identify events in a transaction or investment that might otherwise be easily overlooked.
E) Timelines give present values at each time period.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
34) Is there a need to distinguish between cash inflows and outflows on a timeline?
Answer: Cash inflows and outflows should have opposite signs to give meaningful results that can be
used in decision making. One convention that is easier to follow is to assign a positive sign to all cash
coming in, i.e., cash inflows, and a negative sign to all cash going out, i.e., cash outflows.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 3.4 Assess the effect of interest rates on today's value of future cash flows
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 4 The Time Value of Money
4.1 Valuing a Stream of Cash Flows
1) The present value (PV) of a stream of cash flows is just the sum of the present values of each
individual cash flow.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.1 Value a series of many cash flows
2) When evaluating investment opportunities, we can compare and combine cash flows that occur at
different points in time.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.1 Value a series of many cash flows
3) You are given two choices of investments, Investment A and Investment B. Both investments have
the same future cash flows. Investment A has a discount rate of 4%, and Investment B has a discount
rate of 5%. Which of the following is true?
A) The present value of cash flows in Investment A is higher than the present value of cash flows in
Investment B.
B) The present value of cash flows in Investment A is lower than the present value of cash flows in
Investment B.
C) The present value of cash flows in Investment A is equal to the present value of cash flows in
Investment B.
D) The present value of cash flows in Investment A is half the present value of cash flows in Investment
B.
E) No comparison can be made - we need to know the cash flows to calculate the present value.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 4.1 Value a series of many cash flows
4) Which of the following investments has a higher present value, assuming the same (strictly positive)
interest rate applies to both investments?
Year
1
2
3
4
Investment X
$5,000
$7,000
$9,000
$11,000
Investment Y
$11,000
$9,000
$7,000
$5,000
A) Investment X has a higher present value.
B) Investment Y has a higher present value.
C) Investment X and Investment Y have the same present value, since the total of the cash flows is the
same for both.
D) Investment Y has half the present value of Investment X.
E) No comparison can be made - we need to know the interest rate to calculate the present value.
Answer: B
Explanation: B) You get more money sooner.
Diff: 1 Type: MC
Skill: Conceptual
Objective: 4.1 Value a series of many cash flows
5) Consider the following timeline detailing a stream of cash flows:
If the current market rate of interest is 8%, then the present value (PV) of this stream of cash flows is
closest to:
A) $22,871
B) $21,211
C) $24,074
D) $26,000
E) $19,111
Answer: B
Explanation: B) PV = 5000 / (1.08) 1 + 6000 / (1.08)2 + 7000 / (1.08)3 + 8000 / (1.08)4 = $21,210.73
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
6) Consider the following timeline detailing a stream of cash flows:
6) Consider the following timeline detailing a stream of cash flows:
If the current market rate of interest is 8%, then the future value (FV) of this stream of cash flows is
closest to:
A) $11,699
B) $10,832
C) $12,635
D) $10,339
E) $13,605
Answer: A
Explanation: A) FV = 1000(1.08)4 + 2000(1.08)3 + 3000(1.08)2 + 4000(1.08)1 = $11,699
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
7) Consider the following timeline detailing a stream of cash flows:
If the current market rate of interest is 10%, then the present value (PV) of this stream of cash flows is
closest to:
A) $674
B) $600
C) $460
D) $287
E) $410
Answer: C
Explanation: C) PV = 100 / (1.10)1 + 100 / (1.10)2 + 200 / (1.10)3 + 200 / (1.10)4 = $460
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
eholders.der the following timeline detailing a stream of cash flows:
8) Consider the following timeline detailing a stream of cash flows:
If the current market rate of interest is 6%, then the future value (FV) of this stream of cash flows is
closest to:
A) $1723
B) $1500
C) $1626
D) $1288
E) $2007
Answer: A
Explanation: A) FV = 100(1.06)5 + 200(1.06)4 + 300(1.06)3 + 400(1.06)2 + 500(1.06)1 = $1723
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
9) Given that the interest rate is 10% per annum, what is the present value of an investment that has 5
equal payments of $50,000 each year for 5 years, starting today?
A) $250,000
B) $25,000
C) $208,493.27
D) $158,493.27
E) $ 178,493.27
Answer: C
Explanation: C) Calculate the PV with PMT= $50,000, interest= 10% and N = 4, which gives PV = $50,000
(for today's pmt) + $158,493.27 = $208,493.27
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
10) Suppose the current interest rate is 8.5%, what is the future value of a $15 million investment in 10
years?
A) $16.275 million
B) $33.915 million
C) $17.858 million
D) $150 million
E) $15 million
Answer: B
Explanation: B) FV = 15(1.085)10 = $33.915 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
11) Jessica deposits her $2,500 bonus cheque into the bank at the end of 2015. At the end of 2016 , she
deposits another bonus cheque, which is double the amount of last year's cheque. Given that the interest
rate is 5%, what is the total future value of these two bonuses at the end of 2017?
A) $7625
B) $8406.56
C) $7875
D) $7,500
E) $8,006.25
Answer: E
Explanation: E) FV= 2500(1.052) + 5000(1.05) =$8,006.25
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
12) An investor receives $250,000 at the end of each of the next 5 years. What is the present value of her
investment, given that the interest rate is 5%?
A) $1,082,369.17
B) $1,250,000
C) $979,407.71
D) $1,332,369.17
E) $1,000,000
Answer: A
Explanation: A) PV = 250,000/(1.05) +250,000/(1.05) 2 + 250,000/(1.05)3+ 250,000/(1.05)4+ 250,000/(1.05)5=
OR Calculate the PV with PMT= $250,000, interest= 5% and N = 5, which gives PV = $1,082,369.17
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
13)
Year
0
1
2
3
4
Cash Flow
$12,000
$14,000
$16,000
$18,000
$20,000
What is the total future value of these cash flows in year 4, given that the interest rate is 10%?
A) $80,000
B) $65,134.35
C) $117,128
D) $95,363.20
E) $75,363.20
Answer: D
Explanation: D) Total FV= 12,000(1.1 4) + 14,000(1.13) + 16,000(1.12) + 18,000(1.1) + 20,000 = $95,363.20
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
Use the information for the question(s) below.
Joe just inherited the family business, and having no desire to run the family business, he has decided to
sell it to an entrepreneur. In exchange for the family business, Joe has been offered an immediate
payment of $100,000. Joe will also receive payments of $50,000 in one year, $50,000 in two years, and
$75,000 in three years. The current market rate of interest for Joe is 6%.
14) In terms of present value (PV), how much will Joe receive for selling the family business?
Answer: PV = $100,000 + $50,000 / (1.06) 1 + $50,000 / (1.06)2 + $75,000 / (1.06)3 = $254,641
Diff: 2 Type: ES
Skill: Analytical
Objective: 4.1 Value a series of many cash flows
15) If a few intermediate cash flows in valuing a stream of cash flows are zero, can we delete those
points on the timeline and squeeze the timeline to show only nonzero cash flows?
Answer: Every cash flow contains two pieces of information—the nominal value and the time stamp. If
we decide to eliminate the zero cash flows from the timeline and concentrate only on the nonzero ones,
we will be distorting the time stamp of some nonzero cash flows. Hence, we need to show the timeline
in full, including all cash flows zero as well as nonzero.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 4.1 Value a series of many cash flows
4.2 Perpetuities and Annuities
1) Cash flows from an annuity occur every year in the future.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
2) To calculate the future value of an annuity, we divide the annuity formula by the appropriate
discount factor.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
3) A homeowner in a sunny climate has the opportunity to install a solar water heater in his home for a
cost of $2400. After installation the solar water heater will produce a small amount of hot water every
day, forever, and will require no maintenance. How much must the homeowner save on water heating
costs every year if this is to be a sound investment? (The interest rate is 9% per year.)
A) $216
B) $240
C) $248
D) $262
E) $220
Answer: A
Explanation: A) Calculate the cash flow as the perpetuity whose PV = $2,400;
hence, annual heating cost = 2400 × 0.09 = $216.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
4) What is the PV of an investment that will pay you $1,500 every year, forever, starting in one year's
time, if the interest rate is 8%?
A) $18,750
B) $1,500
C) $15,000
D) $25,000
E) $12,000
Answer: A
Explanation: A) PV Perpetuity = 1500 / 0.08 = $18,750
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
5) A perpetuity will pay $1000 per year, starting five years after the perpetuity is purchased. What is the
present value (PV) of this perpetuity on the date that it is purchased, given that the interest rate is 4%?
A) $1410
B) $20,582
C) $20,548
D) $34,604
E) $25,000
Answer: C
Explanation: C) The first step is to calculate the PV perpetuity = 1000 / 0.04 = $ 25,000; the next step is to
calculate its PV using TVM keys: input FV = 25,000, number of years 5 not 4, and interest rate = 4%; PV =
$20,548.18.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
6) Jason buys a consol (perpetual bond) that pays out a fixed cash flow of $750,000 every year, forever,
starting at the end of this year. If the current market rate is 12.5%, what is the present value of the cash
flows?
A) $6,000,000
B) $750,000
C) $843,750
D) $600,000
E) $7,500,000
Answer: A
Explanation: A) PV(perpetuity)= 750,000/12.5% = $6,000,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
7) James is a law student who wishes to understand how a perpetuity works. His grandfather invested
in a perpetual bond 25 years ago, which pays $15,000 annually at a 12% interest rate. What was the
present value of the cash flows of this perpetuity when it was purchased?
A) $84,753.35
B) $150,000
C) $125,000
D) $133,928.57
E) $16,800
Answer: C
Explanation: C) PV at time of purchase= 15,000/0.12 = $125,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
8) JJ & Co has decided to donate money to a cancer research fund every year for the next 25 years. They
will make annual payments of $3.5 million. What is the present value of their donation if the current
market rate is 7.5%?
A) $87.5 million
B) $14.3 million
C) $33.33 million
D) $46.7 million
E) $39.0 million
Answer: E
Explanation: E) PV(annuity)= (3.5/ 0.075)((1 - [1/(1.075)25])= $39 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
9) Anya finally decides that she will give her cousin, Zen, the loan he requested. He is expected to pay
Anya $12,500 each year for the next 5 years, starting at the end of this year. The loan interest rate at the
bank is 5% but because he is family, she will only charge him half of this interest rate. What is the
current value of this loan, today?
A) $58,072.86
B) $500,000
C) $62,500
D) $54,118.46
E) $55,240.89
Answer: A
Explanation: A) PV= (12,500/0.025)(1 - [1/(1.025)5]) = $58,072.86
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
10) Jackie & her husband started a savings account for their twin daughters when they were 2 years old.
They have been saving $100,000 a year at an interest rate of 10%, and intend on keeping up with their
annual contribution to the fund until the girls are 21. What is the future value of their investment?
A) $864,869.43
B) $836,492.01
C) $5,115,909.05
D) $6,400,249.94
E) $2,090,000
Answer: C
Explanation: C) PV= (100,000/0.1)(1 - [1/(1.0119)]) = $836,492.01
FV= ($836,492.01)(1.119) = $5,115,909.05
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
11) A perpetuity will pay $1000 per year, starting five years after the perpetuity is purchased. What is
the future value (FV) of this perpetuity, given that the interest rate is 4%?
A) $1410
B) $20,582
C) $21,370
D) $25,000
E) There is no solution to this problem.
Answer: E
Explanation: E) The future value of a perpetuity cannot be calculated, since there is no ending date.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
12) Which of the following is true about perpetuities?
A) Since a perpetuity generates cash flows every period infinitely, the cash flow generated equals the
PV times the interest rate.
B) Since a perpetuity generates cash flows every period infinitely, each cash flow must be discounted to
calculate the present value.
C) Since a perpetuity generates cash flows every period infinitely, there is no way to solve for the cash
flow given the present value and the interest rate.
D) A perpetuity does not generate cash flows every period infinitely.
E) Since a perpetuity generate cash flows every period infinitely, the cash flow generated equals the PV
divided by the interest rate.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
13) Which of the following is true about perpetuities?
A) All else equal, the value of a perpetuity is higher when the periodic cash flow is lower.
B) All else equal, the value of a perpetuity is higher when the interest rate is higher.
C) If two perpetuities have the same present value and the same interest rate, they must have the same
cash flows.
D) All else equal, the value of a perpetuity is lower when the interest rate is lower.
E) If two perpetuities have the same cash flows, they must have the same present value.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
14) An annuity will pay you $12,000 per year for 20 years. What is the PV of this annuity if your cost of
capital is 7%?
A) $224,299
B) $240,000
C) $127,128
D) $491,946
E) $238,245
Answer: C
Explanation: C) PMT = 12,000; I = 7; N = 20; Compute PV = $127,128
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
15) An annuity will pay you $1,000 per year for 75 years. What is the PV of this annuity if your cost of
capital is 4%?
A) $25,000
B) $72,115
C) $75,000
D) $23,680
E) $24,038
Answer: D
Explanation: D) PMT = 1,000; I = 4; N = 75; Compute PV = $23,680
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
16) An annuity will pay you $1,000 per year for 30 years. What is the FV of this annuity at the end of 30
years, if your cost of capital is 3%?
A) $47,575
B) $19,600
C) $30,131
D) $30,000
E) $30,900
Answer: A
Explanation: A) PMT = 1,000; I = 3; N = 30; Compute FV = $47,575
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
17) An annuity will pay you $5,000 per year for 25 years. What is the FV of this annuity at the end of 25
years, if your interest rate is 8%?
A) $126,207
B) $365,530
C) $125,000
D) $135,000
E) $53,374
Answer: B
Explanation: B) PMT = 5,000; I = 8; N = 25; Compute FV = $365,530
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
18) You are saving money for the down payment on a house. If you can save $7,500 per year for the next
five years at an interest rate of 8%, how much will you have saved at the end of five years?
A) $40,500
B) $37,500
C) $44,000
D) $29,945
E) $93,750
Answer: C
Explanation: C) PMT = 7,500; I = 8; N = 5; Compute FV = $44,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
19) Matthew wants to take out a loan to buy a car. He calculates that he can make repayments of $4000
per year. If he can get a five-year loan with an interest rate of 7.5%, what is the maximum price he can
pay for the car?
A) $16,184
B) $18,243
C) $20,324
D) $21,674
E) $20,000
Answer: A
Explanation: A) Calculate PV using TVM keys: input PMT = 4000, N = 5, and interest rate = 7.5%; PV =
$16,183.5396.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
20) If the current rate of interest is 8%, then the present value (PV) of an investment that pays $1000 per
year and lasts 20 years is closest to:
A) $18,519
B) $45,761
C) $9818
D) $20,000
E) $10,016
Answer: C
Explanation: C) N = 20
I=8
PMT = 1000
FV = 0
Compute PV = $9818.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
21) If the current rate of interest is 8%, then the future value (FV) of an investment that pays $1000 per
year and lasts 20 years is closest to:
A) $18,519
B) $45,762
C) $9,818
D) $20,000
E) $10,016
Answer: B
Explanation: B) N = 20
I=8
PMT = 1000
PV = 0
Compute FV = $45,762
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
22) You are saving money to buy a car. If you save $300 per month starting one month from now at an
interest rate of 4%, how much will you be able to spend on the car after saving for 4 years?
A) $41,778.96
B) $15,287.27
C) $15,587.88
D) $13,286.65
E) $15,939.84
Answer: C
Explanation: C) N = 48
I = 4/12
PMT = 300
PV = 0
Compute FV = $15,587.88
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
23) You are borrowing money to buy a car. If you can make payments of $300 per month starting one
month from now at an interest rate of 4%, how much will you be able to borrow for the car today if you
finance the amount over four years?
A) $6,358.54
B) $13,067.62
C) $15,587.88
D) $13,286.65
E) $15,287.27
Answer: D
Explanation: D) N = 48
I = 4/12
PMT = 300
FV = 0
PV = $13,286.65
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
24) Since your first birthday, your grandparents have been depositing $1000 into a savings account on
every one of your birthdays. The account pays 4% interest annually. Immediately after your
grandparents make the deposit on your 18th birthday, the amount of money in your savings account
will be closest to:
A) $25,645
B) $36,465
C) $12,659
D) $18,000
E) $50,645
Answer: A
Explanation: A) N = 18
PMT = 1000
I=4
PV = 0
Compute FV = $25,645.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
25) Since your first birthday, your grandparents have been depositing $100 into a savings account every
month. The account pays 4% interest annually. Immediately after your grandparents make the deposit
on your 18th birthday, the amount of money in your savings account will be closest to:
A) $11,941,266
B) $31,559
C) $30,774
D) $21,600
E) $31,764
Answer: B
Explanation: B) N = 216
PMT = 100
I = 4/12
PV = 0
Compute FV = $31,559.24
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
26) Can we apply the annuity or perpetuity equations to cash flows that do not arrive at regular
intervals?
Answer: No, these formulas only apply when cash flows arrive at regular intervals. Cash flows with
irregular timing would each have to be discounted separately.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
27) What is the difference between a perpetuity and an annuity?
Answer: A perpetuity is a constant stream of regular cash flows that last forever, while and annuity is a
constant stream of regular cash flows that ends after a fixed number of payments.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
4.3 Solving for Variables Other Than Present Value or Future Value
1) The internal rate of return (IRR) is the interest rate that sets the net present value (NPV) of the cash
flows equal to zero.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
2) Trial and error is the only way to compute the internal rate of return (IRR) when interest is calculated
over five or more periods.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
3) Dan buys a property for $250,000. He is offered a 20-year loan by the bank, at an interest rate of 6%
per year. What is the annual loan payment Dan must make?
A) $21,796.14
B) $24,864.98
C) $32,684.66
D) $64,486.34
E) $13,250.00
Answer: A
Explanation: A) Calculate PMT using TVM keys: input PV = 250,000, N = 20, and interest rate = 6%;
PMT = $21,796.139.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
4) The timeline below shows a $10,000 dollar investment that is being compounded at a set rate per
year. What is that rate?
Date
(years)
Cash
Flows
0
-$30,000
1
$11,250
2
$12, 656.25
3
$14,238.18
A) 11.25%
B) 12.50%
C) 15.00%
D) 18.50%
E) 16.25%
Answer: B
Explanation: B) Use CF keys to enter the cash flows and calculate internal rate of return (IRR).
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
5) A bank offers a home buyer a 25-year loan at 8% per year. If the home buyer borrows $120,000 from
the bank, how much must be repaid every year?
A) $7896.45
B) $9845.89
C) $10,786.66
D) $11,241.45
E) $5,184.00
Answer: D
Explanation: D) Calculate PMT using TVM keys: input PV = 120,000, N = 25, and interest rate = 8%;
PMT = $11,241.453.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
6) A businessman wants to buy a truck. The dealer offers to sell the truck for either $120,000 now, or six
yearly payments of $25,000. Which of the following is closest to the interest rate being offered by the
dealer?
A) 5%
B) 7%
C) 9%
D) 11%
E) 8%
Answer: B
Explanation: B) Calculate interest rate using TVM keys: input PV = 120,000, N = 6, and PMT = 25,000;
interest rate = 6.77, rounded to 7%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
7) How long will it take $50,000 placed in a savings account at 10% interest to grow into $75,000?
A) 4.25 years
B) 5.00 years
C) 5.25 years
D) 5.50 years
E) 4.75 years
Answer: A
Explanation: A) Calculate N using TVM keys: input PV = 50,000, interest rate = 10%, and FV = 75,000;
N = 4.25 years.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
8) What is the interest rate of an investment that pays $65 million next year with a current value of $58
million?
A) 15.07%
B) 10.77%
C) 1.207%
D) 1.12%
E) 12.07%
Answer: E
Explanation: E) FV = 65 PV = 58, FV = PV(1 + r), r = (FV/PV ) - 1 = (65/58) - 1 =12.07%
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
9) An investor receives X dollars at the end of each of the next 3 years. If the present value of her
investment is $10 million, what is her yearly cash flow, given that the interest rate is 5%?
A) $3.672 million
B) $3.33 million
C) $2.5 million
D) $2.879 million
E) $3.472 million
Answer: A
Explanation: A) PV = X/(1.05) + X/(1.05) 2 + X/(1.05)3 = X[ 1/(1.05) + 1/(1.05)2 + 1/(1.05)3]
X = 10/[ 1/(1.05) + 1/(1.05)2 + 1/(1.05)3] = 10/2.72348029 = 3.672 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
10) A consol bond (perpetual bond) pays $27,500 every year. If its present value is $3,000,000, what is
the interest rate?
A) 9.17%
B) 3%
C) 0.275%
D) 0.917%
E) 2.75%
Answer: D
Explanation: D) PV = C/r
r = (C/PV) = (27,500/3,000,000)= 0.917%
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
11) Joey buys a bond for $10,000 that will mature in 25 years. He will receive a single payment of
$150,000 when the bond reaches maturity. What is the interest rate?
A) 15%
B) 11.44%
C) 114.4%
D) 6.67%
E) 10%
Answer: B
Explanation: B) r = (FV/PV)1/25 - 1= (150,000/10,000)1/25 - 1= 11.44%
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
12) The present value of an annuity that pays $1 million per year for n years, is $9 million. If the interest
rate is 5% per annum, n is approximately equal to how many years?
A) 45 years
B) 8 years
C) 11 years
D) 16.5 years
E) 12.25 years
Answer: E
Explanation: E) PV = C/r[1 - 1/(1 + r)n]
n = log{1/(1 - [rPV/C])} / log{1 +r }
n = log{1/(1 - [0.05(9)/1])} / log{1.05} = log1.81818/log 1.05 = 12.25 years
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
13) Faisal has $15,000 in his savings account and can save an additional $5000 per year. If interest rates
are 12%, how long will it take his savings to grow to $50,000?
A)
years
B) 3 years
C)
years
D) 5 years
E) 4 years
Answer: C
Explanation: C) Calculate N using TVM keys: input PV = 15,000, FV = 50,000, interest rate = 12%, PMT =
$5,000; N = 4.244 years. In some calculators the PV and PMT will require a negative sign while the FV is
positive.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
14) What is the internal rate of return (IRR) of an investment that requires an initial investment of
$10,000 today and pays $14,000 in one year's time?
A) 4%
B) 14%
C) 24%
D) 40%
E) 33%
Answer: D
Explanation: D) Calculate interest rate using TVM keys: input PV = 10,000, N= 1, and FV = -14,000;
interest rate = 40%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
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15) You are interested in purchasing a new automobile that costs $35,000. The dealership offers you a
special financing rate of 6% APR (0.5%) per month for 48 months. Assuming that you do not make a
down payment on the auto and you take the dealer's financing deal, then your monthly car payments
would be closest to:
A) $729
B) $822
C) $842
D) $647
E) $789
Answer: B
Explanation: B) PV = 35,000
I = 0.5
N = 48
FV = 0
Compute payment = $821.98.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
16) You are considering purchasing a new home. You will need to borrow $250,000 to purchase the
home. A mortgage company offers you a 15-year fixed rate mortgage (180 months) at 9% APR (0.75%
month). If you borrow the money from this mortgage company, your monthly mortgage payment will
be closest to:
A) $2585
B) $660
C) $2535
D) $1390
E) $1868
Answer: C
Explanation: C) PV = 250000
I = 0.75
N = 180
FV = 0
Compute payment = $2535.67.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
17) You are considering investing in a zero-coupon bond that will pay you its face value of $1000 in ten
years. If the bond is currently selling for $485.20, then the internal rate of return (IRR) for investing in
this bond is closest to:
A) 12%
B) 8.0%
C) 7.5%
D) 10%
E) 9%
Answer: C
Explanation: C) PV = -485.20
FV = 1000
PMT = 0
N = 10
Compute I = 7.5%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
18) You are offered an investment opportunity that costs you $28,000, has a net present value (NPV) of
$2278, lasts for three years, has interest rate of 10%, and produces the following cash flows:
The missing cash flow from year 2 is closest to:
A) $12,500
B) $12,000
C) $13,000
D) $10,000
E) $14,000
Answer: B
Explanation: B) NPV = PV benefits - PV of costs
2278 = 10000 / (1.10)1 + X / (1.10)2 + 15000 / (1.10)3 - 28000
30278 = 10000 / (1.10)1 + X / (1.10)2 + 15000 / (1.10)3
30278 = 9091 + X / (1.10)2 + 11270
9917 = X / (1.10)2
X = 11,999.57
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
fective board of director
4.4 Growing Cash Flows
1) A growing perpetuity where the rate of growth is greater than the discount rate will have an
infinitely large present value (PV).
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
2) A perpetuity with a first payment of $500 grows at a constant rate of 5%. If the interest rate is 7%,
what is the Present Value of this perpetuity?
A) $10,000
B) $25,000
C) $7,142.86
D) $4,166.67
E) $50,000
Answer: B
Explanation: B) PV = 500/(0.07-0.05) = $25,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
3)
Initial Payment
Growth of Cash Flow
Interest Rate
No. of years (Annuity)
$40,000
4%
6%
5
What is the future value of this annuity?
A) $243,145.35
B) $200,000
C) $181,692.35
D) $168,494.55
E) $238,301.70
Answer: A
Explanation: A) PV = (40,000/ 0.02)((1 - [1.04/1.06]5) = $181,692.35
FV = ($181,692.35)(1.06)5 = $243,145.35
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
4) Mark invests in a 10-year annuity with an initial payment of $20,000, that grows at 4% per year.
What is the future value of this annuity, if the interest rate is 8%?
A) $200,000
B) $339,340.36
C) $157,180.24
D) $162,217.92
E) $350,216.31
Answer: B
Explanation: B) PV = (20,000/ 0.04)((1 - [1.04/1.08]10) = $157,180.24
FV = ($157,180.24)(1.08)10 = $339,340.36
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
5) AB Company has decided to donate to the children's hospital every year. The company 's first
payment will be $1 million and it will grow at a constant rate of 3% forever. What is the present value of
this growing perpetuity if the current market rate is 5%?
A) $150 million
B) $20 million
C) $33.33 million
D) $53.33 million
E) $50 million
Answer: E
Explanation: E) PV(growing perpetuity) = 1/ (0.05 - 0.03) = $50 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
6) A growing perpetuity' with a first payment of $17,500 grows at a constant rate, g. If the present value
of this perpetuity is $1,000,000, what is the growth rate of the cash flows, given that the interest rate is
6%?
A) 1.75%
B) 6%
C) 6.75%
D) 4.25%
E) 10.75%
Answer: D
Explanation: D) PV = C/(r-g)
g = r - (C/PV) = 0.06 - (17,500/1,000,000) = 0.06 - 0.0175 = 4.25%
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
7) Clarissa wants to fund a growing perpetuity that will pay $5000 per year to a local museum, starting
next year. She wants the annual amount paid to the museum to grow by 5% per year. Given that the
interest rate is 8%, how much does she need to fund this perpetuity?
A) $62,500.00
B) $102,112.33
C) $143,445.65
D) $166,666.67
E) $100,000.00
Answer: D
Explanation: D) PV growth perpetuity = 5000 / (0.08 - 0.05) = $166,666.67
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
8) Investment X and Investment Y are both growing perpetuities with initial cash flow of $100. Both
investments have the same interest rate (r). The present value of Investment X is $5,000, while the
present value of Investment Y is $4,000. Which of the following is true?
A) Investment X has a higher growth rate than Investment Y.
B) Investment X has a lower growth rate than Investment Y.
C) Investment X has the same growth rate as Investment Y.
D) The answer cannot be determined without knowing the interest rate for both investments.
E) This makes no sense—with the same initial cash flow and the same interest rate Investment X and
Investment Y should have the same present value.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
9) Martin wants to provide money in his will for an annual bequest to whichever of his living relatives
is oldest. That bequest will provide $1000 in the first year, and will grow by 7% per year, forever. If the
interest rate is 11%, how much must Martin provide to fund this bequest?
A) $9090.91
B) $14,285.71
C) $25,000.00
D) $36,687.45
E) $5555.56
Answer: C
Explanation: C) PV growth perpetuity = 1000 / (0.11 - 0.07) = $25,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
10) A rich donor gives a hospital $100,000 one year from today. Each year after that, the hospital will
receive a payment 5% larger than the previous payment, with the last payment occurring in ten years'
time. What is the present value (PV) of this donation, given that the interest rate is 9%?
A) $467,922.22
B) $585,987.27
C) $772,173.49
D) $779,843.27
E) $1,120,727.79
Answer: D
Explanation: D) Payment in 11th year, if there were one = 100,000 × (1.05)^10 = $162,889.4627;
PV of growth perpetuity in year 10 = 162,889.4627/(0.09 - 0.05) = 4,072,236.567;
PV of this CF at time zero = 1,720,156.734;
PV of entire CF = 100,000/(0.09 - 0.05) = 2,500,000;
Difference of the two cash flows = 2,500,000 - 1,720,156.734 = $779,843.2659
Diff: 3 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
Use the information for the question(s) below.
Suppose that a young couple has just had their first baby and they wish to ensure that enough money
will be available to pay for their child's college education. Currently, college tuition, books, fees, and
other costs average $12,500 per year. On average, tuition and other costs have historically increased at a
rate of 4% per year.
11) Assuming that college costs continue to increase an average of 4% per year and that all her college
savings are invested in an account paying 7% interest, then the amount of money she will need to have
available at age 18 to pay for all four years of her undergraduate education is closest to:
A) $97,110
B) $107,532
C) $101,291
D) $50,000
E) $85,790
Answer: A
Explanation: A) This is a two-step problem.
Step 1: Determine the cost of the first year of college.
FV = PV(1 + i)N = $12,500(1.04)18 = $25,322.71
Step 2: Figure out the value for four years of college.
PV of a growing annuity due = C ×
= $25,322.71 ×
(1 + r)
(1 + 0.07) = $97,110.01
Diff: 3 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
an help mitigate principal costs continue to increase an average of 4% per year and that all her college
12) Assuming that college costs continue to increase an average of 4% per year and that all her college
savings are invested in an account paying 7% interest, then what is the amount of money she will need
to have available at age 18 to pay for all four years of her undergraduate education?
Answer: This is a two-step problem.
Step 1: Determine the cost of the first year of college.
FV = PV(1 + i)N = $12,500(1.04)18 = $25,322.71
Step 2: Figure out the value for four years of college.
PV of a growing annuity due = C ×
(1 + r)
= $25,322.71 ×
(1 + 0.07) = $97.110.01
Diff: 3 Type: ES
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
13) Suppose that a young couple has just had their first baby and they wish to ensure that enough
money will be available to pay for their child's college education. They decide to make deposits into an
educational savings account on each of their daughter's birthdays, starting with her first birthday.
Assume that the educational savings account will return a constant 7%. The parents deposit $2000 on
their daughter's first birthday and plan to increase the size of their deposits by 5% each year. Assuming
that the parents have already made the deposit for their daughter's 18th birthday, then the amount
available for the daughter's college expenses on her 18th birthday is closest to:
A) $42,825
B) $97,331
C) $67,998
D) $103,063
E) $50,000
Answer: B
Explanation: B) FV of a growing annuity
$2000 ×
(1.07)18 = $97,331
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
ses. the information for the question(s) below.
Use the information for the question(s) below.
Assume that you are 30 years old today, and that you are planning on retirement at age 65. Your current
salary is $45,000 and you expect your salary to increase at a rate of 5% per year as long as you work. To
save for your retirement, you plan on making annual contributions to a retirement account. Your first
contribution will be made on your 31st birthday and will be 8% of this year's salary. Likewise, you
expect to deposit 8% of your salary each year until you reach age 65. Assume that the rate of interest is
7%.
14) The present value (PV) (at age 30) of your retirement savings is closest to:
A) $87,003
B) $108,000
C) $46,600
D) $75,230
E) $88,741
Answer: A
Explanation: A) First deposit = 0.08 × $45,000 = $3600
$3600 ×
= $87,003
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
15) The future value (FV) at retirement (age 65) of your savings is closest to:
A) $497,530
B) $928,895
C) $1,263,236
D) $108,000
E) $1,013,783
Answer: B
Explanation: B) First deposit = 0.08 × $45,000 = $3600
$3600 ×
(1.07)35= $928,895 or
PVA (growing) = $3600 ×
= $87,003
FV = PV(1 + i)N = $87,003(1.07)35 = $928,895
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
ting is the practice of choosing
16) Define the following terms:
(a) perpetuity
(b) annuity
(c) growing perpetuity
(d) growing annuity
Answer:
(a) A perpetuity is a stream of equal cash flows that occur at regular intervals and lasts forever.
(b) An annuity is a stream of N equal cash flows paid at regular intervals.
(c) A growing perpetuity is a cash flow stream that occurs at regular intervals and grows at a constant
rate forever.
(d) A growing annuity is a stream of N growing cash flows, paid at regular intervals.
Diff: 2 Type: ES
Skill: Definition
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
17) How do you calculate (mathematically) the present value (PV) of a(n):
(a) perpetuity
(b) annuity
(c) growing perpetuity
(d) growing annuity
Answer:
(a) PV of a perpetuity =
(b) PV of an annuity = C ×
(c) PV of a growing perpetuity =
(d) PV of a growing annuity = C ×
Diff: 2 Type: ES
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
18) You are thinking about investing in a mine that will produce $10,000 worth of ore in the first year.
As the ore closest to the surface is removed it will become more difficult to extract the ore. Therefore,
the value of the ore that you mine will decline at a rate of 8% per year forever. If the appropriate interest
rate is 6%, then the value of this mining operation is closest to:
A) $71,429
B) $500,000
C) $166,667
D) $41,667
E) This problem cannot be solved.
Answer: A
Explanation: A) PVP = C / r - g = 10,000 / (0.06 - (-0.08)) = 10,000 / 0.14 = $71,429
Diff: 3 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
14) What is a captured board?perpetuity equation for negative growth as well?
19) Can we apply the growth perpetuity equation for negative growth as well?
Answer: Yes, it is perfectly in order to apply the growth perpetuity for negative growth. A negative
growth gives two negatives in the denominator making it larger than a positive growth, thus reducing
the valuation compared to a positive growth of similar magnitude.
Diff: 3 Type: SA
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
20) How do the growth perpetuity results differ with negative and positive growths of similar
magnitude, assuming everything else remains unchanged?
Answer: The denominator in the formula for growth perpetuity plays in important role on the results
for negative and positive growths of similar magnitude. A positive growth results in a smaller
denominator, thereby increasing the present value (PV). Contrarily, a negative growth results in a larger
denominator, giving a smaller present value (PV).
Diff: 2 Type: SA
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
21) Why must a growing perpetuity have a growth rate less than the discount rate?
Answer: If g > r, the cash flows grow faster than they are discounted, and each term gets larger, rather
than smaller. The sum of these cash flows will be infinite, and no matter how much money you start
with, it is impossible to reproduce those cash flows on your own. No one would be willing to offer one
at any finite price.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
4.5 The Net Present Value of a Stream of Cash Flows
1) When the net present value (NPV) of an investment is positive, the benefits exceed the costs and the
investment should be made.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
2)
Year
0
1
2
Cash Flow
($50,000)
$25,000
$25,000
What is the Net Present Value of this investment, given that the interest rate is 5%?
A) $100,000
B) $0
C) -$1,190.48
D) -$3,514.74
E) -$22,222.22
Answer: D
Explanation: D) NPV = -50,000 + 25,000/1.05 + 25,000/(1.05 2) = -$3,514.74
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
3)
Year
0
0
1
Cash Flow
($100,000)
$30,000
$80,000
What is the interest rate if the NPV= $0?
A) 14.3%
B) 11%
C) 10%
D) 8%
E) 3%
Answer: A
Explanation: A) NPV = (100,000) + 30,000 + 80,000/(1 + r) = 0
70,000 = 80,000/(1 + r)
r = 80,000/70,000 - 1 = 14.3%
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
4) A bank is negotiating a loan. The loan can either be paid off as a lump sum of $100,000 at the end of
five years, or as equal annual payments at the end of each of the next five years. If the interest rate on
the loan is 10%, what annual payments should be made so that both forms of payment are equivalent?
A) $12,000
B) $16,380
C) $19,588
D) $20,000
E) $18,000
Answer: B
Explanation: B) Calculate PMT with FV = $100,000, interest = 10% and N = 5, which gives PMT =
$16,379.75.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
5) A business is deciding whether to give an end-of-year bonus of $5000 each year for the next four
years to an employee, in order to increase the number of sales that employee makes. What is the
minimum extra profit the employee must generate this year for the bonus to be worthwhile over the
next four years, if the discount rate is 7%?
A) $12,263
B) $14,480
C) $16,936
D) $20,000
E) $18,600
Answer: C
Explanation: C) Calculate the PV with PMT = $5,000, interest = 7% and N = 4, which gives PV = $16,936.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
6) An investor can invest $1000 at the start of a certain year, then $1000 the end of that year and the next
year in a certain business. The business guarantees that the investor will receive a payment at the end of
the year in five years. What is the future value (FV) of that payment if the investor is to break even,
given that the discount rate over those five years is 6% per year?
A) $2002
B) $2681
C) $3000
D) $3792
E) $3370
Answer: D
Explanation: D) The first step is to calculate the PV using CF keys: input CF0 = 1,000, CF1 = 1,000, and
CF2 = 1,000 using interest = 6%, which gives PV = 2,833.3927; next calculate the FV using TVM keys:
input PV = 2,833.3927, N = 5, and interest = 6%, which gives FV = $3791.72.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
7) If $10,000 is invested in a certain business at the start of the year, the investor will receive $3000 at the
end of each of the next four years. What is the net present value (NPV) of this business opportunity if
the interest rate is 7% per year?
A) $148.53
B) $161.63
C) $172.45
D) $178.88
E) $183.43
Answer: B
Explanation: B) Calculate the NPV using CF keys: input CF0 = -10,000, CF1 = $3000, and F1 = 4 using
interest = 7%, which gives NPV = $161.63.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
8) A business promises to pay the investor of $2000 today a payment of $500 in one year's time, $1000 in
two years' time and $1000 in three years' time. What is the present value of this business opportunity if
the interest rate is 5% per year?
A) $247.06
B) $253.78
C) $256.88
D) $261.07
E) $273.09
Answer: A
Explanation: A) Calculate the NPV using CF keys: input CF0 = -2,000, CF1 = $500, F1 = 1, CF2 = 1000,
and F2 = 2 using interest = 6%, which gives NPV = 247.0576.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
9) Alex buys a consol (perpetual bond) for $90,000. This consol promises him a fixed cash flow of
$10,000 every year, forever, starting at the end of the year. If the current market rate is 10%, what is the
net present value of his purchase?
A) $10,000
B) $100,000
C) $90,000
D) $80,000
E) $190,000
Answer: A
Explanation: A) NPV = PV(Benefit) - PV(Cost)
PV(Cost of consol ) = $90,000
PV(Benefit of consol) = 10,000/10% = $100,000
NPV= $100,000 - $90,000 = $10,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
10) Allan decides to invest in a new company which would allow him to receive $250,000 at the end of
each year for the next 5 years. He purchases 100,000 shares at the price of $6.50. What is the NPV of a
single share, if the interest rate is 15% per year?
A) $8.38
B) $1.88
C) $6.00
D) $838,038.77
E) $188,038.77
Answer: B
Explanation: B) NPV(100,000 shares)= -650,000+ (250,000/0.15)(1 - (1/[1.15]5) = $188,038.77
NPV(100,000 shares)= $188,038.77 /100,000 = $1.88
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
11) Damon is contemplating taking a deal with his uncle, who is a very successful entrepreneur. He
must pay his uncle $50,000 this year and an additional $50,000 at the end of both the fifth and tenth
year. This would allow him to receive a perpetual annual cashflow of $12,000. What is the NPV of this
offer if the interest rate is 10%?
A) $120,000
B) $30,000
C) $220,323.23
D) $69,676.77
E) $19,676.77
Answer: E
Explanation: E) NPV = -50,000 - 50,000/(1.1)5 - 50,000/(1.1)10 + 12,000/0.1 = $19,676.77
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.2 Apply shortcuts to value special sets of regular cash flows called perpetuities and annuities
12) Which of the following investments has the highest net present value (NPV), given that the interest
rate is 5.5%?
A) one that pays $250 at the end of each of the next four years
B) one that pays $500 at the end of next year and $500 in four years' time
C) one that pays $250 at the end of next year and $750 in four years' time
D) one that pays $200 at the end of next year, $200 at the end of the second year, and $300 at the end of
the third and fourth years
E) one that pays $250 at the beginning of each year for the next four years.
Answer: E
Explanation: E) Calculate PV of each alternative using either TVM keys or CF keys and pick the
highest:
PV(A) = $876.29; PV(B) = $877.54; PV(C) = $842.38; PV(D) = $866.91; PV(E) = $924.48
hence PV(E) = $924.48 is the highest.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
13) Salvatore has the opportunity to invest in a scheme which will pay $5000 at the end of each of the
next 5 years. He must invest $10,000 at the start of the first year and an additional $10,000 at the end of
the first year. What is the net present value (NPV) of this investment if the interest rate is 4%?
A) -$1410.67
B) -$112.23
C) $1248.56
D) $2643.73
E) $3210.15
Answer: D
Explanation: D) The first step is to calculate the investment in PV terms: using TVM keys input FV =
10,000, N = 1, interest = 4%, which gives PV = $9615.3846; total investment = $19,615.38; using CF keys
input CF0 = 19,615.38, CF1 = 5000, F1 = 5; using interest rate = 4%, NPV = $2,643.727.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
14) Micha offers to pay an investor of a lump sum in her business today $1000 in one year's time, $2000
in two years' time, $3000 in three years' time and $4000 in 4 years' time. If the interest rate is 8%, what is
the minimum value of the lump sum she must ask of an investor if the net present value (NPV) is to be
equal to zero?
A) $6,660.02
B) $6,836.34
C) $7,962.22
D) $8,468.56
E) $7,350.30
Answer: C
Explanation: C) Calculate the PV of the cash flows using CF keys: input CF1 = 1000, CF2 = 2000, CF3 =
3000, CF4 = 4000; using interest rate = 8%, NPV = $7962.2197.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
15) An investment of $6000 at the start of the year will pay $1000 at the end of the year for a set number
of years. What is the minimum number of years these payments must be made for if the investment is to
be worthwhile, given that the interest rate is 6%?
A) 6 years
B) 7 years
C) 8 years
D) 9 years
E) 10 years
Answer: C
Explanation: C) Calculate the break-even number of years and then round it up; using the TVM keys
input PV = -6000. PMT = 1000; using interest rate = 6%, number of years = 7.659; hence the minimum
number of years for the investment to be worthwhile = 8.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
16) Kresta can invest in a scheme which will pay $10,000 at the end of each of the next four years. She
must make an investment at the start of the first year of $32,000. Should she make this investment, given
that the interest rate is 7%?
A) Yes, because the net present value (NPV) is negative.
B) Yes, because the net present value (NPV) is positive.
C) No, because the net present value (NPV) is negative
D) No because the net present value (NPV) is positive.
E) No, because the net present value (NPV) is zero.
Answer: B
Explanation: B) Using TVM keys, calculate PV cash inflows: input PMT = 10,000, number of years = 4,
interest = 7%, calculate PV = $33,872.1126; since investment is $32,000, NPV > 0.
Diff: 1 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
17) You have been offered the following investment opportunity: if you pay $2500 today, you will
receive $1000 at the end of each of the next three years. Assuming that you could otherwise earn 10%
per year on your money, the net present value (NPV) for this opportunity is closest to:
A) $12
B) $18
C) -$13
D) $500
E) -$18
Answer: C
Explanation: C) NPV = -2500 + 1000 / (1.10)1 + 1000 / (1.10)2 + 1000 / (1.10)3 = -13.15, which is
approximately -$13.
Diff: 2 Type: MC
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
Use the information for the question(s) below.
Joe just inherited the family business, and having no desire to run the family business, he has decided to
sell it to an entrepreneur. In exchange for the family business, Joe has been offered an immediate
payment of $100,000. Joe will also receive payments of $50,000 in one year, $50,000 in two years, and
$75,000 in three years. The current market rate of interest for Joe is 6%.
18) Suppose a second entrepreneur approaches Joe and offers him $250,000 today for the business.
Should Joe accept the new entrepreneur's offer or stick with the original offer of $100,000 and the series
of payments over three years? Why?
Answer: Joe should take the original offer of $100,000 + payments.
PV of the original offer = $100,000 + $50,000 / (1.06) 1 + $50,000 / (1.06)2 + $75,000 / (1.06)3 = $254,641
So, the NPV of taking the second offer is $250,000 - $254,641 = -$4641.
Since the NPV is negative he should not take the second offer.
Diff: 2 Type: ES
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
Use the table for the question(s) below.
Year
0
1
2
3
A
-$150
40
80
100
B
-$225
175
125
-50
19) If the interest rate is 10%, then which investment(s), if any, would you take and why?
Answer: NPVA = -150 + 40 / (1.10)1 + 80 / (1.10)2 + 100 / (1.10)3 = $27.61
NPVB = -225 + 175 / (1.10)1 + 125 / (1.10)2 + -50 / (1.10)3 = -$0.17
Therefore, you should take A since NPVA > 0 and reject B since NPVB < 0.
Diff: 3 Type: ES
Skill: Analytical
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
20) What is the decision criteria for the Net Present Value rule?
Answer: The decision criteria for the Net Present Value rule is to accept projects if their NPV > 0 and
reject otherwise. Thus, an accepted project will add to the value of the firm by the amount of its net
present value (NPV).
Diff: 1 Type: SA
Skill: Conceptual
Objective: 4.3 Compute the number of periods, cash flow, or rate of return in a loan or investment
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 5 Interest Rates
5.1 Interest Rate Quotes and Adjustments
1) When you borrow money, the interest rate on the borrowed money is the price you pay to be able to
convert your future loan payments into money today.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
2) When there are large numbers of people looking to save their money and there is little demand for
loans, one would expect interest rates to be high.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
3) The annual percentage rate indicates the amount of interest, including the effect of any
compounding.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
4) Which of the following would be most likely to lower the interest rate that a bank offers a borrower?
A) The number of borrowers seeking funds is high.
B) The expected inflation rate is expected to be high.
C) The borrower is judged to have a low degree of risk.
D) The investment will be for a long period of time.
E) The number of savers depositing funds at the bank is low.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
5) What is the effective annual rate (EAR)?
A) the interest rate that would earn the same interest with annual compounding
B) the ratio of the number of the annual percentage rate to the number of compounding periods per
year
C) the discount rate for an n-year time interval, where n may be more than one year or less than or equal
to one year (a fraction)
D) the cash flows from an investment over a one-year period divided by the number of times that
interest is compounded during the year
E) the amount of simple interest earned in one year without considering the effects of compounding.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
6) A bank offers a loan that will requires you to pay 6% interest compounded monthly. Which of the
following is closest to the EAR charged by the bank?
A) 5.84%
B) 6.00%
C) 6.17%
D) 72.00%
E) 6.48%
Answer: C
Explanation: C) EAR = {(1 + APR)/m} m - 1; EAR = {(1 + 0.06)/12}12 - 1; 0.0617 × 100 = 6.17%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
7) Your bank account pays monthly interest with an EAR of 8%. What amount of interest will you earn
each month?
A) 0.64%
B) 0.67%
C) 1.00%
D) 0.60%
E) 0.80%
Answer: A
Explanation: A) 1.08^(1/12) - 1 = 0.64% per month
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
8) Your bank account pays quarterly interest with an EAR of 7%. What amount of interest will you earn
each quarter?
A) 1.80%
B) 1.75%
C) 1.70%
D) 1.50%
E) 2.00%
Answer: C
Explanation: C) 1.07^(1/4) - 1 = 1.7% per quarter
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
9) Your bank account pays quarterly interest with an APR of 7%. What is the EAR?
A) 7.50%
B) 7.2%
C) 7.0%
D) 7.8%
E) 8.0%
Answer: B
Explanation: B) (1 + 0.07/4)^(4) - 1 = 7.2%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
10) Your bank account pays daily interest with an APR of 4.5%. What is the EAR?
A) 4.0%
B) 4.8%
C) 4.5%
D) 4.6%
E) 4.4%
Answer: D
Explanation: D) (1 + 0.045/365)^(365) - 1 = 4.6%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
11) Your bank account pays quarterly interest with an APR of 8.75%. What is the EAR?
A) 9.25%
B) 8.5%
C) 8.4%
D) 8.75%
E) 9.0%
Answer: E
Explanation: E) (1 + 0.0875/4^(4) - 1 = 9.0%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
12) Your bank account pays monthly interest with an EAR of 10%. You are planning to buy a house in
10 years, and you wish to save $100,000 for the down payment. If you currently have no money in your
account, how much will you need to save at the end of each month?
A) $833.33
B) $500.35
C) $488.17
D) $9646.39
E) $475.13
Answer: B
Explanation: B) 1.10^(1/12) - 1 = 0.7974% per month = I/Y
FV = 100,000; N = 10 × 12 = 120; PV = 0.
PMT = $500.35
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
13) Your bank account pays monthly interest with an APR of 8%. You are planning to buy a house in 6
years, and you wish to save $40,000 for the down payment. If you currently have no money in your
account, how much will you need to save at the end of each month?
A) $451.18
B) $500.34
C) $555.56
D) $434.66
E) $438.53
Answer: D
Explanation: D) 0.08/12 = 0.6667% per month = I/Y
FV = 40,000; N = 6 × 12 = 72; PV = 0.
PMT = $434.66
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
14) Howard is saving for a long holiday. He deposits a fixed amount every month in a bank account
with an EAR of 7.5%. If this account pays interest every month then how much should he save from
each monthly paycheck in order to have $10,000 in the account in two years' time?
A) $161
B) $166
C) $388
D) $4818
E) $417
Answer: C
Explanation: C) First calculate the APR using an EAR of 7.5% and monthly compounding, which comes
to 7.25%. Then using a periodic rate of 7.25/12, calculate the payment over 24 months that gives a future
value (FV) of $10,000.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
15) An 8% APR with monthly compounding is closest to which of the following?
A) an EAR of 6.7%
B) an EAR of 7.72%
C) an EAR of 8.3%
D) an EAR of 8.5%
E) an EAR of 9.14%
Answer: C
Explanation: C) Can use the financial calculator or the formula EAR = {(1 + 0.08 / 12} 12 - 1 = 8.3%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
16) Which of the following best describes the annual percentage rate?
A) the quoted interest rate which considered with the compounding period gives the effective interest
rate
B) the effective annual rate after compounding is taken into account
C) the discount rate when compounded more than once a year or less than once a year
D) the discount rate when it is divided by the number of of times it is compounded in a year
E) the total amount of interest that will be earned in one year
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
17) Which of the following accounts has the highest EAR?
A) one that pays 6.1% every six months
B) one that pays 1.0% per month
C) one that pays 12.6% per year
D) one that pays 3% every three months
E) one that pays 0.2% per week
Answer: B
Explanation: B) Calculate the EAR for each choice and pick the highest:
A = 12.57%; B=12.68%; C = 12.6%; D = 12.55%; E = 10.95%
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
18) Drew receives an inheritance that pays him $50,000 every three months for the next two years.
Which of the following is closest to the present value (PV) of this inheritance if the interest rate is 8.5%
(EAR)?
A) $354,223
B) $364,309
C) $365,322
D) $400,000
E) $339,782
Answer: C
Explanation: C) First calculate the APR with quarterly compounding, which equals 8.24%; then using a
periodic interest rate of 8.24/4%, calculate the present value (PV) of an annuity of $50,000 for eight
periods.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
19)
Investment:
Rate of Return:
Compounding
A
5.7%
Yearly
B
5.6%
semi-annually
C
5.5%
Monthly
D
5.5%
Weekly
E
5.3%
Daily
The table above shows the rate of return (APR) for four investment alternatives. Which offers the
highest EAR?
A) Investment A
B) Investment B
C) Investment C
D) Investment D
E) Investment E
Answer: A
Explanation: A) Calculate the EAR for each; A = 5.70%; B = 5.68%; C = 5.64%; D = 5.65%; E = 5.44%
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
20) A bank offers an account with an APR of 6% and an EAR of 6.09%. How does the bank compound
interest for this account?
A) weekly compounding
B) monthly compounding
C) semi-annual compounding
D) annual compounding
E) daily compounding
Answer: C
Explanation: C) Using an APR = 6%, calculate the EAR for the compounding periods given in each
choice: A = 6.18%; B = 6.17%; C = 6.09%; D = 6%; E = 6.18%
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
21) What is the present value (PV) of an investment that pays $10,000 every year for four years if the
interest rate is 7% APR, compounded quarterly?
A) $33,730
B) $33,872
C) $38,680
D) $40,000
E) $30,516
Answer: A
Explanation: A) Calculate EAR = 7.1859%; Calculate PV Annuity = $33,730
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
22) A small foundry agrees to pay $250,000 two years from now to a supplier for a given amount of
coking coal. The foundry plans to deposit a fixed amount in a bank account every three months, starting
three months from now, so that at the end of two years the account holds $250,000. If the account pays
5.5% APR compounded monthly, how much must be deposited every three months?
A) $29,770
B) $29,777
C) $29,740
D) $31,250
E) $28,077
Answer: A
Explanation: A) Calculate the EAR = 5.64%; calculate APR with quarterly compounding = 5.52%;
calculate the payment for 8 quarters with $250,000 as future value (FV).
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
23) Emma runs a small factory that needs a vacuum oven for brazing small fittings. She can purchase
the model she needs for $180,000 up front, or she can lease it for five years for $4200 per month. She can
borrow at 7% APR, compounded monthly. Assuming that the oven will be used for five years, should
she purchase the oven or should she lease it?
A) Lease, since the present value (PV) of the lease is $12,224 less than the cost of the oven.
B) Lease, since the present value (PV) of the lease is $8642 less than the cost of the oven.
C) Lease, since the present value (PV) of the lease is $2212 less than the cost of the oven.
D) Buy, since the present value (PV) of the lease is $32,108 more than the cost of the oven.
E) Buy, since the present value (PV) of the lease is $72,000 more than the cost of the oven.
Answer: D
Explanation: D) Calculate PV lease payments = $212,108; subtract $180,000 to get $32,108.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
24) The effective annual rate (EAR) for a loan with a stated APR of 8% compounded monthly is closest
to:
A) 8.30%
B) 8.33%
C) 8.00%
D) 8.24%
E) 8.16%
Answer: A
Explanation: A) EAR = (1 + APR / k)k - 1 = (1 + 0.08 / 12)12 - 1 = 0.083 or 8.3%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
25) The effective annual rate (EAR) for a loan with a stated APR of 10% compounded quarterly is closest
to:
A) 10.52%
B) 10.25%
C) 10.38%
D) 10.00%
E) 10.47%
Answer: C
Explanation: C) EAR = (1 + APR / k)k - 1 = (1 + 0.10 / 4)4 - 1 = 0.1038 or 10.38%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
26) The effective annual rate (EAR) for a savings account with a stated APR of 4% compounded daily is
closest to:
A) 4.00%
B) 4.10%
C) 4.08%
D) 4.06%
E) 4.05%
Answer: C
Explanation: C) EAR = (1 + APR / k)k - 1 = (1 + 0.04 / 365)365 - 1 = 0.040808 or 4.08%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
Use the table for the question(s) below.
Consider the following investment alternatives:
Investment
A
B
C
D
E
Rate
6.25%
6.10%
6.125%
6.120%
6.15%
Compounding
Annual
Daily
Quarterly
Monthly
Semi-annual
27) Which alternative offers you the highest effective rate of return?
A) Investment A
B) Investment B
C) Investment C
D) Investment D
E) Investment E
Answer: D
Explanation: D) EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or 6.250%
EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 = 0.06289 or 6.289%
EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or 6.267%
EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or 6.300%
EAR (E) = (1 + APR / k)k - 1 = (1 + 0.0615 / 2)2 - 1 = 0.06245 or 6.245%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
28) Which alternative offers you the lowest effective rate of return?
A) Investment A
B) Investment B
C) Investment C
D) Investment D
E) Investment E
Answer: E
Explanation: E) EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or 6.250%
EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 = 0.06289 or 6.289%
EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or 6.267%
EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or 6.300%
EAR (E) = (1 + APR / k)k - 1 = (1 + 0.0615 / 2)2 - 1 = 0.06245 or 6.245%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
29) The highest effective rate of return you could earn on any of these investments is closest to:
A) 6.250%
B) 6.267%
C) 6.300%
D) 6.310%
E) 6.245%
Answer: C
Explanation: C) EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or 6.250%
EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 = 0.06289 or 6.289%
EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or 6.267%
EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or 6.300%
EAR (E) = (1 + APR / k)k - 1 = (1 + 0.0615 / 2)2 - 1 = 0.06245 or 6.245%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
30) The lowest effective rate of return you could earn on any of these investments is closest to:
A) 6.245%
B) 6.267%
C) 6.100%
D) 6.300%
E) 6.250%
Answer: A
Explanation: A) EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or 6.250%
EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 = 0.06289 or 6.289%
EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or 6.267%
EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or 6.300%
EAR (E) = (1 + APR / k)k - 1 = (1 + 0.0615 / 2)2 - 1 = 0.06245 or 6.245%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
Use the information for the question(s) below.
Your firm needs to invest in a new delivery truck. The life expectancy of the delivery truck is five years.
You can purchase a new delivery truck for an upfront cost of $200,000, or you can lease a truck from the
manufacturer for five years for a monthly lease payment of $4000 (paid at the end of each month). Your
firm can borrow at 6% APR with quarterly compounding.
31) The effective annual rate on your firm's borrowings is closest to:
A) 6.00%
B) 6.24%
C) 6.17%
D) 6.14%
E) 6.18%
Answer: D
Explanation: D) EAR = (1 + APR / k)k - 1 = (1 + 0.06 / 4)4 - 1 = 0.06136 or 6.14%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
32) The monthly discount rate that you should use to evaluate the truck lease is closest to:
A) 0.487%
B) 0.512%
C) 0.498%
D) 0.500%
E) 0.504%
Answer: C
Explanation: C) EAR = (1 + APR / k)k - 1 = (1 + 0.06 / 4)4 - 1 = 0.06136 or 6.14%
Monthly rate = (1 + EAR)(1/12) - 1= (1.06136)(1/12) - 1 = 0.004975 = 0.498%
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
33) The present value (PV) of the lease payments for the delivery truck is closest to:
A) $206,900
B) $207,050
C) $207,680
D) $198,420
E) $205,475
Answer: B
Explanation: B) First we need to calculate the monthly discount rate for the lease arrangement.
EAR = (1 + APR / k)k - 1 = (1 + 0.06 / 4)4 - 1 = 0.06136 or 6.14%
Monthly rate = (1 + EAR)(1/12) - 1= (1.06136)(1/12) - 1 = 0.004975 = 0.4975%
Now we can apply the PVA formula to calculate the PV of the lease or by calculator:
I = 0.4975
N = 60 (5 years × 12 months/yr)
FV = 0
PMT = $4000
Compute PV = 207,051.61.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
34) You are considering purchasing a new automobile that will cost you $28,000. The dealer offers you
4.9% APR financing for 60 months (with payments made at the end of the month). Assuming you
finance the entire $28,000 and finance through the dealer, your monthly payments will be closest to:
A) $1454
B) $527
C) $467
D) $478
E) $497
Answer: B
Explanation: B) First we need the monthly interest rate = APR / k = 0.049 / 12 = 0.004083 or 0.4083%.
Now:
PV = 28000
I = 0.4083
FV = 0
N = 60
Compute PMT = $527.11
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
35) You are considering purchasing a new truck that will cost you $34,000. The dealer offers you 1.9%
APR financing for 48 months (with payments made at the end of the month). Assuming you finance the
entire $34,000 and finance through the dealer, your monthly payments will be closest to:
A) $708
B) $594
C) $736
D) $1086
E) $697
Answer: C
Explanation: C) First we need the monthly interest rate = APR / k = 0.019 / 12 = 0.001583 or 0.1583%.
Now:
PV = 34000
I = 0.1583
FV = 0
N = 48
Compute PMT = $736.15.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
Use the information for the question(s) below.
You are purchasing a new home and need to borrow $250,000 from a mortgage lender. The mortgage
lender quotes you a rate of 6.25% APR for a 30-year fixed rate mortgage. The mortgage lender also tells
you that if you are willing to pay two points, they can offer you a lower rate of 6.0% APR for a 30-year
fixed rate mortgage. One point is equal to 1% of the loan value. So if you take the lower rate and pay the
points, you will need to borrow an additional $5000 to cover points you are paying the lender.
36) Assuming you do not pay the points and borrow from the mortgage lender at 6.25%, your monthly
mortgage payment (with payments made at the end of the month) will be closest to:
A) $1570
B) $1530
C) $1540
D) $1500
E) $1510
Answer: C
Explanation: C) First we need the monthly interest rate = APR / k = 0.0625 / 12 = 0.005208 or 0.5208%.
Now:
PV = 250,000 (no points)
I = 0.5208
FV = 0
N = 360 (30 years × 12 months)
Compute PMT = $1539.29.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
37) Assuming you pay the points and borrow from the mortgage lender at 6.00%, your monthly
mortgage payment (with payments made at the end of the month) will be closest to:
A) $1540
B) $1530
C) $1570
D) $1500
E) $1510
Answer: B
Explanation: B) First we need the monthly interest rate = APR / k = 0.0600 / 12 = 0.005000 or 0.50%.
Now:
PV = 255,000 (2 points)
I = 0.50
FV = 0
N = 360 (30 years × 12 months)
Compute PMT = $1528.85.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
Use the information for the question(s) below.
Two years ago you purchased a new SUV. You financed your SUV for 60 months (with payments made
at the end of the month) with a loan at 5.9% APR. You monthly payments are $617.16 and you have just
made your 24th monthly payment on your SUV.
38) The amount of your original loan is closest to:
A) $37,000
B) $32,000
C) $20,300
D) $31,250
E) $29,000
Answer: B
Explanation: B) First we need the monthly interest rate = APR / k = 0.059 / 12 = 0.004917 or 0.4917%.
Now:
I = 0.4917
FV = 0
N = 60
PMT = 617.16
Compute PV = $31,999.86.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
39) Assuming that you have made all of the first 24 payments on time, then the outstanding principal
balance on your SUV loan is closest to:
A) $31,250
B) $20,300
C) $19,200
D) $32,000
E) $29,000
Answer: B
Explanation: B) First we need the monthly interest rate = APR / k = 0.059 / 12 = 0.004917 or 0.4917%.
Now:
I = 0.4917
FV = 0
N = 36 (remaining payments 60 - 24 = 36)
PMT = 617.16
Compute PV = $20,316.92.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
40) A 12% APR with bi-monthly compounding is equivalent to an EAR of:
A) 11.98%
B) 12.50%
C) 12.00%
D) 12.62%
E) 12.14%
Answer: D
Explanation: D) EAR = {(1 + 0.12 / 6} 6 - 1 = 12.62%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
41) Which of the following is/are TRUE?
I. The EAR can never exceed the APR.
II. The APR can never exceed the EAR.
III. The APR and EAR can never be equal.
A) Only I is true.
B) Only II is true.
C) Only II & III are true.
D) Only I & III are true.
E) Only III is true.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
42) Everything else remaining the same, under what situation will APR and EAR be equal?
Answer: An APR will equal EAR only with annual compounding assuming everything else remains
same.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
43) What is the general relationship between the absolute values of APR and EAR for an investment?
Answer: The APR of a project will either equal its EAR or be smaller than EAR. The APR will equal
EAR with annual compounding for all other compounding intervals the APR will be smaller than EAR.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
44) Is it possible to analyze cash flows that occur in time intervals that are not exactly equal to a year?
Answer: Yes, in the real world cash flows may have any periodicity. They may be shorter than a year or
longer than a year. Additional care need to be taken in both cases. For cash flows that have an interval
larger than one year, one should be careful to show the years with zero cash flows. Alternately, for those
with shorter than a year, one should be careful about modifying the interest rate to match the time
interval.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
45) What care, if any, should be taken when cash flows occur in periodicities that are shorter than a
year—e.g., quarterly or monthly cash flows?
Answer: In the real world, cash flows can occur with any periodicity but interest rates are generally
quoted in annual terms. As such, when cash flows occur at a shorter than annual time interval, the
interest rates have to be modified to correspond to the cash flow interval. One way to do that is to
match the compounding period equal to cash flow interval.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
46) How do we handle a situation when both compounding period and cash flow interval are given to
us, but both are less than a year and not equal to each other?
Answer: Additional care should be taken when the compounding period is given to us and it does not
equal the cash flow interval. This requires some additional steps in computing the applicable interest
rate. The compounding interval has to match the cash flow interval to enable transformation to present
value (PV) or future value (FV). In most cases, it should be possible to achieve this by calculating the
effective annual rate from the given compounding interval and subsequently calculating the annual
percentage rate and periodic interest rate for the cash flow interval.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 5.1 Understand the different ways interest rates are quoted
47) You are in the process of purchasing a new automobile that will cost you $25,000. The dealership is
offering you either a $1000 rebate (applied toward the purchase price) or 3.9% financing for 60 months
(with payments made at the end of the month). You have been pre-approved for an auto loan through
your local credit union at an interest rate of 7.5% for 60 months. Should you take the $1000 rebate and
finance through your credit union or forgo the rebate and finance through the dealership at the lower
3.9% APR?
Answer: First we need the monthly interest rate = APR / k = 0.075 / 12 = 0.00625 or 0.625%.
Now:
PV = 24,000 (25,000 - 1000 rebate)
I = 0.625
FV = 0
N = 60
Compute PMT = $480.91.
Dealership:
First we need the monthly interest rate = APR / k = 0.039 / 12 = 0.00325 or 0.325%.
Now:
PV = 25,000 (no rebate)
I = 0.325
FV = 0
N = 60
Compute PMT = $459.29
Since 459.29 < 480.91, go with the dealership financing and forgo the rebate.
Diff: 3 Type: ES
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
48) You are purchasing a new home and need to borrow $325,000 from a mortgage lender. The
mortgage lender quotes you a rate of 6.5% APR for a 30-year fixed rate mortgage (with payments made
at the end of each month). The mortgage lender also tells you that if you are willing to pay one point,
they can offer you a lower rate of 6.25% APR for a 30-year fixed rate mortgage. One point is equal to 1%
of the loan value. So if you take the lower rate and pay the points, you will need to borrow an
additional $3250 to cover points you are paying the lender. Assuming that you do not intend to prepay
your mortgage (pay off your mortgage early), are you better off paying the one point and borrowing at
6.25% APR or just taking out the loan at 6.5% without any points?
Answer: Pay the points!
Points (6.25% APR)
First we need the monthly interest rate = APR / k = 0.0625 / 12 = 0.00520833 or 0.5208%.
Now:
PV = 328,250 ( 325,000 + 1 point)
I = 0.5208
FV = 0
N = 360 (30 years × 12 months)
Compute PMT = $2021.01
No Points
First we need the monthly interest rate = APR / k = 0.065 / 12 = 0.005417 or 0.5417%.
Now:
PV = 325,000 (no points)
I = 0.5417
FV = 0
N = 360 (30 years × 12 months)
Compute PMT = $2054.22
Since $2021.01 < $2054.22, pay the points!
Diff: 3 Type: ES
Skill: Analytical
Objective: 5.1 Understand the different ways interest rates are quoted
5.2 Application: Discount Rates and Loans
1) Joe borrows $100,000 and agrees to repay the principal, plus 7% APR interest compounded monthly,
at the end of three years. Joe has taken out an amortizing loan.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.2 Use quoted rates to calculate loan payments and balances
2) You decide to take out a car loan for $20,000 at 7% APR for 60 months. How much are your monthly
payments?
A) $396.02
B) $333.33
C) $406.48
D) $400.00
E) $367.54
Answer: A
Explanation: A) PV = 20,000; N = 60, I = 7/12%; PMT = $396.02
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
3) You decide to take out a car loan for $14,995 at 3% APR for 48 months. How much are your monthly
payments?
A) $312.40
B) $321.77
C) $331.90
D) $593.47
E) $336.17
Answer: C
Explanation: C) PV = 14,995 N =48, I = 3/12%; PMT = $331.90
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
4) You decide to take out a car loan for $34,575 at 4% APR for 72 months. How much are your monthly
payments?
A) $480.21
B) $540.93
C) $1,470.30
D) $549.63
E) $499.42
Answer: B
Explanation: B) PV = 34,575 N =72, I = 4/12%; PMT = $540.93
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
5) You decide to take out a car loan at 4.5% APR for 60 months. If your monthly payments are $512.68,
what is the price of your car?
A) $30,000
B) $10,581
C) $30,761
D) $32,145
E) $27,500
Answer: E
Explanation: E) PMT = 512.68 N =60, I = 4.5/12%; PV = $27,500
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
6) You decide to take out a car loan for $35,000 at 5% APR with monthly payments of $838.12. Over how
many years is your loan being paid?
A) 2 years
B) 3 years
C) 4 years
D) 5 years
E) 6 years
Answer: C
Explanation: C) PV = 35,000; PMT = 838.12, I = 7/12%; N = 48. 48/12 = 4 years.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
7) You decide to take out a car loan for $25,000 at 6% APR for 60 months. What is the outstanding
principal of your loan after you make your first payment?
A) $24,875.00
B) $24,516.68
C) $24,641.68
D) $24.734.32
E) $24,975.14
Answer: C
Explanation: C) PV = 25,000; I = 6/12%; N = 60; PMT = 483.32.
Interest = 6/12% × 25,000 = 125. Payment - interest = 483.32 - 125 = $358.32
Principal after first payment = 25,000 - 358.32 = $24,641.68
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
8) You decide to take out a 25-year mortgage for $350,000 at 5% APR. What are your monthly
payments?
A) $2,035.62
B) $2,046.07
C) $1,166.67
D) $2,069.45
E) $2,054.11
Answer: A
Explanation: A) I = (1 + 0.05/2)^(1/6) = 0.4124% per month
PV = 350,000, N = 25 × 12 = 300
PMT = $2,035.62
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
9) You decide to take out a 30-year mortgage for $445,000 at 6% APR. What are your monthly
payments?
A) $2,622.69
B) $2,646.96
C) $2,694.06
D) $2,688.32
E) $2,667.99
Answer: B
Explanation: B) I = (1 + 0.06/2)^(1/6) = 0.4939% per month
PV = 445,000, N = 30 × 12 = 360
PMT = $2,646.96
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
10) You decide to take out a 25-year mortgage for $375,000 at 5% APR. What will your outstanding
balance be at the end of the mortgage's initial 5-year term?
A) $330,000
B) $332,176
C) $331,584
D) $331,903
E) $244,139
Answer: D
Explanation: D) I = (1 + 0.05/2)^(1/6) = 0.4124% per month
PV = 375,000, N = 25 × 12 = 300
PMT = $2,181.02
Calculate PV with above PMT and I, and N = 240. PV = $331,903
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
11) A $60,000 loan is taken out on a boat with the terms 7% APR for 36 months. How much are the
monthly payments on this loan?
A) $1666.66
B) $1783.33
C) $1796.54
D) $1852.62
E) $1901.24
Answer: D
Explanation: D) Calculate the PMT when PV of ordinary annuity = $60,000, periodic interest = 7/12%,
and number of periods = 36.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
12) Ursula wants to buy an $18,999 used car. She has savings of $2,000 plus an $800 trade-in. She wants
her monthly payments to be about $272. Which of the following loans offers monthly payments closest
to $272?
A) 6.5% APR for 36 months
B) 6.5% APR for 48 months
C) 6.5% APR for 60 months
D) 6.5% APR for 72 months
E) 6.5% APR for 84 months
Answer: D
Explanation: D) Calculate N when PV of ordinary annuity = $18,999 - $2000 - $800 = $16,199, periodic
interest = 6.5/12%, and monthly payments = $272.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
13) A house costs $138,000. It is to be paid off in exactly ten years, with monthly payments of $1675.
What is the quoted APR of this mortgage?
A) 7.52%
B) 7.80%
C) 8.14%
D) 8.33%
E) 8.54%
Answer: C
Explanation: C) Calculate the periodic interest rate when PV of ordinary annuity = $138,000, number of
months = 120, and monthly payments = $1675; the periodic interest rate = 0.6674%, which is an effective
semi-annual rate of 4.072%. Multiply by 2 to get 8.14%, the APR compounded semi-annually.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
14) A home buyer buys a house for $225,000. She pays 20% cash, and takes a fixed-rate mortgage for ten
years at a quoted APR of 6.26%. If she makes biweekly payments, which of the following is closest to
each of her payments?
A) $915.08
B) $928.61
C) $937.50
D) $1165.07
E) $1160.76
Answer: B
Explanation: B) Calculate biweekly payment when PV of ordinary annuity = $180,000, APR is 6.26%
with semi-annual compounding, payments are biweekly, so periodic interest =
(1+ 0.0626/2)1/13 - 1 = .002374 or .2374% , and number of periods = 260, using a financial calculator,
payment = $928.61.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
15) A construction company takes a loan of $280,000 to cover the cost of a new grader. If the interest rate
is 8.75%APR, and payments are made monthly for five years, what percentage of the outstanding
principal does the company pay in interest each month?
A) 0.73%
B) 7.29%
C) 8.75%
D) 9.25%
E) 10.5%
Answer: A
Explanation: A) The percentage of outstanding principal paid is the monthly periodic interest rate =
8.75/12 = 0.73%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
16) A homeowner has five years of monthly payments of $1400 before she has paid off her house. If the
quoted interest rate is 7% APR, what is the remaining balance on her mortgage?
A) $59,890
B) $64,918
C) $70,872
D) $84,000
E) $88,830
Answer: C
Explanation: C) Calculate PV of the ordinary annuity of $1400 paid per month, APR is 7% with semiannual compounding, so periodic interest rate = (1 + 0.07/2) 1/6 - 1 = .575% over 60 months = $70,872.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
17) A Xerox DocuColor photocopier costing $42,000 is paid off in 60 monthly installments at 6.5% APR.
After three years the company wishes to sell the photocopier. What is the minimum price for which
they can sell the copier so that they can cover the cost of the balance remaining on the loan?
A) $18,448
B) $19,645
C) $19,842
D) $26,813
E) $17,946
Answer: A
Explanation: A) The first step is to calculate the monthly payment using a present value (PV) of $42,000
monthly interest rate of 6.5/12 = 0.54%, and 60 periods, which = $821.79; the second step is to use that
monthly payment to calculate the present value (PV) of 24 months remaining payment keeping the
interest rate unchanged. Using a financial calculator with N = 24, I = 6.5/12 and PMT = -821.79, calculate
PV = $18,448.02.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
18) A truck costing $112,000 is paid off in monthly installments over four years with 8% APR. After
three years the owner wishes to sell the truck. What is the closest amount from the following list that he
needs to pay on his loan before he can sell the truck?
A) $24,867
B) $28,678
C) $31,432
D) $87,255
E) $44,792
Answer: C
Explanation: C) The first step is to calculate the monthly payment using a present value (PV) of
$112,000 monthly interest rate of 8/12 = 0.67%, and 48 periods, which = $2734.25; the second step is to
use that monthly payment to calculate the present value (PV) of 12 months remaining payment keeping
the interest rate unchanged. Using a financial calculator with N = 12, I = 8/12, and PMT = -2734.25,
calculate PV = $31,432.34.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
19) A small business refits its store. The builders charge them $125,000, which will be paid back in
monthly installments over three years at 6% APR. The builders will reduce this rate to 5.5% APR if they
pay $2500 up front. By approximately how much will this reduce the monthly loan repayments ?
A) $104
B) $28
C) $214
D) $77
E) $192
Answer: A
Explanation: A) The first step is to calculate the monthly payment using a present value (PV) of
$125,000 monthly interest rate of 6/12 = 0.5%, and 36 periods, which = $3802.74; the second step is to use
that monthly payment using a monthly interest rate of 5.5/12 = 0.4583% and a PV of $125,000 - $2,500 =
$122,500 to calculate the payment = $3699.00; the difference of the two = $3802.74 - $3699.00 = $103.74.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
20) An investor buys a property for $640,000 with a 25-year mortgage and monthly payments at a
quoted APR of 8%. After 18 months the investor resells the property for $712,000. How much cash will
the investor have made from the sale, once the mortgage is paid off?
A) $63,218
B) $72,412
C) $85,082
D) $92,644
E) $72,000
Answer: C
Explanation: C) The first step is to calculate the monthly payment using a present value (PV) of
$640,000, monthly interest rate of (1 + .08/2)1/6 - 1 = 0.656%, and 300 periods, which = $4885.4792; the
second step is to use that monthly payment to calculate the present value (PV) of 282 months keeping
the interest rate unchanged, which = $626,918.2346; finally calculate the difference between $712,000 $626,918.23 = $85,081.77.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
21) Michael has credit card debt of $60,000 that has an 18% APR, compounded monthly. The minimum
monthly payment only requires him to pay the interest on his debt. He receives an offer for a credit card
with an APR of 10% compounded monthly. If he rolls over his debt onto this card and makes the same
monthly payment as before, how long will it take him to pay off his credit card debt?
A) 72 months
B) 78 months
C) 84 months
D) 98 months
E) 104 months
Answer: D
Explanation: D) The first step is to calculate the minimum monthly payment using the debt balance of
$60,000 and 18% APR compounded monthly, which = $60,000 × 0.18/12 = $900. The second step is to use
the same $900 as payment, and using a discount rate of 10/12 = 0.83%, calculate the number of months
required to pay off the present value (PV) of $60,000, which = 97.7165 months rounded to 98 months.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
22) A homeowner has a $200,000 home with a 20-year mortgage, paid monthly at a quoted APR of
7.25%. After five years he receives $50,000 as an inheritance. If he pays this $50,000 toward his mortgage
along with his regular payment, by approximately how many years will it reduce the amount of time it
takes him to pay off his mortgage?
A) 6 years
B) 5 years
C) 4 years
D) 3 years
E) 2 years
Answer: A
Explanation: A) The first step is to calculate the monthly payment using a present value (PV) of
$200,000, monthly interest rate of (1 + .0725/2) 1/6 - 1 = 0.595%, and 240 periods, which = $1567.45; the
second step is to use that monthly payment to calculate the balance at the end of five years, which =
$172,879.156; next step is to reduce this balance by $50,000 to the new outstanding balance of
$122,879.156; now calculate the number of months required to pay off this balance, which = 105.89; the
last step is to calculate the difference between 180 - 105.89 = 74.11, when divided by 12 gives 6.18 years.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
23) Joseph buys a Hummer for $60,000, financing it with a five-year 6.5% APR loan paid monthly. He
decides to pay an extra $50 per month in addition to his monthly payments. Approximately how long
will he take to pay off the loan under these conditions?
A) 4 years 10 months
B) 4 years 9 months
C) 4 years 6 months
D) 4 years 4 months
E) 5 years
Answer: B
Explanation: B) The first step is to calculate the monthly payment using a present value (PV) of $60,000,
monthly interest rate of 6.5/12 = 0.54%, and 60 periods, which = $1173.97; the second step is to add $50 to
this monthly payment giving the new monthly payment of $1,223.97; the last step is to calculate the
time required to pay off the loan = 57.1275 months, which = 4 years 9 months.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
24) Liam had an extension built onto his home. He financed it for 48 months with a loan at 4.9% APR.
His monthly payments were $750. How much was the loan amount for this extension?
A) $32,631
B) $34,842
C) $36,000
D) $38,420
E) $37,764
Answer: A
Explanation: A) Calculate the PV annuity of $750 for 48 months at 4.9/12 = 0.4083%, which = $32,631.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
25) Corey buys 10 Tufflift 4-post, 4.5-ton car hoists for his parking garage at a total cost of $410,000. He
finances this with a five-year loan at 6.2% APR with monthly payments. After he has made the first 20
payments, how much is the outstanding principal balance on his loan?
A) $150,969
B) $250,698
C) $287,153
D) $302,284
E) $310,104
Answer: C
Explanation: C) The first step is to calculate the monthly payment using a present value (PV) of
$410,000, monthly interest rate of 6.2/12 = 0.5167%, and 60 periods, which = $7964.63; the second step is
to use that monthly payment to calculate the present value (PV) of 40 months keeping the interest rate
unchanged, which = $287,152.99.
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
26) Assume your current mortgage payment is $900 per month. If you begin to pay $1,000 per month
(with the extra $100 per month going to principal), which of the following will be TRUE?
A) The mortgage balance will decrease faster with $1,000 monthly payments compared to $900 monthly
payments.
B) The total paid (principal and interest) will increase with $1,000 monthly payments compared to $900
monthly payments.
C) The total interest expense will increase with $1,000 monthly payments compared to $900 monthly
payments.
D) The total principal paid will decrease with $1,000 monthly payments compared to $900 monthly
payments.
E) The time until your mortgage is paid off will increase with $1,000 monthly payments compared to
$900 monthly payments
Answer: A
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
27) Five years ago you took out a 30-year mortgage with a quoted APR of 6.5% for $200,000. If you were
to refinance the mortgage today for 20 years at a quoted APR of 4.25%,, by how much would your
monthly payment change?
A) The monthly payment will increase by $98.33.
B) The monthly payment will decrease by $98.33.
C) The monthly payment will increase by $343.12.
D) The monthly payment will decrease by $343.12.
E) The monthly payment will not change.
Answer: B
Explanation: B) Current Mortgage Payment: P/Y = 12, N = 360, I/Y = (1 + 0.065/2)1/6 - 1 = 0.5345%, PV =
200,000, Solve for PMT = 1,252.85
Current Mortgage Balance: P/Y = 12, N = 300, I/Y = 0.5345, PMT = 1,252.85, Solve for PV = 187,035.67
New Mortgage Payment: P/Y = 12, N = 240, I/Y = (1 + .0425/2) 1/6 -1 = 0.3511%, PV = 187,222.54, Solve for
PMT = 1,154.52
Current Payment - New Payment = $1252.85 - $1154.52 = -$98.33
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
28) Five years ago you took out a 30-year mortgage with a quoted APR of 6.5% for $200,000. If you were
to refinance the mortgage today for 20 years at a quoted APR of 4.25% , how much would you save in
total interest expense?
A) $176,846
B) $75,848
C) $151,696
D) $98,770
E) $108,340
Answer: D
Explanation: D) Current Mortgage Payment: P/Y = 12, N = 360, I/Y = (1 + 0.065/2) 1/6 - 1 = .5345%, PV =
200,000, Solve for PMT = 1,252.85
Current Mortgage Balance: P/Y = 12, N = 300, I/Y = .5345%, PMT = 1,252.85, Solve for PV = 187,035.67
Total of Remaining Payments on Current Mortgage = 300 × $1,252.85= $375,855.00
New Mortgage Payment: P/Y = 12, N = 240, I/Y = (1 + .0425/2) 1/6 -1 = 0.3511% , PV = 187,035.67, Solve for
PMT = 1,154.52
Total Payments on New Mortgage: 240 × $1,154.52 = $277,084.80
Difference in Total of Payments = $375,855.00 - $277,084.80 = $98,770.20
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
29) What is a mortgage?
Answer: A mortgage is a loan for which the borrower offers property as security for the lender.
Diff: 1 Type: SA
Skill: Definition
Objective: 5.2 Use quoted rates to calculate loan payments and balances
30) How are interest and return of principal handled in an amortizing loan payment?
Answer: The amount of periodic payments, generally monthly, for most amortizing loans is held
constant such that a part goes toward paying interest on the outstanding balance and the rest toward
return of principal. Thus this ratio keeps changing over the life of the loan. Initially, when the principal
is highest, a major part of the loan goes toward paying interest and a smaller part toward returning the
principal. However, as the loan progresses, the interest component of the payment increases and the
principal component decreases till the loan is fully paid off.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 5.2 Use quoted rates to calculate loan payments and balances
5.3 The Determinants of Interest Rates
1) Market forces determine interest rates based ultimately on the willingness of individuals, banks, and
firms to borrow, save, and lend.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
2) The real interest rate is the rate of growth of one's purchasing power due to money invested.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
3) Quality adjustments to changes in the CPI most often result in reductions to the inflation rate
calculated from it.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
4) Given a nominal interest rate of 7% and an inflation rate of 2.5%, what is the real interest rate?
A) 4.4%
B) 4.0%
C) 7%
D) 2.5%
E) 9.5%
Answer: A
Explanation: A) 1.07/ 1.025 = 1.044; real rate = 4.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
5) Given a nominal interest rate of 3% and an inflation rate of 4.5%, what is the real interest rate?
A) 3%
B) 0%
C) -1.4%
D) 1.5%
E) 7.5%
Answer: C
Explanation: C) 1.03/ 1.045 = 0.9856; real rate = -1.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
6) Given a real interest rate of 2.5% and an inflation rate of 4.5%, what is the nominal interest rate?
A) 2.5%
B) -2.0%
C) 2.0%
D) 7.1%
E) 4.5%
Answer: D
Explanation: D) 1.045 × 1.025 = 1.071; real rate = 7.1%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
7) Given a real interest rate of 5.8% and an inflation rate of 3.4%, what is the nominal interest rate?
A) 9.8%
B) 2.3%
C) 3.4%
D) 5.8%
E) 9.4%
Answer: E
Explanation: E) 1.034 × 1.058 = 1.094; real rate = 9.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
8) Which of the following formulas gives you the growth in purchasing power?
A) growth of money + growth of prices
B) (1 + real rate) / (1 + nominal rate)
C) (1 + inflation rate) / (1 + nominal rate)
D) growth of money / growth of prices
E) growth of money × growth of prices
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
9) Given an inflation rate of 3.24%, and a short-term municipal bond offers a rate of 2.9%, which of the
following statements is correct?
A) The purchasing power of investors in these bonds grew over the course of the year.
B) The real interest rate for investors in these bonds was greater than the rate of inflation.
C) Investors in these bonds were able to buy less at the end of the year than they could have purchased
at the start of the year.
D) The nominal interest rate offered by these bonds gave the true increase in purchasing power that
resulted from investing in these bonds.
E) Interest rates must have risen during the year.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
10) Historically, why have high inflation rates tended to be associated with high nominal interest rates?
A) Individuals will spend more when they expect their investments to increase in value.
B) Growth in investment and savings is encouraged when consumers are judged to be overspending.
C) High inflation leads to a decrease in purchasing power and thus increases the attractiveness of
investment over consumption in the short term.
D) The real interest rate needs to be high enough so that individuals can expect their savings to have
greater purchasing power in the future than in the present.
E) High interest rates mean that savings grow faster, and when people have more money to spend,
prices will increase.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
11) When the costs of an investment come before that investment's benefits, what will be the the effect
of a rise in interest rates on the attractiveness of that investment to potential investors?
A) It will make it more attractive, since it will increase the investment's net present value (NPV).
B) It will make it more attractive, since it will decrease the investment's net present value (NPV).
C) It will make it less attractive, since it will increase the investment's net present value (NPV).
D) It will make it less attractive, since it will decrease the investment's net present value (NPV).
E) It will be unchanged, since NPV calculations ignore changes in interest rates to more accurately
compare the NPVs of projects beginning at different times.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
12) In which of the following situations would the central bank in a certain country be most likely to
lower interest rates?
A) The economy is growing slowly or not at all.
B) Inflation is rising rapidly.
C) The level of investment is very low.
D) The rate of savings is extremely high.
E) When the government needs to borrow money more cheaply.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
13)
Term in
years:
Rate:
2
2.25%
5
3.125%
10
3.5%
20
4.375%
30
5.15%
The table above shows the interest rates available from investing in risk-free Government of Canada
securities with different investment terms. If an investment offers a risk-free cash flow of $100,000 in ten
years' time, what is the present value (PV) of that cash flow?
A) $80,051
B) $78,320
C) $73,512
D) $70,892
E) $95,102
Answer: D
Explanation: D) Using FV = $100,000, find the present value (PV) at 3.5% for 10 years.
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.2 Use quoted rates to calculate loan payments and balances
14)
Term in
years:
Rate:
1
1.8%
2
2.25%
3
2.30%
4
2.66%
5
3.13%
The table above shows the interest rates available from investing in risk-free Government of Canada
securities with different investment terms. What is the present value (PV) of cash flows from an
investment that yields $4000 at the end of each year for the next four years?
A) $14,898
B) $14,956
C) $14,990
D) $15,093
E) $14,822
Answer: D
Explanation: D) PV of $4000 at 1.8% for 1 year = $3929.27;
PV of $4000 at 2.25% for 2 years = $3825.90;
PV of $4000 at 2.30% for 3 years = $3736.23;
PV of $4000 at 2.66% for 4 years = $3601.26;
sum of these four PVs = $15,093.
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
15) In which of the following situations would it not be appropriate to use the following formula:
PV = C1/(1 + r1) + C2/(1 + r2)2 + . . . . + Cn/(1 + rn)n
when determining the present value (PV) of a cash flow stream?
A) when yield curves are flat
B) when short-term and long-term interest rates vary widely
C) when the inflation rate is high
D) when the discount rate is high
E) when the real interest rate is high
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
16) In an effort to maintain price stability, it is expected that the European Central Bank will raise
interest rates in the future. Which of the following is the most likely effect of such an action on shortand long-term interest rates in Europe?
A) Long-term interest rates will tend to be higher than short-term interest rates.
B) Long-term interest rates will be about the same as short-term interest rates.
C) Both long- and short-term interest rates would be expected to fall sharply.
D) No relative change in short- and long-term interest rates could be predicted.
E) Long-term interest rates will tend to be lower than short-term interest rates.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
17)
Term:
Rate:
1 years
5.00%
2 years
5.50%
3 years
6.10%
5 years
7.50%
10 years
8.50%
20 years
9.25%
Given the above term structure of interest rates, which of the following is most likely in the future?
Option I
Interest rates will rise.
Option II Economic growth will slow.
Option III Long-term rates will fall relative to short-term rates.
A) Option I only
B) Option II only
C) Option III only
D) Options I and II
E) Options II and III
Answer: A
Explanation: A) A sharply increasing (steep) yield curve, with long-term rates much higher than shortterm rates, generally indicates that interest rates are expected to rise in the future. The yield curve tends
to be steep as the economy comes out of a recession.
Diff: 2 Type: MC
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
18) Which of the following reasons for considering long-term loans inherently more risky than shortterm loans is most accurate?
A) There is a greater chance that a borrower will default in a longer time-frame.
B) The penalties for closing out a long-term loan early make them unattractive to many investors.
C) Long-term loans typically have ongoing costs that accumulate over the life of the loan.
D) The loan values are very sensitive to changes in market interest rates.
E) There is a greater chance that an investor will need cash before the loan term is complete.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
19) A bank lends some money to a business. The business will pay the bank a single payment of
$180,000 in ten years time. How much greater is the present value (PV) of this payment if the interest
rate is 9% rather than 8%?
A) $7341
B) $35,892
C) $76,033
D) $83,374
E) $18,000
Answer: A
Explanation: A) PV of $180,000 at 8% for 10 years = $83,374.82;
PV of $180,000 at 9% for 10 years = $76,033.95; difference = $7340.88
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
20) Which of the following statements is true?
A) The interest rates that banks offer on investments or charge on loans is independent of the time
horizon of the investment or loan.
B) The Bank of Canada determines very short-term interest rates through its influence on the federal
funds rate.
C) The interest rates that are quoted by banks and other financial institutions are real interest rates.
D) Fundamentally, interest rates are determined by the Bank of Canada.
E) If interest rates are expected to fall in the future, long-term rates will tend to be higher than shortterm rates.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
21) If the current inflation rate is 5%, then the nominal rate necessary for you to earn an 8% real interest
rate on your investment is closest to:
A) 13.0%
B) 13.4%
C) 4.9%
D) 3.0%
E) 8.0%
Answer: B
Explanation: B) nominal = (1 + inflation)(1 + real) - 1 = (1.05)(1.08) - 1 = 0.134 or 13.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
22) If the current inflation rate is 4% and you have an investment opportunity that pays 10%, then the
real rate of interest on your investment is closest to:
A) 10.0%
B) 14.0%
C) 6.0%
D) 5.8%
E) 4.0%
Answer: D
Explanation: D) 1 + nominal = (1 + inflation)(1 + real)
real interest rate =
- 1 = 0.057692 or 5.77%
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
Use the table for the question(s) below.
Suppose the term structure of interest rates is shown below:
Term
Rate
(EAR%)
1 year
5.00%
2 years
3 years
5 years
10 years
20 years
4.80%
4.60%
4.50%
4.25%
4.15%
23) What is the shape of the yield curve and what expectations are investors likely to have about future
interest rates?
A) inverted; higher
B) normal; higher
C) inverted; lower
D) normal; lower
E) flat; unchanged
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
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24) The present value (PV) of receiving $1000 per year with certainty at the end of the next three years is
closest to:
A) $2737
B) $2723
C) $2733
D) $2744
E) $3000
Answer: A
Explanation: A) PV = 1000 / (1.05) + 1000 / (1.048) 2 + 1000 / (1.046)3 = 2737
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
25) Consider an investment that pays $1000 certain at the end of each of the next four years. If the
investment costs $3,500 and has a net present value (NPV) of $74.26, then the four year risk-free interest
rate is closest to:
A) 4.5%
B) 4.58%
C) 4.55%
D) 4.53%
E) 5.0%
Answer: D
Explanation: D) NPV = 74.26 = -3500 + 1000 / (1.05)1 + 1000 / (1.048)2 + 1000 / (1.046)3 + 1000 / (1 + x)4
3574.26 - 1000 / (1.05)1 + 1000 / (1.048)2 + 1000 / (1.046)3 = 1000 / (1 + x)4
837.60 = 1000 / (1 + X)4 ==>> (1 + X)4 = 1000 / 837.60 ==>> X = 0.0453 or 4.53%
Diff: 3 Type: MC
Skill: Analytical
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
26) The net present value (NPV) of an investment that costs $2700 and pays $1000 certain at the end of
one, three, and five years is closest to:
A) $21.47
B) $1665.62
C) -$100.26
D) -$71.38
E) $0
Answer: D
Explanation: D) NPV = -2700 + 1000 / (1.05)1 + 1000 / (1.046)3 + 1000 / (1.045)5 = -71.38
Diff: 2 Type: MC
Skill: Analytical
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
27) Inflation measures
A) how price changes impact interest rates.
B) how the purchasing power increases due to increasing interest rates.
C) changes in nominal interest rates.
D) changes in real interest rates.
E) how purchasing power declines due to increasing prices.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
28) The yield curve is typically
A) downward sloping.
B) upward sloping.
C) flat.
D) inverted.
E) fluctuating.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
29) Can the nominal interest rate ever be negative? Can the real interest rate ever be negative? Explain.
Answer: The nominal interest rate can never be negative since by just holding your money you are
earning a 0% return (no negative) on your money. The real rate, however, can be negative any time that
the inflation rate exceeds the nominal rate.
Diff: 1 Type: ES
Skill: Conceptual
Objective: 5.3 Know how inflation, expectations, and risk combine to determine interest rates
Use the table for the question(s) below.
Suppose the term structure of interest rates is shown below:
Term
Rate
(EAR%)
1 year
5.00%
2 years
3 years
5 years
10 years
20 years
4.80%
4.60%
4.50%
4.25%
4.15%
30) After examining the yield curve, what predictions do you have about interest rates in the future?
About future economic growth and the overall state of the economy?
Answer: This is an inverted yield curve, which implies that interest rates should be falling in the future.
An inverted yield curve is often interpreted as a negative forecast for economic growth. Since each of
the last six recessions in the United States were proceeded by a period with an inverted yield curve, it
could be a leading indicator of a future recession.
Diff: 2 Type: ES
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
31) What is the net present value (NPV) of an investment that costs $2500 and pays $1000 certain at the
end of one, three, and five years?
Answer: NPV = -2500 + 1000 / (1.05)1 + 1000 / (1.046)3 + 1000 / (1.045)5 = 128.62
Diff: 2 Type: ES
Skill: Analytical
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
32) What is the implied assumption about interest rates when using the built-in functions of a financial
calculator to calculate the present value (PV) of an annuity?
Answer: The built-in functions for present value of ordinary annuity in a financial calculator assume
that interests rates are the same for every maturity on the yield curve.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
33) What is the implied assumption about interest rates when the equation to calculate the present value
(PV) of perpetuity is used?
Answer: The equation for computation of present value of perpetuity assumes that the interest rates are
same and held constant for every maturity on the yield curve.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 5.4 Be exposed to the term structure of interest rates and yield curves
5.4 The Opportunity Cost of Capital
1) The opportunity cost of capital is the best available expected return offered in the market on an
investment of comparable risk and term to the cash flow being discounted.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.5 See the link between interest rates in the market and a firm's opportunity cost of capital
2) The term "opportunity" in opportunity cost of capital comes from the fact that any worthwhile
opportunity for investment will have a cost: the risk to the capital invested.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.5 See the link between interest rates in the market and a firm's opportunity cost of capital
3) The opportunity cost of capital will generally be more than the interest rate offered by Government of
Canada securities with the same term, for a risk-free investment.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 5.5 See the link between interest rates in the market and a firm's opportunity cost of capital
4) What, typically, is used to calculate the opportunity cost of capital on a risk-free investment?
A) the best available expected return offered in any investment available in the market
B) the interest rate on Government of Canada securities with the same term
C) the interest rate of any investments alternatives that are available
D) the best rate of return offered by Government of Canada securities
E) the interest rate on short-term Government of Canada securities
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.5 See the link between interest rates in the market and a firm's opportunity cost of capital
5) Elinore is asked to invest $5000 in a friend's business with the promise that the friend will repay
$5500 in one year's time. Elinore finds her best alternative to this investment, with similar risk, is one
that will pay her $5400 in one year's time. U.S. securities of similar term offer a rate of return of 6%.
What is the opportunity cost of capital in this case?
A) 6%
B) 8%
C) 9%
D) 10%
E) 7%
Answer: B
Explanation: B) $5400 / 1.08 = $5000
Diff: 1 Type: MC
Skill: Analytical
Objective: 5.5 See the link between interest rates in the market and a firm's opportunity cost of capital
6) Why, in general, do investment opportunities offer a rate greater than that offered by Government of
Canada securities for the same horizon?
A) Most investment opportunities offer far greater risk than those offered by Government of Canada.
B) The return from Government of Canada securities generally attracts less tax than the returns from
other investments.
C) The opportunity cost of capital for a given horizon is generally based on Government of Canada
securities with that same horizon.
D) Government of Canada securities are generally considered to be the best alternative to most
investments.
E) Government of Canada securities are the least attractive investment available.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 5.5 See the link between interest rates in the market and a firm's opportunity cost of capital
7) How do we decide on opportunity cost when we have several opportunities that need to be forgone?
Answer: We rank all the forgone opportunities, and opportunity cost is the second-best opportunity
that we forgo. Thus we select the best opportunity and rank all the alternative opportunities and use the
cost of the second-best opportunity as opportunity cost.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 5.5 See the link between interest rates in the market and a firm's opportunity cost of capital
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 6 Bonds
6.1 Bond Terminology
1) The coupon value of a bond is the face value of that bond.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.1 Understand bond terminology
2) A bond is said to mature on the date when the issuer repays its notional value.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.1 Understand bond terminology
3) Which of the following best illustrates why a bond is a type of loan?
A) The issuers of bonds regularly pay interest on the face value of the bond to the buyers of those
bonds.
B) When a company issues a bond, the buyer of that bond becomes a part owner of the issuing
company.
C) Federal and local governments issue bonds to finance long-term projects.
D) When an investor buys a bond from an issuer, the investor is giving money to the issuer, with the
assurance it will be repaid at a date in the future.
E) Bonds are typically bought by banks, so the source of funds is the same.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.1 Understand bond terminology
4) How much will the coupon payments be of a 20-year $500 bond with a 8% coupon rate and quarterly
payments?
A) $3.33
B) $10.00
C) $20.00
D) $40.00
E) $2.00
Answer: B
Explanation: B) $500 × 0.08 / 4 = $10
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
5) How much will the coupon payments be of a 30-year $10,000 bond with a 4.5% coupon rate and semiannual payments?
A) $30
B) $225
C) $350
D) $450
E) $45
Answer: B
Explanation: B) $10,000 × 0.045 / 2 = $225
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
6) How much will the coupon payments be of a 10-year $10,000 bond with a 3% coupon rate and semiannual payments?
A) $150
B) $120
C) $100
D) $300
E) $600
Answer: A
Explanation: A) $10,000 × 0.03/2 = $150
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
7) What is the coupon rate of a 10-year $10,000 bond with semi-annual payments of $300?
A) 1%
B) 10%
C) 1.5%
D) 3%
E) 6%
Answer: E
Explanation: E) 300 × 2 / 10,000 = 6%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
8) What is the coupon rate of a 30-year, $1000 bond with semi-annual payments of $22.50?
A) 5%
B) 2.25%
C) 4.5%
D) 2%
E) 22.5%
Answer: C
Explanation: C) ($22.50 × 2)/ $1,000 = 4.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
9) What is the coupon rate of a 10-year $4,000 bond with annual coupon payments of $100?
A) 2.5%
B) 4%
C) 5%
D) 10%
E) 25%
Answer: A
Explanation: A) ($100 × 1)/ $4,000 = 2.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
10) The face value of a 30-year coupon bond is $100,000. If it pays $1,500 every 3 months, what is its
coupon rate?
A) 1.5%
B) 0.06%
C) 6%
D) 4.5%
E) 15%
Answer: C
Explanation: C) ($1,500 × 4)/ $100,000 =6%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
11) A corporate bond makes payments of $9.67 every month for ten years with a final payment of
$2009.67. Which of the following best describes this bond?
A) a 10-year bond with a face value of $2000 and a coupon rate of 4.8% with monthly payments
B) a 10-year bond with a face value of $2000 and a coupon rate of 5.8% with monthly payments
C) a 10-year bond with a face value of $2009.67 and a coupon rate of 4.8% with monthly payments
D) a 10-year bond with a face value of $2009.67 and a coupon rate of 5.8% with monthly payments
E) a 10-year bond with a face value of $2009.67 and a coupon rate of 6.8% with monthly payments
Answer: B
Explanation: B) $9.67 × 12 / 2000 = 5.802%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
12) Which of the following best shows the timeline for cash flows from a five-year bond with a face
value of $2,000, a coupon rate of 4.2%, and semi-annual payments?
A) 0 1
2
3
4
+-----+-----+-----+-----+-----+
$84 $84
$84 $84
5
$2,084
B) 0 1
2
3
9
10
+-----+-----+-----+--- . . . -----+-----+
$17.50 $17.50 $17.50
$17.50 $2,017.50
C) 0 1
2
3
9
+-----+-----+-----+--- . . . -----+-----+
$48 $48 $48
$48
10
$48
D) 0 1
2
3
9
10
+-----+-----+-----+--- . . . -----+-----+
$42 $42
$42
$42 $2,042
E) 0 1
2
3
9
+-----+-----+-----+--- . . . -----+-----+
$42 $42 $42
$42
Answer: D
10
$42
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.1 Understand bond terminology
13) 0 1
2
3
59
60
+-----+-----+-----+--- . . . -----+-----+
$62.50 $62.50 $62.50
$62.50 $62.50 +$5,000
A corporation issues a bond that generates the above cash flows. If the periods shown are 3 months,
which of the following best describes that bond?
A) a 15-year bond with a notional value of $5000 and a coupon rate of 5% paid quarterly
B) a 15-year bond with a notional value of $5000 and a coupon rate of 1.25% paid annually
C) a 30-year bond with a notional value of $5000 and a coupon rate of 3.75% paid semi-annually
D) a 60-year bond with a notional value of $5000 and a coupon rate of 5% paid quarterly
E) a 30-year bond with a notional value of $5000 and a coupon rate of 2.5% paid semi-annually
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.1 Understand bond terminology
14) A university issues a bond with a face value of $10,000 and a coupon rate of 5.65% that matures on
07/15/2020. The holder of such a bond receives coupon payments of $282.50. How frequently are coupon
payments made in this case?
A) monthly
B) quarterly
C) semi-annually
D) annually
E) biannually
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.1 Understand bond terminology
15) A bond indenture indicates
A) the amounts and dates of all payments to be made.
B) the individual to whom payments will be made.
C) the yield to maturity of the bond.
D) the price of the bond.
E) the bond premium.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.1 Understand bond terminology
16) How are the cash flows of a coupon bond different from an amortizing loan?
Answer: A coupon bond pays interest over the life of the bond and returns the principal at the end of
the term. Thus the cash flows are smaller over the life of the bond with a lump-sum payment at the end.
In contrast, an amortizing loan has identical cash flows over its life with a part of the cash flow going
toward interest and the balance as return of principal.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.1 Understand bond terminology
6.2 Zero-Coupon Bonds
1) The only cash payment an investor in a zero-coupon bond receives is the face value of the bond on its
maturity date.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
2) Treasury bills have original maturities from one to ten years, while Treasury notes have original
maturities of more than ten years.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
3) Prior to its maturity date, the price of a zero-coupon bond is its face value.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
4) How are investors in zero-coupon bonds compensated for making such an investment?
A) Such bonds are purchased at their face value and sold at a premium at a later date.
B) The bond makes regular interest payments.
C) Such bonds are purchased at a discount to their face value.
D) The face value of these bonds is less than the value of the bond when the bond matures.
E) Bond prices always increase over time.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
5) What is the yield to maturity of a one-year, risk-free, zero-coupon bond with a $10,000 face value and
a price of $9600 when released?
A) 3.212%
B) 4.000%
C) 4.167%
D) 9.600%
E) 5.140%
Answer: C
Explanation: C) Calculate the discount rate that equates $10,000 to $9600 in one year.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
6)
Maturity (years)
Price
1
2
3
4
5
$97.25 $94.53 $91.83 $89.23 $87.53
The above table shows the price per $100 face value of several risk-free, zero-coupon bonds. What is the
yield to maturity of the three-year, zero-coupon, risk-free bond shown?
A) 2.83%
B) 2.85%
C) 2.86%
D) 2.88%
E) 2.70%
Answer: D
Explanation: D) Calculate the discount rate that equates $100 to $91.83 in three years.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
7) Suppose that a zero-coupon bond has a face value of $10,000 and 5 years to maturity. If the YTM is
7.2%, at what price will this bond be traded?
A) $7,063.60
B) $6,965.59
C) $9,328.58
D) $7,129.86
E) $10,000
Answer: A
Explanation: A) P = $10,000/ (1.072) 5 = $7,063.60
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
8)
Price
$250,000
Face Value
$1,500,000
Maturity (years)
50
What is the yield to maturity of the zero-coupon bond in the above table?
A) 8.33%
B) 6%
C) 16.67%
D) 1.036%
E) 3.65%
Answer: E
Explanation: E) YTM = (1,500,000/250,000) 1/50 - 1 =3.65%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
9) A zero-coupon bond with a $1000 face value has 7 years left until maturity. If its current price is $786,
then the yield to maturity on this bond is approximately:
A) 3.5%
B) 1.27%
C) 1.03%
D) 0.035%
E) 7%
Answer: A
Explanation: A) YTM = (1,000/786)1/7 - 1 = 3.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
10) The yield to maturity of a 5-year, risk-free, zero-coupon bond is 4.25%. Its face value is $2,500, what
is the cost of purchasing 5 of these zero-coupon bonds?
A) $12,500
B) $2,030.30
C) $2,035.17
D) $10,151.49
E) $10,175.87
Answer: D
Explanation: D) P = $2,500/(1.0425 5) = $2,030.30 [one bond]
P [5 bonds] = $2,030.30 × 5 = $10,151.49
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
11)
Yield to Maturity
Years to Maturity
Price
Bond A
10%
5 years
$1,000
Bond B
10%
10 years
?
Bond A and Bond B are both zero-coupon, risk-free bonds. They both have the same yield to maturity
and face value. However, they have different maturity dates. Using the information in the above table,
what is the Price of Bond B?
A) $1,000
B) $620.92
C) $1,610.51
D) $500
E) $385.54
Answer: B
Explanation: B) FV = $1,000(1.15) = $1,610.51 (Using Bond A's info)
Find Price of B = $1,610.51 /(1.110)
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
12) Why is the yield to maturity of a zero-coupon, risk-free bond that matures at the end of a given
period the risk-free interest rate for that period?
A) Since such a bond provides a risk-free return over that period, the Law of One Price guarantees the
risk-free interest rate be equal to this yield.
B) Since a bond's price will converge on its face value as the bond approaches the maturity date, the
Law of One Price dictates that the risk-free interest rate will reflect this convergence.
C) Since interest rates will rise and fall in response to the movement in bond prices.
D) Since there is, by definition, no risk in investing in such bonds, the return from such bonds is the best
that can be expected from any investment over the period.
E) Since it the easiest bond to value and this gives investors an easy benchmark against which they can
evaluate other investments.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
Use the figure for the question(s) below.
13) The current zero-coupon yield curve for risk-free bonds is shown above. What is the price per $100
face value of a four-year, zero-coupon, risk-free bond?
A) $85.64
B) $87.99
C) $92.15
D) $96.67
E) $90.85
Answer: B
Explanation: B) Using FV = $100, time to maturity = 4 years, and discount rate = 3.25%, calculate PV =
$87.99.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
on Policiesrrent zero-coupon yield curve for risk-free bonds is shown above. What is the risk-free
14) The current zero-coupon yield curve for risk-free bonds is shown above. What is the risk-free
interest rate on a 3-year maturity?
A) 3.00%
B) 3.15%
C) 3.25%
D) 6.34%
E) 3.50%
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
15) A risk-free, zero-coupon bond with a face value of $1,000 has 15 years to maturity. If the YTM is
5.8%, which of the following would be closest to the price this bond will trade at?
A) $721
B) $686
C) $525
D) $429
E) $397
Answer: D
Explanation: D) Using FV = $1,000, time to maturity = 15 years, and discount rate = 5.8% ,calculate PV =
$429.25.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
16) A risk-free, zero-coupon bond has 15 years to maturity. Which of the following is closest to the price
per $100 of face value that the bond will trade at if the YTM is 7%?
A) $29.55
B) $32.68
C) $36.24
D) $38.78
E) $39.41
Answer: C
Explanation: C) Using FV = $100, time to maturity = 15 years, and discount rate = 7%, calculate PV =
$36.24.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
17) A risk-free, zero-coupon bond with a $5000 face value has ten years to maturity. The bond currently
trades at $3650. What is the yield to maturity of this bond?
A) 3.197%
B) 3.284%
C) 3.465%
D) 3.699%
E) 3.747%
Answer: A
Explanation: A) Using FV = $5000, time to maturity = 10 years, and PV = $3,650, calculate discount rate
= 3.197%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
18) Which of the following risk-free, zero-coupon bonds could be bought for the lowest price?
A) one with a face value of $1000, a YTM of 4.8%, and 5 years to maturity
B) one with a face value of $1000, a YTM of 3.2%, and 8 years to maturity
C) one with a face value of $1000, a YTM of 6.8%, and 10 years to maturity
D) one with a face value of $1000, a YTM of 5.9%, and 20 years to maturity
E) one with a face value of $1000, a YTM of 6.2%, and 15 years to maturity
Answer: D
Explanation: D) FV 1000, rate = 5.9, N = 20, computer PV = 317.75
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
19) Which of the following statements is true?
A) A coupon bond is a pure discount bond.
B) Prior to its maturity date, the price of a zero-coupon bond is always greater than its face value.
C) The simplest type of bond is a coupon bond.
D) Treasury bills are Government of Canada bonds with a maturity of up to 10 years.
E) The amount of each coupon payment is determined by the coupon rate of the bond.
Answer: E
Diff: 2 Type: MC
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
20) Consider a zero-coupon bond with $1,000 face value and 20 years to maturity. The price at which
this bond will trade if the YTM is 6% is closest to:
A) $215
B) $312
C) $335
D) $306
E) $402
Answer: B
Explanation: B) FV = 1000
I=6
PMT = 0
N =20
Compute PV =
=
= 311.80
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
21) Consider a zero-coupon bond with a $1000 face value and ten years left until maturity. If the YTM of
this bond is 10.4%, then the price of this bond is closest to:
A) $1000
B) $602
C) $1040
D) $372
E) $906
Answer: D
Explanation: D) FV = 1000
I = 10.4
PMT = 0
N =10
Compute PV =
=
= 371.80
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
22) Consider a zero-coupon bond with a $1000 face value and ten years left until maturity. If the bond
22) Consider a zero-coupon bond with a $1000 face value and ten years left until maturity. If the bond is
currently trading for $459, then the yield to maturity on this bond is closest to:
A) 7.5%
B) 10.4%
C) 9.7%
D) 8.1%
E) 7.2%
Answer: D
Explanation: D) FV = 1000
PV = -459
PMT = 0
N = 10
Compute I = 8.098 or 8.1%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
23) Under what situation can a zero-coupon bond be selling at a premium?
Answer: Unlike a coupon bond, a zero-coupon bond does not have a periodic cash flow with one lumpsum payment of the face value at its maturity. Consequently, a zero-coupon bond will be always selling
at a price less than its face value. If it did, then the time value of money concepts would be be violated,
which never happens.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
24) Under what situation can a zero-coupon bond be selling at par to its face value?
Answer: Unlike a coupon bond, a zero-coupon bond does not have a periodic cash flow with one lumpsum payment of the face value at its maturity. Consequently, a zero-coupon bond will be always selling
at a price less than its face value and can never sell at par with its face value. If it did, then the time
value of money concepts would be violated, which never happens.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
25) How are the cash flows of a zero-coupon bond different from those of a coupon bond?
Answer: A zero-coupon bond has only two cash flows over its life. The first one is associated with the
issues borrowing the money and the second when the issuer returns the principal. A coupon bond, on
the other hand, has several cash flows over its life. The first cash flow of both these types of bonds, zerocoupon and coupon are similar as they denote the issuer borrowing the money. However, for a coupon
bond the subsequent cash flows over its life correspond to the interest payment promised by the issuer
with a final payment equal to the return of principal.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.2 Compute the price and yield to maturity of a zero-coupon bond
6.3 Coupon Bonds
1) Bond traders generally quote bond yields rather than bond prices, since yield to maturity depends on
the face value of the bond.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
2) What is the yield to maturity of a five-year, $5000 bond with a 4.5% coupon rate and semi-annual
coupons if this bond is currently trading for a price of $4876?
A) 4.30%
B) 5.07%
C) 6.30%
D) 8.60%
E) 4.50%
Answer: B
Explanation: B) Using FV = $5000, periods to maturity = 10, PMT = 112.5, and PV = $4876, calculate
discount rate = 2.5339% per period; 2.5339 × 2 = 5.068%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
3) What is the yield to maturity of a ten-year, $1000 bond with a 5.2% coupon rate and semi-annual
coupons if this bond is currently trading for a price of $884?
A) 5.02%
B) 6.23%
C) 6.82%
D) 12.46%
E) 5.20%
Answer: C
Explanation: C) Using FV = $1000, periods to maturity = 20, PMT = 26, and PV = $884, calculate discount
rate = 3.4095% per period; 3.4095 × 2 = 6.82%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
4) A bond has three years to maturity, a $2000 face value, and a 6.3% coupon rate with annual coupons.
What is its yield to maturity if it is currently trading at $1801?
A) 6.30%
B) 8.48%
C) 9.22%
D) 10.32%
E) 9.88%
Answer: D
Explanation: D) Using FV = $2000, periods to maturity = 3, PMT = 126, and PV = $1801, calculate
discount rate = 10.3238% per period.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
5) What must be the price of a $10,000 bond with a 6.5% coupon rate, semi-annual coupons, and two
years to maturity if it has a yield to maturity of 8% APR?
A) $9727.76
B) $9819.74
C) $10,619.63
D) $10,754.44
E) $8816.59
Answer: A
Explanation: A) Using FV = $10,000, periods to maturity = 4, PMT = 325, and periodic discount rate = 4%
per period, calculate PV = $9,727.75.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
6) What must be the price of a $1000 bond with a 5.8% coupon rate, annual coupons, and 30 years to
maturity if YTM is 7.5% APR?
A) $114.22
B) $685.00
C) $799.22
D) $1005.26
E) $184.26
Answer: C
Explanation: C) Using FV = $1000, periods to maturity = 30, PMT = 58, and discount rate = 7.5% per
period, calculate PV.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
7) A $10,000 bond with a coupon rate of 5% paid semi-annually has five years to maturity and a yield to
maturity of 3%. What is the price of this bond?
A) $9,771.01
B) $2,132.55
C) $7,440.94
D) $9,573.49
E) $10,915.94
Answer: D
Explanation: D) P = 250/0.03 (1- 1/(1.03)10) + 10,000/(1.03)10 = $2,132.55 + $7,440.94 = $9,573.49
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
8) A coupon bond with a face value of $25,000 and quarterly coupon payments has five years to
maturity and a yield to maturity of 5%. If the current price is $10,980, what is the coupon rate?
A) 2%
B) 4.39%
C) 0.5%
D) 0%
E) 5%
Answer: A
Explanation: A) $10,980 = CPN/0.05 [1- 1/(1.05)20] + 25,000/(1.05)20
CPN = [10,980 - 25,000/(1.05)20] /{[1- 1/(1.05)20]/0.05} = 125
c = (125 × 4) / 25,000 = 2%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
9) A bond,which is currently trading at $3440, has four years to maturity, a $4000 face value, and a 3.5%
coupon rate with annual coupons. Which of the following is its approximate yield to maturity?
A) 3.84%
B) 3.5%
C) 7.7%
D) 5%
E) 3.01%
Answer: C
Explanation: C) Using FV = $4000, N = 4, PMT = (0.035 × 4,000) =140, and PV = $3440, Calculate YTM =
7.7%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
10) A bond with semi-annual coupon payments of $1,200 has three years to maturity and a yield to
maturity of 10%. If the price of this bond is $20,467.11, what is its face value?
A) $27,000
B) $15,240.80
C) $12,000
D) $15,377.24
E) $20,467.11
Answer: A
Explanation: A) FV = {$20,467.11 - (1200/0.1)[1 - 1/(1.1)6]} × (1.1)6 = $27,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
11)
Price
YTM
Maturity
Coupon Rate
$16,158.26
5%
10 years
6%
The above table provides information on a coupon bond that has annual coupon payments. What is the
face value of this bond?
A) $17,000
B) $20,000
C) $17,442
D) $16,158.26
E) $15,000
Answer: E
Explanation: D)
E) CPN = 0.06 × FV/1
P = 0.06FV/0.05 [1 - 1/(1.05)10] + FV/(1.05)10
$16,158.26 = FV (0.06/0.05 [1 - 1/(1.05)10] + 1/(1.05)10)
FV = $16,158.26/ 1.077217349 = $15,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
12) A $1000 bond with a coupon rate of 5.4% paid semi-annually has five years to maturity and a yield
to maturity of 7.5%. If interest rates rise and the yield to maturity increases to 7.8%, what will happen to
the price of the bond?
A) fall by $9.82
B) fall by $11.58
C) rise by $12.16
D) rise by $10.06
E) The price of the bond will not change.
Answer: B
Explanation: B) Using FV = $1000, periods to maturity = 10 ,PMT = 27, and discount rate = 3.75%,
calculate PV = $913.7657;
Using FV = $1000, periods to maturity = 10, PMT = 27, and discount rate = 3.9%, calculate PV =
$902.1829;
difference = $913.7657 - $902.1829 = $11.5828.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
13) A $5000 bond with a coupon rate of 6.4% paid semi-annually has four years to maturity and a yield
to maturity of 6.2%. If interest rates fall and the yield to maturity decreases by 0.8%, what will happen
to the price of the bond?
A) fall by $98.64
B) fall by $40.49
C) rise by $84.46
D) rise by $142.78
E) The price of the bond will not change.
Answer: D
Explanation: D) Using FV = $5000, periods to maturity = 8, PMT = 160, and discount rate = 3.1%,
calculate PV = $5,034.9509;
Using FV = $5000, periods to maturity = 8, PMT = 160, and discount rate = 2.7%, calculate PV =
$5,177.7345;
difference = $5,177.7345 - $5,034.9505 = $142.7837.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
14) A $10,000 bond with a coupon rate of 3.1% paid semi-annually has 10 years to maturity and a yield
to maturity of 4.8%. If interest rates rise and the yield to maturity increases to 5.8%, what will happen to
the price of the bond?
A) rise by $357.89
B) rise by $126.75
C) rise by $84.78
D) fall by $444.34
E) fall by $689.47
Answer: E
Explanation: E) Using FV = $10,000, periods to maturity = 20, PMT = 155, and discount rate = 2.4%,
calculate PV = $8,662.3179;
Using FV = $10,000, periods to maturity = 20, PMT = 155, and discount rate = 2.9%, calculate PV =
$7,972.8452;
difference = $8,662.3179 - $7,972.8452 = $689.47
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
15) A $3000 bond with a coupon rate of 7.2% paid semi-annually has six years to maturity and a yield to
maturity of 4.6%. If interest rates fall and the yield to maturity decreases by 0.4%, what will happen to
the price of the bond?
A) rise by $24.13
B) rise by $54.77
C) fall by $68.04
D) fall by $67.71
E) fall by $48.65
Answer: C
Explanation: C) Using FV = $3000, periods to maturity = 12, PMT = 108, and discount rate = 2.3%,
calculate PV = $3404.9407;
Using FV = $3000, periods to maturity = 12, PMT = 108, and discount rate = 2.1%, calculate PV =
$3472.9808;
difference = $3404.9407 - $3472.9808 = -$68.04.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
16) What is the coupon rate of a two-year, $10,000 bond with semi-annual coupons and a price of
$9543.45, if it has a yield to maturity of 6.8%?
A) 4.32%
B) 5.60%
C) 6.25%
D) 8.44%
E) 6.80%
Answer: A
Explanation: A) Using FV = $10,000, periods to maturity = 4, and discount rate = 3.4%, calculate PMT =
$215.9987; annual coupon payment = $215.9987 × 2 = $431.997; $431,997/$10,000 = coupon rate = 4.32%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
Use the information to answer the question(s) below.
17) Shown above is information from FINRA regarding one of Caterpillar Financial Services' bonds.
How much would the holder of such a bond earn each coupon payment for each $100 in face value if
coupons are paid annually?
A) $1.38
B) $3.95
C) $4.00
D) $4.36
E) $5.17
Answer: C
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
4) Why is insider trading problematic?s) below.
Use the information for the question(s) below.
18) Shown above is information from FINRA regarding one of Bank of America's bonds. How much
would the holder of such a bond earn each coupon payment for each $100 in face value if coupons are
paid semi-annually?
A) $1.49
B) $2.15
C) $2.32
D) $4.30
E) $2.18
Answer: B
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
Use the information for the question(s) below.
The Sisyphean Company has a bond outstanding with a face value of $1000 that reaches maturity in 15
years. The bond certificate indicates that the stated coupon rate for this bond is 8% and that the coupon
payments are to be made semi-annually.
19) How much will each semi-annual coupon payment be?
A) $60
B) $40
C) $120
D) $80
E) $100
Answer: B
Explanation: B) Coupon = (coupon rate × face value) / number of coupons per year
= (.08 × 1000) / 2 = $40
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
20) Assuming the appropriate YTM on the Sisyphean bond is 7.5%, then the price that this bond trades
20) Assuming the appropriate YTM on the Sisyphean bond is 7.5%, then the price that this bond trades
for will be closest to:
A) $1045
B) $691
C) $1000
D) $957
E) $960
Answer: A
Explanation: A) FV = 1000
I = 3.75 (7.5/2)
PMT = 40 (80/2)
N = 30 (15 × 2)
Compute PV = 1044.57
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
21) Assuming the appropriate YTM on the Sisyphean bond is 9.0%, then the price that this bond trades
for will be closest to:
A) $946
B) $919
C) $1086
D) $1000
E) $917
Answer: B
Explanation: B) FV = 1000
I = 4.5 (9/2)
PMT = 40 (80/2)
N = 30 (15 × 2)
Compute PV = 918.56.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
22) Assuming that this bond trades for $1112, then the YTM for this bond is closest to:
A) 8.0%
B) 3.4%
C) 6.8%
D) 9.2%
E) 11.2%
Answer: C
Explanation: C) FV = 1000
PMT = 40 (80/2)
N = 30 (15 × 2)
PV = -1112
Compute I = 3.3987 × 2 = 6.7975 or 6.8%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
23) Assuming that this bond trades for $903, then the YTM for this bond is closest to:
A) 8.0%
B) 6.8%
C) 9.9%
D) 9.2%
E) 10.7%
Answer: D
Explanation: D) FV = 1000
PMT = 40 (80/2)
N = 30 (15 × 2)
PV = -903
Compute I = 4.6027 × 2 = 9.2054 or 9.2%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
Use the table for the question(s) below.
The following table summarizes prices of various default-free zero-coupon bonds (expressed as a
percentage of face value):
Maturity (years)
Price (per $100 face value)
1
94.52
2
89.68
3
85.40
4
81.65
24) The yield to maturity for the two-year zero-coupon bond is closest to:
A) 6.0%
B) 5.8%
C) 5.6%
D) 5.5%
E) 5.0%
Answer: C
Explanation: C) yield = (100 / price) (1/n) - 1
= (100 / 89.68).5 - 1 = 0.056 or 5.6%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
25) The yield to maturity for the three-year zero-coupon bond is closest to:
A) 5.4%
B) 5.8%
C) 5.6%
D) 6.0%
E) 5.0%
Answer: A
Explanation: A) yield = (100 / price) (1/n) - 1
= (100 / 85.40)(1/3) - 1 = 0.054 or 5.4%
Diff: 2 Type: MC
Skill: Analytical
5
78.35
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
26) The yield to maturity for the five-year zero-coupon bond is closest to:
A) 5.4%
B) 5.8%
C) 5.6%
D) 6.0%
E) 5.0%
Answer: E
Explanation: E) yield = (100 / price) (1/n) - 1
= (100 / 78.35)(1/5) - 1 = 0.050 or 5.0%
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
27) Based upon the information provided in the table above, you can conclude
A) that the yield curve is flat.
B) nothing about the shape of the yield curve.
C) that the yield curve is downward sloping.
D) that the yield curve is upward sloping.
E) that the yield curve is unpredictable.
Answer: C
Diff: 3 Type: MC
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
Use the information for the question(s) below.
The Sisyphean Company has a bond outstanding with a face value of $1000 that reaches maturity in 15
years. The bond certificate indicates that the stated coupon rate for this bond is 8% and that the coupon
payments are to be made semi-annually.
28) How much are each of the semi-annual coupon payments? Assuming the appropriate YTM on the
Sisyphean bond is 8.8%, then at what price should this bond trade for?
Answer: Coupon = (coupon rate × face value) / number of coupons per year
= (.08 × 1000) / 2 = $40
FV = 1000
I = 4.4 (8.8/2)
PMT = 40 (80/2)
N = 30 (15 × 2)
Compute PV = 934.07.
Diff: 2 Type: ES
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
29) Assuming that this bond trades for $1035.44, then what is the YTM for this bond?
Answer: FV = 1000
PMT = 40 (80 / 2)
N = 30 (15 × 2)
PV = -1035.44
Compute I = 3.8 × 2 = 7.6 or 7.6%.
Diff: 3 Type: ES
Skill: Analytical
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
30) What care, if any, should be taken regarding the sign of the cash flows while drawing the timeline
and associated cash flows of a coupon bond?
Answer: A typical coupon bond will have the first cash flow in the opposite direction as compared to
all the rest of the cash flows over its life. The first cash corresponds to the issuer borrowing the money,
while all the rest of the cash flows are payments by the issuer to the bondholder either in the form of
interest or principal.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
31) What care, if any, should be taken regarding the timing of the cash flows while drawing the timeline
and associated cash flows of a coupon bond?
Answer: There are two issues that one has to be careful of in marking the timing of cash flows
associated with a coupon bond. First is to be cognizant of the periodicity of the coupon payment, as
most coupons are not paid annually. The second issue is to make sure that the return of principal at the
end of the life also has a last coupon payment associated with it.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
32) Why do bond traders typically quote bond yields rather than bond prices?
Answer: The advantage of quoting the yield to maturity rather than the price is that the yield is
independent of the face value of the bond.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.3 Compute the price and yield to maturity of a coupon bond
6.4 Why Bond Prices Change
1) Before it matures, the price of any bond is always less than its face value.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
2) A bond will trade at a discount if its coupon rate is less than its yield to maturity.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
3) Which of the following bonds is trading at par?
A) a bond with a $2000 face value trading at $1987
B) a bond with a $1000 face value trading at $999
C) a bond with a $1000 face value trading at $1000
D) a bond with a $2000 face value trading at $2012
E) a bond with a $1000 face value trading at $1200
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
4) A company releases a five-year bond with a face value of $1000 and coupons paid semi-annually. If
market interest rates imply a YTM of 6%, what should be the coupon rate offered if the bond is to trade
at par?
A) 3%
B) 4%
C) 6%
D) 8%
E) 9%
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
5) A company releases a five-year bond with a face value of $1000 and coupons paid semi-annually. If
market interest rates imply a YTM of 6%, which of the following coupon rates will cause the bond to be
issued at a premium?
A) 3%
B) 4%
C) 6%
D) 8%
E) 5%
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
6) Which of the following bonds is trading at a premium?
A) a five-year bond with a $2000 face value whose yield to maturity is 7.0% and coupon rate is 7.2%
APR paid semi-annually
B) a ten-year bond with a $4000 face value whose yield to maturity is 6.0% and coupon rate is 5.9% APR
paid semi-annually
C) a 15-year bond with a $10,000 face value whose yield to maturity is 8.0% and coupon rate is 7.8%
APR paid semi-annually
D) a two-year bond with a $50,000 face value whose yield to maturity is 5.2% and coupon rate is 5.2%
APR paid monthly
E) a 20-year bond with a $5000 face value whose yield to maturity is 10.0% and coupon rate is 6.5%
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
7) Which of the following statements is true?
A) A fall in bond prices causes interest rates to fall.
B) A fall in interest rates causes a fall in bond prices.
C) A rise in interest rates causes bond prices to fall.
D) Bond prices change independently of interest rates.
E) Interest rates change independently of bond prices.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
8) A bond is currently trading below par. Which of the following must be true about that bond?
A) The bond's yield to maturity is less than its coupon rate.
B) The bond's yield to maturity is equal to its coupon rate.
C) The bond's yield to maturity is greater than its coupon rate.
D) The bond is close to maturity.
E) The bond has just been issued.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
9) If the yield to maturity of all of the following bonds is 6%, which trades at the greatest discount per
$100 face value?
A) a bond with a $10,000 face value, four years to maturity and 6.2% semi-annual coupon payments
B) a bond with a $500 face value, ten years to maturity and 5.2% annual coupon payments
C) a bond with a $5000 face value, seven years to maturity and 5.5% annual coupon payments
D) a bond with a $1000 face value, five years to maturity and 6.3% annual coupon payments
E) a bond with a $100 face value, 3 years to maturity and 6.0% annual coupon payments
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
10) A bond has a $1000 face value, ten years to maturity, and 7% semi-annual coupon payments. What
would be the expected difference in this bond's price immediately before and immediately after the next
coupon payment?
A) $18
B) $35
C) $70
D) $84
E) $100
Answer: B
Explanation: B) Since bond pays semi-annual coupon of $35
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
11)
Bond A
Bond B
Bond C
Bond D
Bond E
Face Value
$1,000
$2,000
$3,000
$2,000
$1,000
Maturity
5
4
3
5
4
Coupon Rate
4%
4%
6%
7%
7%
Type of Payment
annual
annual
semi-annual
semi-annual
semi-annual
Using the information in the above table, which bond trades at the greatest premium to par value if the
interest rate is 3.5%?
A) Bond A
B) Bond B
C) Bond C
D) Bond D
E) Bond E
Answer: A
Explanation: A)
Bond
Price
A
$1,022.57
B
$2036.73
C
$2,920.07
D
$2,000
E
$1,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.4 Analyze why bond prices change over time
12) A ten-year, zero-coupon bond with a yield to maturity of 6% has a face value of $1000. An investor
purchases the bond when it is initially traded, and then sells it four years later. What is the internal rate
of return (IRR) of this investment, assuming the yield to maturity does not change?
A) 0.26%
B) 3.07%
C) 6.00%
D) 7.65%
E) 8.14%
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
13) Suppose Alex purchases a 10-year, zero-coupon bond with a yield to maturity of 7.5% and face
value
of $10,000. If he sold it 3 years later, what would be the rate of return of his investment, given that the
yield to maturity is now 6%?
A) 7.72%
B) 6%
C) 1.5%
D) 11.08%
E) 13.5%
Answer: D
Explanation: D) Purchase price = 10,000/(1.075) 10 = $4,851.94
Sale Price = 10,000/(1.06)7 = $6,650.57
Rate of return = ($6,650.57/$4,851.94)1/3 - 1 = 11.08%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.4 Analyze why bond prices change over time
14) Allan purchases a 10-year $100 coupon bond with 10% annual coupons. If its yield to maturity
decreases from 7.5% to 6%, what is the percentage change in the price of the bond?
A) -9.49%
B) 10.48%
C) 1.5%
D) 9.49%
E) -10.48%
Answer: B
Explanation: B) Initial P = ($10/0.06)(1 - 1/(1.075)10) + 100/(1.075)10 = $117.16
P after change = ($10/0.075)(1 - 1/(1.06)10) + 100/(1.06)10 = $129.44
Price change = ($129.44 - $117.16 )/$117.16 = 10.48%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.4 Analyze why bond prices change over time
15) Which of the following bonds will be most sensitive to a change in interest rates?
A) a ten-year bond with a $2000 face value whose yield to maturity is 5.8% and coupon rate is 5.8% APR
paid semi-annually
B) a 15-year bond with a $5000 face value whose yield to maturity is 7.4% and coupon rate is 6.2% APR
paid annually
C) a 20-year bond with a $3000 face value whose yield to maturity is 6.0% and coupon rate is 5.4% APR
paid semi-annually
D) a 30-year bond with a $1000 face value whose yield to maturity is 5.5% and coupon rate is 6.4% APR
paid annually
E) a five-year bond with a $10,000 face value whose yield to maturity is 6.4% and coupon rate is 6.8%
APR paid annually
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
16) An investor purchases a 30-year, zero-coupon bond with a face value of $1000 and a yield to
maturity of 6.5%. He sells this bond ten years later. What is the internal rate of return (IRR) on his
investment, assuming yield to maturity does not change?
A) 6.04%
B) 6.24%
C) 6.50%
D) 6.62%
E) 6.74%
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
17) Which of the following bonds will be least sensitive to a change in interest rates?
A) a ten-year bond with a $2000 face value whose yield to maturity is 5.8% and coupon rate is 5.8% APR
paid semi-annually
B) a 15-year bond with a $5000 face value whose yield to maturity is 7.4% and coupon rate is 6.2% APR
paid annually
C) a 20-year bond with a $3000 face value whose yield to maturity is 6.0% and coupon rate is 5.4% APR
paid semi-annually
D) a 30-year bond with a $1000 face value whose yield to maturity is 5.5% and coupon rate is 6.4% APR
paid annually
E) a 25-year bond with $4000 face value whose yield to maturity is 6.2% and coupon rate is 5.6% APR
paid annually
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
18) Which of the following bonds will be most sensitive to a change in interest rates if all bonds have the
same initial yield to maturity?
A) a ten-year bond with a $1000 face value whose coupon rate is 5.8% APR paid semi-annually
B) a ten-year bond with a $1000 face value whose coupon rate is 7.4% APR paid semi-annually
C) a 20-year bond with a $1000 face value whose coupon rate is 5.8% APR paid semi-annually
D) a 20-year bond with a $1000 face value whose coupon rate is 7.4% APR paid semi-annually
E) a 15-year bond with a $1000 face value whose coupon rate is 6.6% APR paid semi-annually
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
19) A company issues a ten-year $1000 bond at par with a coupon rate of 6% paid semi-annually. The
YTM at the beginning of the third year of the bond (8 years left to maturity) is 7.8%. What is the new
price of the bond?
A) $894.35
B) $569.65
C) $722.06
D) $1,000.00
E) $1,064.52
Answer: A
Explanation: A) FV = 1000
PMT = 30
N = 16
I = 3.9
Solve for PV
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.4 Analyze why bond prices change over time
20) A company issues a ten-year $1000 bond at par with a coupon rate of 6% paid semi-annually. The
YTM at the beginning of the third year of the bond (8 years left to maturity) is 7.8%. What was the
percentage change in the price of the bond over the past two years?
A) 11.81%
B) -43.04%
C) -10.56%
D) 75.55%
E) 6.57%
Answer: C
Explanation: C) The new price would be $894.35.
$894.35 - $1000)/1000 - 1 = -10.56%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.4 Analyze why bond prices change over time
21) Why do bond prices fall as interest rates rise?
Answer: When interest rates increase investors apply a higher discount rate for a bond's cash flows,
reducing their present value and hence the bond's price.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
22) Why do bond prices increase as the next coupon payment gets closer?
Answer: As the next payment from a bond grows nearer, the price of the bond increases to reflect the
increasing present value of that cash flow and all other bond cash flows.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 6.4 Analyze why bond prices change over time
6.5 Corporate Bonds
1) Bonds with a high risk of default generally offer high yields.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
2) The credit spread of a bond shrinks if it is perceived that the probability of the issuer defaulting
increases.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
3) Which of the following best describes a bond rated by Standard and Poor's , Moody's, and DBRS as
B?
A) judged to be high quality by all standards
B) possessing many favorable characteristics
C) neither highly protected nor poorly secured
D) generally lacks the characteristics of a desirable investment
E) may be in default
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
4) Why are the interest rates of Government of Canada notes less than the interest rates of equivalent
corporate bonds?
A) The Canadian government has a high credit spread.
B) There is significant risk that the Canadian government will default.
C) Canadian government securities are widely regarded to be risk-free.
D) Canadian government securities are generally used to determine interest rates.
E) Canadian government securities have a larger supply and thus a lower price.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
5)
Based on Figure 6.5, which of the following is least likely to default?
A) Bell Canada Enterprises
B) Province of British Columbia
C) Government of Canada
D) All of the above
E) None of the above
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
6) A Government of Canada zero-coupon bond has a yield to maturity of 4%. Investors believe that AB
Company will default with certainty at the end of 1 year, only being able to pay 85% of its obligations.
The company's bond promises $5,000 next year. What is the price of a one-year zero-coupon bond
issued by AB Company?
A) $4,450
B) $4,250
C) $4,086.54
D) $5,000
E) $4,278.85
Answer: C
Explanation: C) P = 0.85 × (5,000)/1.04 = $4,086.54
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
7)
Security
Treasury Bill
AAA Corporate
BBB Corporate
B Corporate
Yield (%)
4.1
4.3
5.2
6
The yields to maturity on a number of one-year, zero-coupon securities are shown in the table above.
What is the price (expressed as a percentage of the face value) of a one-year, zero-coupon corporate
bond with a B rating?
A) 94.33%
B) 95.06%
C) 95.88%
D) 96.06%
E) 100%
Answer: A
Explanation: A) P as a % of FV = [100/1.06] / 100 = 94.33%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
8)
Security
Treasury Bill
AAA Corporate
A Corporate
BBB Corporate
Yield (%)
3.9
4.3
4.7
5.9
The yields to maturity on a number of one-year, zero-coupon securities are shown in the table above.
What is the credit spread on a one-year, zero-coupon corporate bond with an A rating?
A) 4.7%
B) 2%
C) 1.2%
D) 0.4%
E) 0.8%
Answer: E
Explanation: E) 4.7 - 3.9 = 0.8%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
Use the information for the question(s) below.
Security:
Yield (%):
Treasury
5.2
AAA Corporate
5.4
A Corporate
5.8
BBB
Corporate
6.2
B Corporate
6.9
9) The above table shows the yields to maturity on a number of one-year, zero-coupon securities. What
is the price per $100 of the face value of a one-year, zero-coupon corporate bond with a BBB rating?
A) $92.21
B) $93.54
C) $94.16
D) $94.87
E) $94.52
Answer: C
Explanation: C) Calculate the PV of the bond with FV = $100, YTM = 6.2%, and N = 1, which = $94.16.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
10) The above table shows the yields to maturity on a number of one-year, zero-coupon securities. What
is the credit spread on a one-year, zero-coupon corporate bond with a B rating?
A) 0.7%
B) 1.7%
C) 1.8%
D) 6.9%
E) 0.6%
Answer: B
Explanation: B) 6.9 - 5.2 = 1.7
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
11) A firm issues ten-year bonds with a coupon rate of 6.5%, paid semi-annually. The credit spread for
this firm's ten-year debt is 0.8%. New ten-year Treasury notes are being issued at par with a coupon rate
of 5%. What should the price of the firm's outstanding ten-year bonds be per $100 of face value?
A) $97.28
B) $98.27
C) $100.86
D) $105.26
E) $105.80
Answer: D
Explanation: D) Calculate the PV of the bond with FV = $100, YTM = 2.9%, PMT = 3.25, and N =
20,which = $105.26.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
12) A firm issues 20-year bonds with a coupon rate of 4.8%, paid semi-annually. The credit spread for
this firm's 20-year debt is 1.2%. New 20-year Treasury notes are being issued at par with a coupon rate
of 4.6%. What should the price of the firm's outstanding 20-year bonds be if their face value is $1000?
A) $882.53
B) $975.98
C) $977.48
D) $1000.86
E) $981.23
Answer: A
Explanation: A) Calculate the PV of the bond with FV = $1000, YTM = 2.9%, PMT = 24, and N = 40,
which = $882.53.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
13)
Security:
Yield (%):
AAA Corporate AA Corporate
5.6
5.7
A Corporate
5.9
BBB
Corporate
6.4
BB Corporate
7.0
A mining company needs to raise $100 million in order to begin open pit mining of a coal seam. The
company will fund this by issuing 30-year bonds with a face value of $1000 and a coupon rating of 6%,
paid annually. The above table shows the yield to maturity for similar 30-year corporate bonds of
different ratings. If the mining company's bonds receive a A rating, what will be their selling price?
A) $947.22
B) $967.64
C) $1013.91
D) $1016.41
E) $875.91
Answer: C
Explanation: C) Calculate the PV of the bond with FV = $1000, YTM = 5.9%, PMT = 60 ,and N = 30,
which = $1,013.91.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
14)
Security:
Yield (%):
AAA Corporate AA Corporate
6.2
6.4
A Corporate
6.7
BBB
Corporate
7.0
BB Corporate
7.5
Consolidated Insurance wants to raise $35 million in order to build a new headquarters. The company
will fund this by issuing 10-year bonds with a face value of $1,000 and a coupon rating of 6.5%, paid
semi-annually. The above table shows the yield to maturity for similar 10-year corporate bonds of
different ratings. Which of the following is closest to how many more bonds Consolidated Insurance
would have to sell to raise this money if their bonds received an A rating rather than an AA rating?
A) 686
B) 750
C) 765
D) 1156
E) 872
Answer: C
Explanation: C) Calculate the PV of the bond with FV = $1000, YTM = 3.2%, PMT = 32.5, and N = 20,
which = $1007.30; thus, the number of bonds sold if AA rating = 34,746.24;
Calculate the PV of the bond with FV = $1000, YTM = 3.35%, PMT = 32.5, and N = 20, which = $985.59;
thus, the number of bonds sold if A rating = 35,511.62;
hence, the difference = 765.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
15)
Security:
Yield (%):
AAA Corporate AA Corporate
5.7
5.7
A Corporate
6.0
BBB
Corporate
6.6
BB Corporate
6.9
Lloyd Industries raised $28 million in order to upgrade its roller kiln furnace for the production of
ceramic tile. The company funded this by issuing 15-year bonds with a face value of $1000 and a coupon
rating of 6.2%, paid annually. The above table shows the yield to maturity for similar 15-year corporate
bonds of different ratings issued at the same time. When Lloyd Industries issued their bonds, they
received a price of $962.63. Which of the following is most likely to be the rating these bonds received?
A) AA
B) A
C) BBB
D) BB
E) AAA
Answer: C
Explanation: C) Calculate the YTM of the bond with FV = $1000, PMT = 62, and N = 15, which = 6.6%;
the table shows that the bonds received a BBB rating.
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
16) A corporate bond which receives a BBB rating from Standard and Poor's is considered
A) a junk bond.
B) an investment grade bond.
C) a defaulted bond.
D) a high-yield bond.
E) a speculative bond
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
Use the table for the question(s) below.
Consider the following yields to maturity on various one-year zero-coupon securities:
17)
Security
Yield (%)
Treasury
4.6
AAA corporate
4.8
BBB corporate
5.6
B Corporate
6.2
The price (expressed as a percentage of the face value) of a one-year, zero-coupon, corporate bond with
a BBB rating is closest to:
A) 95.60
B) 94.16
C) 95.42
D) 94.70
E) 95.10
Answer: D
Explanation: D) P = 100 / (1.056) = 94.70
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
18)
Security:
Yield (%):
Treasury
5.2
AAA Corporate
5.4
A Corporate
5.8
BBB
Corporate
6.2
B Corporate
6.9
The price (expressed as a percentage of the face value) of a one-year, zero-coupon corporate bond with a
AAA rating is closest to:
A) 94.70
B) 95.60
C) 94.16
D) 95.42
E) 95.10
Answer: D
Explanation: D) P = 100 / (1.048) = 95.42
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
19)
Security:
Yield (%):
Treasury
5.2
AAA Corporate
5.4
A Corporate
5.8
BBB
Corporate
6.2
B Corporate
6.9
The credit spread of the BBB corporate bond is closest to:
A) 1.0%
B) 5.6%
C) 1.6%
D) 0.8%
E) 1.8%
Answer: A
Explanation: A) 5.6% - 4.6% (BBB Yield - risk-free yield) = 1.0%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
20)
Security:
Yield (%):
Treasury
5.2
AAA Corporate
5.4
A Corporate
5.8
BBB
Corporate
6.2
B Corporate
6.9
The credit spread of the B corporate bond is closest to:
A) 1.6%
B) 0.8%
C) 1.0%
D) 1.4%
E) 1.8%
Answer: A
Explanation: A) 6.2% - 4.6% (B Yield - risk-free yield) = 1.6%
Diff: 1 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
Use the information for the question(s) below.
Luther Industries needs to raise $25 million to fund a new office complex. The company plans on
issuing ten-year bonds with a face value of $1000 and a coupon rate of 7.0% (annual payments). The
following table summarizes the YTM for similar ten-year corporate bonds of various credit ratings:
Rating
YTM
AAA
6.70%
AA
6.80%
A
7.00%
BBB
7.40%
BB
8.00%
21) Assuming that Luther's bonds receive a AAA rating, the price of the bonds will be closest to:
A) $1021
B) $1014
C) $1000
D) $937
E) $933
Answer: A
Explanation: A) FV = 1000
PMT = 70
N = 10
I = 6.7
Compute PV = 1021.37
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
22) Assuming that Luther's bonds receive a AAA rating, the number of bonds that Luther must issue to
raise the needed $25 million is closest to:
A) 24,655
B) 25,000
C) 24,477
D) 26,681
E) 25,114
Answer: C
Explanation: C) FV = 1000
PMT = 70
N = 10
I = 6.7
Compute PV = 1021.37.
Total number of bonds = $25,000,000 / 1021.37 = 24,476.93
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
23) Assuming that Luther's bonds receive a AA rating, the price of the bonds will be closest to:
A) $1021
B) $1014
C) $1000
D) $937
E) $933
Answer: B
Explanation: B) FV = 1000
PMT = 70
N = 10
I = 6.8
Compute PV
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
24) Assuming that Luther's bonds receive a AA rating, the number of bonds that Luther must issue to
raise the needed $25 million is closest to:
A) 24,655
B) 25,000
C) 24,477
D) 26,681
E) 25,114
Answer: A
Explanation: A) FV = 1000
PMT = 70
N = 10
I = 6.8
Compute PV
Total number of bonds = $25,000,000/1014 = 24,655
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
25) What rating must Luther receive on these bonds if they want the bonds to be issued at par?
A) A
B) B
C) BBB
D) AA
E) AAA
Answer: A
Explanation: A) FV = 1000
PMT = 70
N = 10
I = 7.0 (yield for A rating)
Compute PV = 1000.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
26) Suppose that when these bonds were issued, Luther received a price of $972.42 for each bond. What
is the likely rating that Luther's bonds received?
A) AA
B) BBB
C) B
D) A
E) AAA
Answer: B
Explanation: B) FV = 1000
PMT = 70
N = 10
PV = -972.42
Compute I = 7.4 which is the BBB rating yield.
Diff: 2 Type: MC
Skill: Analytical
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
27) Why is the yield of bonds with credit risk higher than that of otherwise identical default-free bonds?
Answer: Because the yield to maturity is calculated using the promised cash flows instead of the
expected cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical
default-free bonds.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 6.5 Know how credit risk affects the expected return from holding a corporate bond
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 7 Valuing Stocks
7.1 Stock Basics
1) The ownership in a corporation is divided into shares of stock, which carry rights to share in the
profits of the firm through future dividend payments.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
2) What are dividend payments?
A) payments made to a company by investors for a share of the ownership of that company
B) incremental increases in the value of the stock held by an investor due to rises in share price
C) the difference between the original cost price of a share and the price an investor receives when that
share is sold
D) a part share of the profits or earnings of a company paid to each shareholder on the basis of the
number of shares they hold
E) periodic payments to the bondholders
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
Use the figure for the question(s) below.
3) The above screen shot from Google Finance shows basic stock information for PepsiCo. If you owned
2000 shares of PepsiCo for the period shown, how much would you have earned in dividend payments?
A) $108.33
B) $120.00
C) $760.00
D) $860.00
E) $1020.00
Answer: C
Explanation: C) 2000 × .38 = $760 There is a 38-cent dividend payment just before March 2008, which is
the only dividend payment received during the period shown above.
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
@꛰@ꜜ @Ꜹ@Ꝏ@ꝰ @Ꞗ @꛰@꛰@꛰@ꭖ @꛰@꛰@꛰@꛰@꛰@꛰@곞@고@긔@깄@꺔
Use the figure for the question(s) below.
4) The above screen shot from Google Finance shows the basic stock information for Logitech
International SA (USA). What is Logitech International SA (USA)'s ticker symbol?
A) LIS
B) LOGITECH
C) LOG
D) LOGI
E) NASDAQ
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
5) The above screen shot from Google Finance shows the basic stock information for Logitech
5) The above screen shot from Google Finance shows the basic stock information for Logitech
International SA (USA) after the close of business on May 30, 2008. What is the difference between the
opening and closing price of the stock on this date?
A) $0.49
B) $0.27
C) $0.24
D) $0.03
E) $0.18
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
Use the figure for the question(s) below.
6) The above screen shot from Google Finance shows the basic stock information for Kraft Foods Inc.
after the close of the stock market on May 30, 2008. What is the highest that the stock has traded at in
the last 12 months?
A) $32.44
B) $32.48
C) $32.99
D) $35.29
E) $32.84
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
@坲@垆@垚@垮@埄@埦@堌@壐@妬@後@徎@搪@摌@摲@收@攸@敦@杊@杬@枒@橘
Use the figure for the question(s) below.
7) The above screen shot above from Google Finance shows the price history of Progenics, a
pharmaceutical company. In the time period shown, Progenics released information that an
intravenously-administered formulation of their leading product had failed in a Phase III clinical trial.
In which of the months shown in the price history is this most likely to have occurred?
A) February 2008
B) March 2008
C) April 2008
D) May 20008
E) January 2008
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
8) What is the difference between common stock and preferred stock?
Answer: Preferred stock has preference over common stock in the distribution of dividends or
liquidation. A firm may not pay a dividend to common stockholders unless they pay the promised
dividend to preferred shareholders first.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
@㑜@㒂@㕤@㕦@㖢@㛈@㛪@ùdifference between cumulative and non-cumulative preferred stock?
9) What is the difference between cumulative and non-cumulative preferred stock?
Answer: With cumulative preferred stock, any unpaid dividends are carried forward, and a firm
cannot pay any dividends to common shareholders until it has paid all the unpaid preferred dividends.
With non-cumulative preferred stock, missed dividends do not accumulate, and the firm can pay
current dividend payments first to preferred and then to common stock shareholders.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 7.1 Describe the basics of common stock, preferred stock, and stock quotes
7.2 The Dividend-Discount Model
1) The Valuation Principle states that the value of a stock is equal to the present value (PV) of both the
dividends and future sale price of that stock which the investor will receive.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.2 Value a stock as the present value of its expected future dividends
2) The net present value (NPV) of a stock is calculated by discounting cash flows arising from this stock
using the risk-free interest rate.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.2 Value a stock as the present value of its expected future dividends
3) Danforth Corp has a current stock price of $117.15 and is expected to pay a dividend of $4.50 in one
year. If Danforth's equity cost of capital is 10%, what price would Danforth's stock be expected to sell
for immediately after it pays the dividend?
A) $124.37
B) $128.87
C) $121.65
D) $112.65
E) $113.06
Answer: A
Explanation: A) 1.10 × $117.15 = 128.87; 128.87 - 4.50 = $124.37
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
4) Northern Railways has a current stock price of $56.75 and is expected to pay a dividend of $1.15 in
one year. If Northern's equity cost of capital is 12%, what price would Northern's stock be expected to
sell for immediately after it pays the dividend?
A) $57.65
B) $63.56
C) $62.41
D) $57.78
E) $55.60
Answer: C
Explanation: C) 1.12 × $56.75 = 63.56; 63.56 - 1.15 = $62.41
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
5) Midwest Corporation is expected to pay an annual dividend of $0.45 per share in the coming year,
and to trade for $31.10 at the end of the year. If investments with the same risk as Midwest's stock have
an expected return of 8.5%, what is the most you would pay today for Midwest's stock?
A) $31.10
B) $29.08
C) $31.55
D) $28.25
E) $30.65
Answer: B
Explanation: B) P0 = (Div1 + P1)/(1 + r) = (0.45 + 31.10)/(1.085) = $29.08
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
6) Fanshaw Corporation is expected to pay an annual dividend of $0.20 per share in the coming year,
and to trade for $15.15 at the end of the year. If investments with the same risk as Fanshaw's stock have
an expected return of 10.75%, what is the most you would pay today for Fanshaw's stock?
A) $15.15
B) $15.35
C) $13.50
D) $14.95
E) $13.86
Answer: E
Explanation: E) P0 = (Div1 + P1)/(1 + r) = (0.20 + 15.15)/(1.1075) = $13.86
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
7) Maple Corporation is expected to pay an annual dividend of $0.45 per share in the coming year, and
to trade for $12.50 at the end of the year. If investments with the same risk as Maple's stock have an
expected return of 6.95%, what is Maple's dividend yield?
A) 3.7%
B) 3.6%
C) 3.5%
D) 4.0%
E) 3.4%
Answer: A
Explanation: A) P0 = (Div1 + P1)/(1 + r) = (0.45 + 12.50)/(1.0695) = $12.11
Dividend yield = 0.45/12.11 = 3.7%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
8) Jessie Inc. is expected to pay an annual dividend of $1.10 per share in the coming year, and to trade
for $53.45 at the end of the year. If investments with the same risk as Jessie's stock have an expected
return of 7.5%, what is Jessie's dividend yield?
A) 2.0%
B) 2.1%
C) 2.2%
D) 2.3%
E) 2.5%
Answer: C
Explanation: C) P0 = (Div1 + P1)/(1 + r) = (1.10 + 53.45)/(1.075) = $50.74
Dividend yield = 1.10/50.74 = 2.2%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
9) Ashbury Inc. is expected to pay an annual dividend of $1.50 per share in the coming year, and to
trade for $36.25 at the end of the year. If investments with the same risk as Ashbury's stock have an
expected return of 8.75%, what is Ashbury's capital gain rate?
A) 4.7%
B) 4.1%
C) 4.3%
D) 4.4%
E) 4.2%
Answer: D
Explanation: D) P0 = (Div1 + P1)/(1 + r) = (1.50 + 36.25)/(1.0875) = $34.71
Capital gain rate = (36.25 - 34.71)/34.71 = 4.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
10) Roswell Inc. is expected to pay an annual dividend of $0.66 per share in the coming year, and to
trade for $9.25 at the end of the year. If investments with the same risk as Roswell's stock have an
expected return of 11%, what is Roswell's capital gain rate?
A) 3.9%
B) 3.8%
C) 3.5%
D) 3.7%
E) 3.6%
Answer: E
Explanation: E) P0 = (Div1 + P1)/(1 + r) = (0.66 + 9.25)/(1.11) = $8.93
Capital gain rate = (9.25 - 8.93)/8.93 = 3.6%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
11) Which of the following situations is a potential source of cash flows for a shareholder of a certain
stock?
I. The investor may be able to sell the shares at a future date.
II. The firm in which the shares are held might pay out cash to shareholders in the form of dividends.
III. The firm in which the shares are held might increase the value of its shares by reducing the total
number of shares outstanding.
A) I only
B) II only
C) I and II
D) II and III
E) I and III
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.2 Value a stock as the present value of its expected future dividends
12) Coolibah Holdings is expected to pay dividends of $1.20 every six months for the next three years. If
the current price of Coolibah stock is $22.40, and Coolibah's equity cost of capital is 16%, what price
would you expect Coolibah's stock to sell for at the end of three years?
A) $26.74
B) $28.82
C) $29.34
D) $31.36
E) $29.60
Answer: A
Explanation: A) Using a financial calculator, PV = -22.4, PMT = 1.2, n = 6, I = 8;
calculate FV = 26.74.
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
13) Matilda Industries pays a dividend of $2.25 per share and is expected to pay this amount
indefinitely. If Matilda's equity cost of capital is 12%, which of the following would be expected to be
closest to Matilda's stock price?
A) $12.25
B) $14.65
C) $18.75
D) $21.98
E) $22.35
Answer: C
Explanation: C) PV0 = 2.25 / 0.12 = $18.75
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
14) Jumbuck Exploration has a current stock price of $2.00 and is expected to sell for $2.10 in one year's
time, immediately after it pays a dividend of $0.26. Which of the following is closest to Jumbuck
Exploration's equity cost of capital?
A) 9%
B) 12%
C) 18%
D) 22%
E) 26%
Answer: C
Explanation: C) 0.26 + 2.10 = 2.36; cost of capital = 0.36 / 2 = 18%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
15) Garville Corporation has a current stock price of $7.43 and is expected to sell for $8.14 in one year's
time, immediately after it pays a dividend of $0.35. Which of the following is closest to Garville's equity
cost of capital?
A) 4.8%
B) 6.1%
C) 6.7%
D) 9.6%
E) 14.3%
Answer: E
Explanation: E) 0.35 + 8.14 = 8.49; cost of capital = 8.49/7.43 - 1 = 14.3%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
16) A stock is bought for $22.00 and sold for $26.00 one year later, immediately after it has paid a
dividend of $1.50. What is the capital gain rate for this transaction?
A) 0.27%
B) 4.00%
C) 15.00%
D) 18.18%
E) 20.00%
Answer: D
Explanation: D) (26 - 22) / 22 = 18.18%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
17) Credenza Industries is expected to pay a dividend of $1.20 at the end of the coming year. It is
expected to sell for $62.00 at the end of the year. If its equity cost of capital is 8%, what is the expected
capital gain from the sale of this stock at the end of the coming year?
A) $3.48
B) $4.86
C) $14.28
D) $58.52
E) $62.00
Answer: A
Explanation: A) (1.2 + 62) / 1.08 = 58.5185; 62 - 58.5185 = $3.48
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
18) The Busby Corporation had a share price at the start of the year of $26.20, paid a dividend of $0.56 at
the end of the year, and had a share price of $29.00 at the end of the year. Which of the following is
closest to the rate of return of investments in companies with equal risk to The Busby Corporation for
this period?
A) 5%
B) 7%
C) 9%
D) 13%
E) 15%
Answer: D
Explanation: D) 29.56 - 26.20 = 3.36; 3.36 / 26.2 = 12.82%; rounded up to 13%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
19) Valorous Corporation will pay a dividend of $1.80 per share at this year's end and a dividend of
$2.40 per share at the end of next year. It is expected that the price of Valorous' stock will be $44 per
share after two years. If Valorous has an equity cost of capital of 8%, what is the maximum price that a
prudent investor would be willing to pay for a share of Valorous stock today?
A) $39.27
B) $40.22
C) $41.45
D) $42.40
E) $43.50
Answer: C
Explanation: C) Using a financial calculator, CF0 = 0, CF1 = 1.8, CF2 = (44 + 2.4) = 46.4;
calculate NPV at I = 8%, equals $41.45.
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
20) A stock is expected to pay $0.80 per share every year indefinitely. If the current price of the stock is
$18.90, and the equity cost of capital for the company that released the shares is 6.4%, what price would
an investor be expected to pay per share five years into the future?
A) $12.50
B) $20.43
C) $21.23
D) $22.65
E) $22.90
Answer: A
Explanation: A) P0 = 0.8 / 0.064 = $12.50
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
21) A stock is expected to pay $1.25 per share every year indefinitely and the equity cost of capital for
the company is 7.5%. What price would an investor be expected to pay per share ten years in the future?
A) $16.67
B) $25.01
C) $33.34
D) $41.68
E) $12.50
Answer: A
Explanation: A) P0 = 1.25 / 0.075 = $16.67
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
22) Rylan Industries is expected to pay a dividend of $5.20 per year for the next four years. If the current
price of Rylan stock is $32.63, and Rylan's equity cost of capital is 14%, what price would you expect
Rylan's stock to sell for at the end of the four years?
A) $29.52
B) $55.11
C) $25.58
D) $80.70
E) $11.83
Answer: A
Explanation: A) Using a financial calculator, PV = -32.63, PMT = 5.2, n = 4, I = 14;
Calculate FV = 29.52
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
23) Bondi Company is expected to pay a quarterly dividend of $0.45 for the next five years. If the
current price of Bondi stock is $17.62, and Bondi's equity cost of capital is 12% per year, what price
would you expect Bondi's stock to sell for at the end of the five years?
A) $26.62
B) $17.62
C) $17.92
D) $19.11
E) $28.19
Answer: D
Explanation: D) I = (1.12)1/4 - 1 = 2.8737%
Using a financial calculator, PV = -17.62, PMT = 0.45, n = 20, I = 2.8737;
Calculate FV = 19.11
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
24) Wellington Corporation is expected to pay a monthly dividend of $0.12 for the next three years. If
the current price of Wellington stock is $41.35, and Wellington's equity cost of capital is 15% per year,
what price would you expect Wellington's stock to sell for at the end of the three years?
A) $41.35
B) $45.67
C) $59.26
D) $62.47
E) $57.55
Answer: E
Explanation: E) I = (1.15)1/12 - 1 = 1.1715%
Using a financial calculator, PV = -41.35, PMT = 0.12, n = 36, I = 1.1715;
Calculate FV = 57.55
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
25) A stock is expected to pay $3.20 per share every year indefinitely and the equity cost of capital for
the company is 10%. What price would an investor be expected to pay per share next year?
A) $8.00
B) $16.00
C) $24.00
D) $32.00
E) $35.20
Answer: D
Explanation: D) P0 = 3.20 / 0.10 = $32.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.2 Value a stock as the present value of its expected future dividends
7.3 Estimating Dividends in the Dividend-Discount Model
1) A firm can either pay its earnings out to its investors, or it can keep them and reinvest them.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
2) Cook Pharmaceuticals plans to pay $1.55 per share in dividends in the coming year. If its equity cost
of capital is 8%, and dividends are expected to grow by 3% per year in the future, what is the value of
Cook's stock?
A) $31.00
B) $19.38
C) $51.67
D) $28.70
E) $55.80
Answer: A
Explanation: A) P0 = Div1 / (rE - g) = $1.55 / (0.08 - 0.03) = $31.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
3) Herring Fisheries plans to pay $0.65 per share in dividends in the coming year. If its equity cost of
capital is 11%, and dividends are expected to grow by 2.5% per year in the future, what is the value of
Herring's stock?
A) $24.05
B) $7.84
C) $5.91
D) $7.65
E) $26.00
Answer: D
Explanation: D) P0 = Div1 / (rE - g) = $0.65/ (0.11 - .025) = $7.65
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
4) Shield Security pays annual dividends and has just paid this year's dividend of $1.20. If its equity cost
of capital is 10%, and dividends are expected to grow by 5% per year in the future, what is the value of
Shield's stock?
A) $24.00
B) $25.20
C) $12.60
D) $12.00
E) $26.00
Answer: B
Explanation: B) Use next year's dividend: 1.20 × 1.05 = 1.26
P0 = Div1 / (rE - g) = $1.26/ (0.10 - .05) = $25.20
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
5) Bentham Books pays annual dividends and has just paid this year's dividend of $0.65. If its equity
cost of capital is 12%, and dividends are expected to grow by 3% per year in the future, what is the
value of Bentham's stock?
A) $5.42
B) $7.22
C) $7.44
D) $21.67
E) $5.58
Answer: C
Explanation: C) Use next year's dividend: 0.65 × 1.03 = 0.67
P0 = Div1 / (rE - g) = $0.67/ (0.12 - .03) = $7.44
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
6) Canberra Corp expects to have earnings per share of $8.40 in the coming year. Canberra has a return
on new investment of 14%. If the firm's dividend payout rate is 75%, and its equity cost of capital is 9%,
what is the value of Canberra's stock?
A) $114.55
B) $152.72
C) $70.00
D) $93.33
E) $129.23
Answer: A
Explanation: A) Div = EPS × Dividend Payout Rate = 8.40 × 0.75 = $6.30
g = Retention rate × return on new investment = 0.25 × 0.14 = 3.5%
P = Div/(r - g) = 6.30/(0.09 - 0.035) = $114.55
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
7) Adelaide Industries expects to have earnings per share of $3.20 in the coming year. Adelaide has a
return on new investment of 11%. If the firm's dividend payout rate is 60%, and its equity cost of capital
is 8%, what is the value of Adelaide's stock?
A) $24.00
B) $53.33
C) $40.00
D) $88.89
E) $91.43
Answer: B
Explanation: B) Div = EPS × Dividend Payout Rate = 3.20 × 0.60 = $1.92
g = Retention rate × return on new investment = 0.4 × 0.11 = 4.4%
P = Div/(r - g) = 1.92/(0.08 - 0.044) = $53.33
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
8) NoGrowth Industries presently pays an annual dividend of $1.50 per share and it is expected that
these dividend payments will continue indefinitely. If NoGrowth's equity cost of capital is 12%, then the
value of a share of NoGrowth's stock is closest to:
A) $10.00
B) $15.00
C) $14.00
D) $12.50
E) $13.00
Answer: D
Explanation: D) P0 = Div1 / (rE - g) = $1.50 / (0.12 - 0) = $12.50
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
9) Von Bora Corporation (VBC) is expected to pay a $2.00 dividend at the end of this year. If you expect
VBC's dividend to grow by 5% per year forever and VBC's equity cost of capital is 13%, then the value
of a share of VBS stock is closest to:
A) $25.00
B) $40.00
C) $15.40
D) $11.10
E) $10.00
Answer: A
Explanation: A) P0 = Div1 / (rE - g) = 2.00 / (0.13 - 0.05) = $25.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
10) Luther Industries has a dividend yield of 4.5% and and a cost of equity capital of 12%. Luther
Industries' dividends are expected to grow at a constant rate indefinitely. The growth rate of Luther's
dividends is closest to:
A) 7.5%
B) 5.5%
C) 16.5%
D) 12%
E) 4.5%
Answer: A
Explanation: A) rE = Div1 / P0 + g
0.12 = 0.045 + g, so g = 0.075
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
11) The Sisyphean Company's common stock is currently trading for $25.00 per share. The stock is
expected to pay a $2.50 dividend at the end of the year and the Sisyphean Company's equity cost of
capital is 14%. If the dividend payout rate is expected to remain constant, then the expected growth rate
in the Sisyphean Company's earnings is closest to:
A) 8%
B) 6%
C) 4%
D) 2%
E) 0%
Answer: C
Explanation: C) P0 = Div1 / (rE - g) = 25.00 = 2.50 / (0.14 - g), so g = 0.04
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
12) You expect KT industries (KTI) will have earnings per share of $3 this year and expect that they will
pay out $1.50 of these earnings to shareholders in the form of a dividend. KTI's return on new
investments is 15% and their equity cost of capital is 12%. The expected growth rate for KTI's dividends
is closest to:
A) 6.0%
B) 7.5%
C) 4.5%
D) 3.0%
E) 2.0%
Answer: B
Explanation: B) g = retention rate × return on new investment
= (3.00 - 1.50) / 3.00 × 0.15 = 0.075 or 7.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
13) You expect KT industries (KTI) will have earnings per share of $3 this year and expect that they will
pay out $1.50 of these earnings to shareholders in the form of a dividend. KTI's return on new
investments is 15% and their equity cost of capital is 12%. The value of a share of KTI's stock is closest
to:
A) $39.25
B) $20.00
C) $33.35
D) $12.50
E) $25.75
Answer: C
Explanation: C) g = retention rate × return on new investment
= (3.00 - 1.50) / 3.00 × 0.15 = 0.075 or 7.5%
P0 = Div1 / (rE - g) = 1.50 / (0.12 - 0.075) = 33.33
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
14) JRN Enterprises just announced that it plans to cut its dividend from $2.50 to $1.50 per share and use
the extra funds to expand its operations. Prior to this announcement, JRN's dividends were expected to
grow at 4% per year and JRN's stock was trading at $25.00 per share. With the new expansion, JRN's
dividends are expected to grow at 8% per year indefinitely. Assuming that JRN's risk is unchanged by
the expansion, the value of a share of JRN after the announcement is closest to:
A) $25.00
B) $15.00
C) $31.25
D) $27.50
E) $29.75
Answer: A
Explanation: A) Two steps.
Step 1: Solve for rE:
rE = Div1 / P0 + g = 2.50 / 25.00 + 0.04 = 0.14 or 14%
Step 2: Solve for new stock price:
P0 = Div1 / (rE - g) = 1.50 / (0.14 - 0.08) = 25.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
15) Xport International just announced that it plans to cut its dividend from $1.75 to $1.00 per share and
use the extra funds to expand its operations. Prior to this announcement, Xport's dividends were
expected to grow at 5% per year and Xport's stock was trading at $35.00 per share. With the new
expansion, Xport's dividends are expected to grow at 7% per year indefinitely. Assuming that Xport's
risk is unchanged by the expansion, the value of a share of Xport after the announcement is closest to:
A) $30.00
B) $33.33
C) $35.00
D) $37.50
E) $50.00
Answer: B
Explanation: B) Two steps.
Step 1: Solve for rE:
rE = Div1 / P0 + g = 1.75 / 35.00 + 0.05 = 0.10 or 10%
Step 2: Solve for new stock price:
P0 = Div1 / (rE - g) = 1.00 / (0.10 - 0.07) = 33.33
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
16) You expect that Bean Enterprises will have earnings per share of $2 for the coming year. Bean plans
to retain all of its earnings for the next three years. For the subsequent two years, the firm plans on
retaining 50% of its earnings. It will then retain only 25% of its earnings from that point forward.
Retained earnings will be invested in projects with an expected return of 20% per year. If Bean's equity
cost of capital is 12%, then the price of a share of Bean's stock is closest to:
A) $17.00
B) $10.75
C) $27.75
D) $43.50
E) $37.50
Answer: C
Explanation: C)
Year
Earnings Dividends
g
1
$2.00
$0.00
20%
2
$2.40
$0.00
20%
3
$2.88
$0.00
20%
4
$3.46
$1.73
10%
5
$3.80
$1.90
10%
6
$4.18
$3.14
5%
P0 = 1.73 / (1.12)4 + 1.90 / 1.125 + (3.14 / (0.12 - 0.05)) / 1.125 = 27.63
Each g is calculated as the 20% return on the projects × the retention ratio.
Diff: 3 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
17) Avril Synchronistics will pay a dividend of $1.30 per share this year.It is expected that this dividend
will grow by 5% each year in the future. What will be the current value of a single share of Avril's stock
if the firm's equity cost of capital is 14%?
A) $9.23
B) $9.28
C) $14.44
D) $15.16
E) $16.21
Answer: C
Explanation: C) P0 = 1.3/(0.14 - 0.05) = $14.44
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
18) Spacefood Products will pay a dividend of $2.40 per share at the end of this year. It is expected that
this dividend will grow by 3% per year each year in the future. What will be the current value of a
single share of Spacefood's stock if the firm's equity cost of capital is 10%?
A) $24.00
B) $23.97
C) $30.22
D) $34.29
E) $37.76
Answer: D
Explanation: D) P0 = 2.4/(0.10 - 0.03) = $34.29
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
19) Gremlin Industries will pay a dividend of $1.80 per share at the end of this year. It is expected that
this dividend will grow by 4% per year each year in the future. The current price of Gremlin's stock is
$22.40 per share. What is Gremlin's equity cost of capital?
A) 11%
B) 12%
C) 14%
D) 16%
E) 18%
Answer: B
Explanation: B) Cost of capital = 1.8 / 22.40 + 0.04 = 12%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
20) A company has stock which costs $42.00 per share and pays a dividend of $2.50 per share this year.
The company's cost of equity is 8%. What is the expected annual growth rate of the company's
dividends?
A) 2%
B) 4%
C) 8%
D) 11%
E) 5%
Answer: A
Explanation: A) Growth rate = 0.08 - 2.5 / 42 = 2%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
21) Kilbright Corporation stock is currently trading at $73.29 per share and pays a dividend of $3.14 per
share this year. The company's cost of equity is 13%. What is the expected annual growth rate of the
company's dividends?
A) 11.2%
B) 6.8%
C) 4.3%
D) 17.3%
E) 8.7%
Answer: E
Explanation: E) Growth rate = 0.13 - 3.14 / 73.39 = 8.7%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
22) Jumbo Transport, an air-cargo company, expects to have earnings per share of $2.50 in the coming
year. It decides to retain 20% of these earnings in order to lease new aircraft. The return on this
investment will be 25%. If its equity cost of capital is 12%, what is the expected share price of Jumbo
Tranport?
A) $16.67
B) $19.23
C) $24.75
D) $28.57
E) $31.86
Answer: D
Explanation: D) D1 = 2.5 × 0.8 = 2; g = 0.2 × 0.25 = 0.05; P0 = 2 / (0.12 - 0.05) = $28.57
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
23) Sunnyfax Publishing pays out all its earnings and has a share price of $38. In order to expand,
Sunnyfax Publishing decides to cut its dividend from $3.00 to $2.00 per share and reinvest the retained
funds. Once the funds are reinvested, they are expected to grow at a rate of 12%. If the reinvestment
does not affect Sunnyfaxs equity cost of capital, what is the expected share price as a consequence of
this decision?
A) $33.33
B) $40.00
C) $50.00
D) $60.00
E) $65.00
Answer: C
Explanation: C) cost of capital = 3/38 = 0.08; g = 0.33 × 0.12 = 0.04;
P0 = 2 / (0.08 -0.04) = $50
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
24) Kirkevue Industries pays out all its earnings as dividends and has a share price of $24. In order to
expand, Kirkevue announces it will cut its dividend payments from $2.00 to $1.80 per share and
reinvest the retained funds. What is the growth rate that should be achieved on the reinvested funds to
keep the equity cost of capital unchanged?
A) 0.83%
B) 15.33%
C) 18.23%
D) 17.97%
E) 12.35%
Answer: A
Explanation: A) re1 = 2/24 = 8.33%; re2 = 1.8/24 = 7.5%; growth rate = 8.33 - 7.5 = 0.83%
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
25) Sinclair Pharmaceuticals, a small drug company, develops a vaccine that will protect against
Helicobacter pylori, a bacteria that is the cause of a number of diseases of the stomach. It is expected that
Sinclair Pharmaceuticals will experience extremely high growth over the next three years and will
reinvest all of its earnings in expanding the company over this time. Earnings were $1.20 per share
before the development of the vaccine and are expected to grow by 40% per year for the next three
years. After this time, it is expected growth will drop to 5% and stay there for the expected future. Four
years from now Sinclair will pay dividends that are 75% of its earnings. If its equity cost of capital is
10%, what is the value of a share of Sinclair Pharmaceuticals today?
A) $33.33
B) $38.96
C) $48.30
D) $52.00
E) $54.45
Answer: B
Explanation: B) E3 = $3.29 D3 =2.470
E4 = $3.4574; D4 = $2.5931; D5 = 2.5931; P4 = 2.5931 / (0.10 - 0.05) = 49.392;
P0 = (49.392 + 2.470) / (1.10)^3 = $38.96
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
26) Assuming everything else remains unchanged, how does a firm's decision to increase its dividendpayout ratio affect its growth rate?
Answer: Increasing dividend-payout ratio will decrease the retention rate, thereby decreasing the
growth rate.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
27) Can the dividend-discount model handle negative growth rates?
Answer: Yes, the dividend-discount model can handle negative growth rates. The model works as long
as growth rate is smaller than the cost of equity and negative growth rate is smaller than the cost of
equity.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
28) How can the dividend-discount model handle changing growth rates?
Answer: Most firms have high growth rate during the early part of their existence, which gradually
tapers to the steady-state growth rate. We cannot apply the formula during the period while the growth
rate is changing. We can only apply it once the growth rate has stabilized to a constant rate.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
29) What is a major assumption about growth rate in the dividend-discount model?
Answer: It is assumed that the growth rate used in the dividend-discount model be constant in the
future.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
30) What is the relationship between the growth rate and the cost of equity implied in the dividenddiscount model?
Answer: For the dividend-discount model equation to make sense, the growth rate should be smaller
than the cost of equity, otherwise the present value of the growing perpetuity is infinite. However, it is
impossible for a stock's dividends to grow at a rate that exceeds the cost of equity forever.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.3 Understand the trade-off between dividends and growth in stock valuation
7.4 Limitations of the Dividend-Discount Model
1) Forecasting dividends requires forecasting the firm's future earnings.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.4 Appreciate the limitations of valuing a stock based on expected dividends
2) Stocks that do not pay a dividend must have a value of $0.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.4 Appreciate the limitations of valuing a stock based on expected dividends
3) What are the major limitations of the dividend-discount model?
Answer: There is a tremendous amount of uncertainty associated with any forecast of a firm's future
dividends, and even small changes in the assumed dividend growth rate can lead to large changes in
the estimated stock price.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.4 Appreciate the limitations of valuing a stock based on expected dividends
7.5 Share Repurchases and the Total Payout Model
1) If a firm has leverage, it is best to use the total payout model to determine the firm's value.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
2) Tarmac Airlines has 115 million shares outstanding and expects earnings at the end of this year of
$370 million. Tarmac plans to pay out 40% of its earnings as a dividend and 20% of its earnings through
share repurchases. The firm has an equity cost of capital of 8%. If Tarmac' earnings are expected to grow
by 3% per year and these payout rates remain constant, what is Tarmac's share price?
A) $38.61
B) $24.13
C) $64.35
D) $25.74
E) $16.09
Answer: A
Explanation: A) PV(future total dividends and repurchases) = (0.6 × 370)/(0.08 - 0.03) = $4.44 billion
Price per share = 4.44 billion / 115 million = $38.61
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
3) Cork Bottlers has 84 million shares outstanding and expects earnings at the end of this year of $54
million. Cork plans to pay out 30% of its earnings as a dividend and 10% of its earnings through share
repurchases. The firm has an equity cost of capital of 12%. If Tarmac' earnings are expected to grow by
6.5% per year and these payout rates remain constant, what is Tarmac's share price?
A) $5.24
B) $2.14
C) $4.68
D) $3.51
E) $11.69
Answer: C
Explanation: C) PV(future total dividends and repurchases) = (0.4 × 54)/(0.12 - 0.065) = $393 million
Price per share = 393 million / 84 million = $4.68
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
4) Which of the following models can be used to value a firm without explicitly forecasting that firm's
dividends, share repurchases, or its use of debt?
I. Dividend-discount model
II. Total payout model
III. Discounted free cash flow model
A) I only
B) II only
C) III only
D) II and III
E) I and II
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
5) Valence Electronics has 217 million shares outstanding. It expects earnings at the end of the year of
$760 million. Valence pays out 40% of its earnings in total—15% paid out as dividends and 25% used to
repurchase shares. If Valences earnings are expected to grow by 6% per year, these payout rates do not
change, and Valence's equity cost of capital is 8%, what is Valences share price?
A) $10.51
B) $24.40
C) $56.60
D) $70.05
E) $85.25
Answer: D
Explanation: D) P0 = (0.4 × 760) / (0.08 - 0.06) = $15,200 million; per share = 15,200 / 217 = $70.05
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
6) Chittenden Enterprises has 632 million shares outstanding. It expects earnings at the end of the year
to be $940 million. The firm's equity cost of capital is 10%. Chittenden pays out 30% of its earnings in
total: 20% paid out as dividends and 10% used to repurchase shares. If Chittenden's earnings are
expected to grow at a constant 4% per year, what is Chittenden's share price?
A) $4.96
B) $3.36
C) $7.44
D) $14.88
E) $16.42
Answer: C
Explanation: C) P0 = (0.3 × $940) / (0.10 - 0.04) = $4,700 million; per share = $4,700/632 = $7.44
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
7) Aaron Inc. has 316 million shares outstanding. It expects earnings at the end of the year to be $602
million. The firm's equity cost of capital is 11.5%. Aaron pays out 50% of its earnings in total: 30% paid
out as dividends and 20% used to repurchase shares. If Aaron's earnings are expected to grow at a
constant 6% per year, what is Aaron's share price?
A) $8.66
B) $17.32
C) $25.98
D) $34.64
E) $12.43
Answer: B
Explanation: B) P0 = (0.5 × $602) / (0.115 -.06) = $5,473 million; per share = $5,473/316 = $17.32
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
8) Flinders Corporation's shares currently cost $32.00, and it has 80 million shares outstanding. If it pays
out 70% of its earnings in total and its equity cost of capital is 10 percent, what are Flinders' earnings,
given that these earnings are expected to grow by 5% per year in the future?
A) $73.14 million
B) $85.33 million
C) $120.64 million
D) $182.86 million
E) $206.32 million
Answer: D
Explanation: D) Value of firm = 32 × 80 = 2560; earnings paid out = 2560 × (0.1 - 0.05) = 128;
total earnings = 128 / 0.7 = $182.86 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
9) If you want to value a firm that has consistent earnings growth, but varies how it pays out these
earnings to shareholders between dividends and repurchases, the simplest model for you to use is the
A) enterprise value model.
B) dividend-discount model.
C) total payout model.
D) discounted free cash flow model.
E) net present value model.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
10) With more firms introducing stock repurchase plans, how can we value such firms?
Answer: We need to use the total payout model rather than dividend-discount model in valuing plans
that have stock repurchase plans in place.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
7.6 The Discounted Free Cash Flow Model
1) The discounted free cash flow model ignores interest income and expense but adjusts for cash and
debt directly.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
2) Parminder Partners is expected to generate free cash flows of $4 million per year for the next 5 years,
after which they are expected to grow at a rate of 3% per year. The firm currently has $2 million of cash,
$7 million of debt, and a cost of capital of 8%. If the firm has 10 million shares outstanding, what is
Parminder's expected current share price?
A) $6.71
B) $6.29
C) $6.55
D) $7.21
E) $6.51
Answer: A
Explanation: A) FCF6 = 4 × (1.03) = 4.12; V5 = 4.12 / (0.08 - 0.03) = 82.4;
using the CF function of a financial calculator, V0 = 72.13;
P0 = (72.13 + 2 - 7) / 10 = $6.71
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
Use the table for the question(s) below.
Year
1
Free Cash Flow $12 million
2
$18 million
3
$22 million
4
$26 million
3) Conundrum Mining is expected to generate the above free cash flows over the next four years, after
which they are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 12%
and Conundrum has cash of $80 million, debt of $60 million, and 30 million shares outstanding, what is
Conundrum's expected current share price?
A) $10.84
B) $13.72
C) $16.16
D) $16.25
E) $17.15
Answer: A
Explanation: A) FCF5 = 26 × (1.05) = 27.3; V4 = 27.3 / (0.12 - 0.05) = 390;
using the CF function of a financial calculator, V0 = 305.09846;
P0 = (305.09846 + 80 - 60) / 30 = $10.84
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
4) Conundrum Mining is expected to generate the above free cash flows over the next four years, after
which they are expected to grow at a rate of 5% per year. If the weighted average cost of capital is 12%
and Conundrum has cash of $80 million, debt of $60 million, and 30 million shares outstanding, what is
Conundrum's expected terminal enterprise value?
A) $371.4 million
B) $390.0 million
C) $410.0 million
D) $391.4 million
E) $403.6 million
Answer: B
Explanation: B) FCF5 = 26 × (1.05) = 27.3; V4 = 27.3 / (0.12 - 0.05) = 390;
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
Use the table for the question(s) below.
Year
1
Free Cash Flow $22 million
2
$26 million
3
$29 million
4
$30 million
5
$32 million
5) General Industries is expected to generate the above free cash flows over the next five years, after
which free cash flows are expected to grow at a rate of 3% per year. If the weighted average cost of
capital is 8% and General Industries has cash of $10 million, debt of $40 million, and 80 million shares
outstanding, what is General Industries' expected current share price?
A) $6.60
B) $6.72
C) $7.67
D) $9.48
E) $10.53
Answer: A
Explanation: A) FCF6 = 32 × 1.03 = 32.96; V5 = 32.96 / (0.08 - 0.03) = 659.2
using financial calculator, V0 = 558.1523;
P0 = (558.1523 + 10 - 40) / 80 = $6.60
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
6) General Industries is expected to generate the above free cash flows over the next five years, after
which free cash flows are expected to grow at a rate of 3% per year. If the weighted average cost of
capital is 8% and General Industries has cash of $10 million, debt of $40 million, and 80 million shares
outstanding, what is General Industries' expected terminal enterprise value?
A) $558.2 million
B) $109.5 million
C) $442.8 million
D) $513.6 million
E) $659.2 million
Answer: E
Explanation: E) FCF6 = 32 × (1.03) = 32.96; V5 = 32.96 / (0.08 - 0.03) = 659.2;
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
Use the information for the question(s) below.
Gonzales Corporation generated free cash flow of $88 million this year. For the next two years, the
company's free cash flow is expected to grow at a rate of 8%. After that time, the company's free cash
flow is expected to level off to the industry long-term growth rate of 4% per year. Suppose the weighted
average cost of capital is 10% and Gonzales Corporation has cash of $100 million, debt of $300 million,
and 100 million shares outstanding.
7) What is Gonzales Corporation's expected terminal enterprise value in year 2?
A) $1,779.15
B) $1,641.60
C) $1,579.15
D) $1,441.60
E) $1,378.35
Answer: A
Explanation: A) FCF1 = 88 × 1.08 = 95.04; FCF2 = 95.04 × (1.08) = 102.64; V2 = (102.64 × 1.04)/ (0.10 - 0.04)
= 1,779.15
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
8) What is Gonzales Corporation's expected free cash flow in year 2?
A) $1,779.15
B) $95.04
C) $1,881.80
D) $102.64
E) $401.52
Answer: D
Explanation: D) FCF1 = 88 × 1.08 = 95.04; FCF2 = 95.04 × (1.08) = 102.64
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
9) What is Gonzales Corporation's expected current share price?
A) $16.42
B) $13.85
C) $14.42
D) $18.42
E) $19.34
Answer: C
Explanation: C) FCF1 = 88 × 1.08 = 95.04; FCF2 = 95.04 × (1.08) = 102.64; V2 = (102.64 × 1.04)/ (0.10 - 0.04)
= 1,779.15
using financial calculator, V0 = 1,641.60;
P0 = (1,641.60-300+100)/100 = $14.42
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
Use the table for the question(s) below.
Year
Sales
Growth versus Prior Year
EBIT (10% of Sales)
Less: Income Tax (37%)
Less Increase in NWC
(12% of Change in Sales)
Free Cash Flow
0
240
1
270
12.5%
27.00
(9.99)
2
290
7.4%
29.00
10.73
3
310
6.9%
31.00
11.47
4
325.5
5.0%
32.55
12.44
3.6
13.41
2.4
15.87
2.4
17.13
1.86
18.65
10) Banco Industries expects sales to grow at a rapid rate over the next three years, but settle to an
industry growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco
Industries. If Banco Industries has a weighted average cost of capital of 12%, $50 million in cash, $60
million in debt, and 18 million shares outstanding, which of the following is the best estimate of Banco's
stock price at the start of year 1?
A) $6.03
B) $11.12
C) $12.03
D) $20.11
E) $24.51
Answer: C
Explanation: C) FCF5 = 18.65 × 1.05 = 19.5825; V4 = 19.5825 / (0.12 - 0.05) = 279.75;
using a financial calculator, V0 = 226.4561;
P0 = (226.4561 + 50 - 60) / 18 = $12.03
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
11) Banco Industries expects sales to grow at a rapid rate over the next 3 years, but settle to an industry
growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries.
Banco Industries has a weighted average cost of capital of 12%, $50 million in cash, $60 million in debt,
and 18 million shares outstanding. If Banco Industries can reduce their operating expenses so that EBIT
becomes 12% of sales, by how much will their stock price increase?
A) $2.80
B) $3.36
C) $4.98
D) $8.89
E) $10.12
Answer: A
Explanation: A) Calculate FCF1 = 16.812, FCF2 = 19.524, FCF3 = 21.036, FCF4 = 22.7478, FCF5 = 23.8852;
V4 = 23.8852 / (0.12 - 0.05) = 341.217
using a financial calculator, V0 = 276.8543
P0 = (276.8543 + 50 - 60) / 18 = $14.8252;
increase from old price of $12.03 = $2.80
Diff: 3 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
12) Which of the following is the appropriate way to calculate the price of a share of a given company
using the free cash flow valuation model?
A) P0 = Div1/(rE - g)
B) P0 = PV(Future Free Cash Flow of Firm)/(Shares Outstanding0)
C) P0 = [Div1/(rE - g)]/(Shares Outstanding0)
D) P0 = (V0 + Cash0 - Debt0)/(Shares Outstanding0)
E) P0 = PV(Future Free Cash Flow of Firm)
Answer: D
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
13) If you want to value a firm that consistently pays out its earnings as dividends, the simplest model
for you to use is the
A) enterprise value model.
B) total payout model.
C) dividend-discount model.
D) discounted free cash flow model.
E) net present value model
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
14) If you want to value a firm but do not want to explicitly forecast its dividends, share repurchases , or
its use of debt, what is the simplest model for you to use?
A) the discounted free cash flow model
B) the dividend-discount model
C) the enterprise value model
D) the total payout model
E) net present value model
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
15) What additional adjustments are required to find the share price, in case we are using the
discounted cash flow model?
Answer: Discounted cash flow model gives us the enterprise value, which needs to be adjusted for debt
and cash to arrive at the stock price.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.5 Value a stock as the present value of either the company's total payout or its free cash flows
7.7 Valuation Based on Comparable Firms
1) In the method of comparables, the known values of a firm's cash flows are used to estimate the
unknown cash flows of a similar firm.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
2) Several methods should be used to provide an estimate of a stock's value since no single method
provides a definitive value.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
3) Suppose Air Canada has a current share price of $10.50 and an EPS of 1.12. Its competitor, WestJet,
has an EPS of 3.13. Using the method of comparables, what is the expected price of WestJet stock?
A) $29.34
B) $3.76
C) $32.87
D) $36.81
E) $25.64
Answer: A
Explanation: A) Air Canada P/E = 10.50/1.12 = 9.375; WestJet stock price = 9.375 × 3.13 = $29.34
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
4) Suppose CP Rail has a current share price of $194.83 and an EPS of 9.01. Its competitor, CN Rail, has
an EPS of 4.27. Using the method of comparables, what is the expected price of CN Rail stock?
A) $411.10
B) $45.63
C) $21.62
D) $92.33
E) $102.86
Answer: D
Explanation: D) CP Rail P/E = 194.83/9.01 = 21.62; CN Rail stock price = 21.62 × 4.27 = $92.33
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
5) Suppose RBC has a current share price of $75.25 and an EPS of 6.57. Its competitor, CIBC, has an EPS
of 8.94. Using the method of comparables, what is the expected price of CIBC stock?
A) $58.74
B) $45.63
C) $102.36
D) $11.45
E) $55.30
Answer: C
Explanation: C) RBC P/E = 75.25/6.57 = 11.45; CIBC stock price = 11.45 × 8.94 = $102.36
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
6) Harbour Corporation pays a dividend of $2.15 per year, which is expected to grow at a rate of 3% per
year. Harbour has a cost of capital of 12%, and an EPS of $4.42. Its competitor, Pallantine Inc., pays a
yearly dividend of $1.25 per year, which is expected to grow at a rate of 6% per year. Pallantine has an
EPS of $5.19. What would be the expected price of Pallantine stock, if estimated using the method of
comparables?
A) $19.33
B) $20.84
C) $23.89
D) $21.04
E) $28.05
Answer: E
Explanation: E) Harbour P/E = (2.15/4.42) / (.12 - .03) = 5.4047;
Pallantine stock price = 5.4047 × 5.19 = 28.05
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
7) Harbour Corporation pays a dividend of $2.15 per year, which is expected to grow at a rate of 3% per
year. Harbour has a cost of capital of 12%, and an EPS of $4.42. Its competitor, Pallantine Inc., pays a
yearly dividend of $1.25 per year, which is expected to grow at a rate of 6% per year. Pallantine has an
EPS of $5.19. Solve for Pallantine's cost of capital using the method of comparables.
A) 9.8%
B) 11.2%
C) 10.5%
D) 11.9%
E) 12.0%
Answer: C
Explanation: C) Harbour P/E = (2.15/4.42) / (.12 - .03) = 5.4047;
Pallantine stock price =5.4047 × 5.19 = 28.05;
r = 1.25/28.05 + .06 = 10.5%
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
Use the figure for the question(s) below.
8) On a particular date, the above information concerning Office Depot, Incorporated, was given on
Google Finance. Its competitor, Staples Incorporated, had a stock price of $24.72. Which of the following
is closest to the EPS of Staples Incorporated if it is estimated using valuation multiples based on priceearnings ratios?
A) $1.65
B) $1.83
C) $2.67
D) $14.37
E) $4.54
Answer: C
Explanation: C) EPS Staples = 24.72 / 9.26 = 2.67
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
ns by managers.for the question(s) below.
Use the table for the question(s) below.
Name
Gannet
New York Times
McClatchy
Media General
Lee Enterprises
Average
Maximum
Minimum
Market
Capitalization
($ million)
6350
2423
675
326
267
Enterprise
Value
($ million)
10,163
3472
3061
1192
1724
P/E
7.36
18.09
9.76
14.89
6.55
11.33
+60%
-40%
Price/
Book
0.73
2.64
1.68
0.39
0.82
1.25
112%
69%
Enterprise
Value/
Sales
1.4
1.10
1.40
1.31
1.57
1.35
+16%
-18%
Enterprise
Value/
EBITDA
5.04
7.21
5.64
7.65
6.65
6.44
+22%
-19%
9) The table above shows the stock prices and multiples for a number of firms in the newspaper
publishing industry. Another newspaper publishing firm (not shown) had sales of $620 million,
EBITDA of $84 million, excess cash of $66 million, $14 million of debt, and 120 million shares
outstanding. If the average enterprise value to sales for comparable businesses is used, which of the
following is the best estimate of the firm's share price?
A) $6.89
B) $6.98
C) $7.41
D) $7.65
E) $8.17
Answer: C
Explanation: C) Enterprise Value = 1.35 × 620 = 837; P0 = (837 + 66 - 14) / 120 = $7.41
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
10) The table above shows the stock prices and multiples for a number of firms in the newspaper
publishing industry. Another newspaper publishing firm (not shown) had sales of $620 million,
EBITDA of $84 million, excess cash of $66 million, $14 million of debt, and 120 million shares
outstanding. If the average enterprise value to sales for comparable businesses is used, which of the
following is the range of reasonable share price estimates?
A) $6.07 to $8.59
B) $5.72 to $8.09
C) $1.12 to $1.68
D) $6.00 to $9.04
E) $7.01 to $8.78
Answer: A
Explanation: A) Enterprise Value = 1.35 × 620 = 837; P 0 = (837 + 66 - 14) / 120 = $7.41
Range is from 82% to 116% of estimate.
$7.41 × 0.82 = $6.07; $7.41 × 1.16 = $8.59
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
11) The table above shows the stock prices and multiples for a number of firms in the newspaper
publishing industry. Another newspaper publishing firm (not shown) had sales of $620 million,
EBITDA of $84 million, excess cash of $66 million, $14 million of debt, and 120 million shares
outstanding. If the firm had an EPS of $0.48, what is the difference between the estimated share price of
this firm if the average price-earnings ratio is used and the estimated share price if the average
enterprise value/EBITDA ratio is used?
A) $0.34
B) $0.49
C) $4.94
D) $5.43
E) $7.12
Answer: B
Explanation: B) Price using price-earnings ratio = 11.33 × 0.48 = 5.4384;
using enterprise value/EBITDA ratio = 6.44 × 84 = 540.96;
P0 = (540.96 + 66 - 14) / 120 = $4.94; difference = 0.49
Diff: 2 Type: MC
Skill: Analytical
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
12) The table above shows the stock prices and multiples for a number of firms in the newspaper
publishing industry. Which of the following ratios would most likely be the most reliable in
determining the stock price of a comparable firm?
A) P/E
B) Price/Book
C) Enterprise Value/Sales
D) Enterprise Value/EBITDA
E) Free cash flow/EBITDA
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
13) Valuation models use the relationship between share value, future cash flows, and the cost of capital
to estimate these quantities for a given firm. Realistically, for a publicly traded firm, what can we
reliably use such models to determine?
I. the firm's future cash flows
II the firm's cost of capital
III the firm's stock price
A) I only
B) II only
C) III only
D) I and II
E) II and III only
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
14) What are the major limitations of valuation using multiples?
Answer: Not all firms are identical, so the usefulness of a valuation multiple will depend on the nature
of the differences between firms and the sensitivity of the multiples to these differences. It may also be
difficult to find comparable firms in a given industry or country. Finally, since comparables will only
provide information on firm value relative to other firms, multiples will not help us determine whether
an entire industry is overvalued.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 7.6 Value a stock by applying common multiples based on the values of comparable firms
7.8 Information, Competition, and Stock Prices
1) If you value a stock using a range of stock valuation methods and these valuations indicate a stock
price that is greater than its actual market price, it is most likely that the stock is under-valued.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
2) In an efficient market, investors will only find positive-NPV trading opportunities if they have some
form of competitive advantage over other investors.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
3) Praetorian Industries will pay a dividend of $2.50 per share this year and has an an equity cost of
capital of 8%. Praetorian's stock is currently trading at $84 per share. By comparing Praetorian with
similar firms, an investor expects that its dividends will grow by up to 5% per year. What is the best
next step that the investor should take regarding Praetorian's stock?
A) Sell any Praetorian stock that she owns.
B) Short Praetorian's stock.
C) Revise Praetorian's equity cost of capital.
D) Revise her estimate of Praetorian's dividend growth.
E) Compare Praetorian's equity cost of capital with similar firms.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
4) On a certain date, Hasbro has a stock price of $37.50, pays a dividend of $0.64, and has an equity cost
of capital of 8%. An investor expects the dividend rate to increase by 6% per year in perpetuity. He then
sells all stocks that he owns in Hasbro. Given Hasbro's share price, was this a reasonable action?
A) No, since the constant dividend growth rate gives a stock estimate of $37.50.
B) No, since the constant dividend growth rate gives a stock estimate greater than $37.50.
C) Yes, since the constant dividend growth rate gives a stock estimate greater than $37.50.
D) No, since the difference between his calculated stock price and the actual stock price most likely
indicates that his estimate of dividend growth rate was incorrect.
E) Yes, since the constant dividend growth rate gives a stock estimate less than $37.50.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
5) Which of the following is the best statement of the efficient markets hypothesis?
A) Investors with information that a stock had a positive net present value (NPV) will buy it, while
investors with information that a stock had a negative net present value (NPV) will sell it.
B) Investor's decisions are dependent on complete current information of a firm's cash flows and
accurate predictions of future cash flows.
C) Competition between investors works to make the net present value (NPV) of all trading
opportunities zero.
D) A share's price is the aggregate of the information of many investors.
E) Investors should only buy stocks with a positive net present value (NPV).
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
6) Carbondale Oil announces that a wildcat well that it has sunk in a new oil province has shown the
existence of substantial oil reserves. The exploitation of these reserves is expected to increase
Carbondale's free cash flow by $100 million per year for eight years. If investors had not been expecting
this news, what is the most likely effect on Carbondale's stock price upon the announcement, given that
Carbondale has 80 million shares outstanding, no debt, and an equity cost of capital of 10%?
A) no effect
B) rise by $5.78
C) rise by $6.67
D) rise by $8.30
E) rise by $10.17
Answer: C
Explanation: C) PV of 100 million for 8 years at 10% = 533.4926
per share = 533.4926 / 80 = $6.67
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
7) Advanced Chemical Industries is awaiting the verdict from a court case over whether it is liable for
the clean-up of wastes on a disused factory site. If it is liable, this will result in a reduction of its free
cash flow by $12 million per year for ten years. If it is not liable, there will be no effect. On the close of
trading the day before the announcement of the verdict, Advanced Chemicals was trading at $20 per
share. Most investors calculate that there is a 100% chance that Advanced Chemicals will have a verdict
returned against them. One investor, Jo, has performed extensive research into the outcome of the trial
and estimates that there is no chance Advanced Chemicals will have a verdict returned against them.
Given that Advanced Chemicals has 60 million shares outstanding and an equity cost of capital of 8%
with no debt, Jo's estimate of the value of a share of Advanced Chemicals would be how much more
than the market price?
A) $1.34
B) $20.46
C) $20.68
D) $20.96
E) $21.42
Answer: A
Explanation: A) Using a financial calculator, PV of 12 million for 10 years at 8% = 80.521;
per-share effect = 80.521 / 60 = $1.34
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
8) Aerelon Airways, a commercial airline, suffers a major crash. As a result, passengers are considered
to be less likely to choose Aerelon as their carrier, and it is expected free cash flows will fall by $20
million per year for five years. If Aerelon has 65 million shares outstanding, an equity cost of capital of
12%, and no debt, by how much would Aerelon's shares be expected to fall in price as a result of this
accident?
A) $0.98
B) $1.11
C) $1.28
D) $1.45
E) $1.76
Answer: B
Explanation: B) Using a financial calculator, PV of 20 million for 5 years at 12% = 72.10;
per-share effect = 72.10 / 65 = $1.11
Diff: 1 Type: MC
Skill: Analytical
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
9) If a manager wishes to raise his stock's price, he should do which of the following?
I. Focus on maximizing the present value (PV) of the free cash flow.
II Focus on accounting earnings.
III. Focus on financial policy.
A) I only
B) II only
C) I and II
D) II and III
E) III only
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
10) What are the implications of the efficient markets hypothesis for corporate managers regarding
accounting earnings?
Answer: Managers should not focus on accounting earnings but instead focus on maximizing cash
flows.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 7.7 Understand how information is incorporated into stock prices through competition in efficient markets
7.9 Individual Biases and Trading
1) Individual investors trade conservatively, given the difficulty of finding over- and under-valued
stocks.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.8 Describe some behavioural biases that influence the way individual investors trade
2) Individual investors who grow up and live during a time of high stock returns are more likely to
invest in stocks.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 7.8 Describe some behavioural biases that influence the way individual investors trade
3) Individual investors' tendency to trade too much based on the mistaken belief that they can pick
winners and losers better than investment professionals is known as
A) the disposition effect.
B) the investor attention hypothesis.
C) the investor overconfidence hypothesis.
D) the excessive trading costs hypothesis.
E) the investor mood hypothesis.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.8 Describe some behavioural biases that influence the way individual investors trade
4) A study of trading behavior of individual investors at a discount brokerage found that individual
investors
A) trade very actively, despite the fact that their performance is actually worse because of trading costs.
B) trade very conservatively, despite the fact that their performance is actually worse because of trading
costs.
C) trade very actively, partly because their performance is better than the professionals' because of low
trading costs.
D) trade very conservatively, partly because their performance is better than the professionals' because
of low trading costs.
E) trade very actively, because they avoid the costs associated with hiring a professional.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.8 Describe some behavioural biases that influence the way individual investors trade
5) Which of the following tendencies of individual investors is called the disposition effect?
A) the tendency to trade too much based on the mistaken belief that they can pick winners and losers
better than investment professionals
B) the tendency to buy stocks that have been in the news, advertised more, have very high trading
volume, or recently had extreme (high or low) returns
C) the tendency to put too much weight on their own experience rather than considering historical
evidence
D) the tendency to hold on to stocks that have lost value and sell stocks that have risen in value since
the time of purchase
E) the tendency for stock returns to be higher on sunny days
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 7.8 Describe some behavioural biases that influence the way individual investors trade
6) Why is the disposition effect costly from a tax perspective?
Answer: Because capital gains are taxed only when the asset is sold, it is optimal for tax purposes to
postpone taxable capital gains by continuing to hold profitable investments. On the other hand,
investors should capture tax losses by selling their losing investments, in order to accelerate the tax
write-off. The tendency to sell winners and hang on to losers (the disposition effect), thus increases the
present value of taxes paid.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 7.8 Describe some behavioural biases that influence the way individual investors trade
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 8 Investment Decision Rules
8.1 The NPV Rule
1) Preference for cash today versus cash in the future in part determines net present value (NPV).
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
2) Net present value (NPV) is the difference between the present value (PV) of the benefits and the
present value (PV) of the costs of a project or investment.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
3) Most corporations measure the value of a project in terms of which of the following?
A) discount value
B) discount factor
C) future value (FV)
D) present value (PV)
E) market value
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
4) What is the present value (PV) of an investment?
A) the amount that an investment would yield if the benefit were realized today
B) the difference between the cost of the investment and the benefit of the investment in dollars today
C) the amount you need to invest at the current interest rate to re-create the cash flow from the
investment
D) the amount by which the cash flow of an investment exceeds or falls short of the cash flow generated
by the same amount of money invested at market rate
E) the amount of profit the investment would return if all benefits were realized today
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
5) You have an investment opportunity that will cost $50,000 today and will return $54,000 in one year.
If interest rates are 4%, what is the NPV of this investment?
A) $1,923
B) $4,000
C) $2,000
D) $50,000
E) $0
Answer: A
Explanation: A) $54,000 / 1.04 = $51,923; $51,923 - $50,000 = $1,923
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
6) You have an investment opportunity that will cost $10,000 today and will return $10,500 in one year.
If interest rates are 8%, what is the NPV of this investment?
A) $462.96
B) $500
C) -$277.78
D) -$462.96
E) $0
Answer: C
Explanation: C) NPV = -10,000 + 10,500/1.08 = -$277.78
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
7) A furniture store offers no money down and no payment for one year. You decide to purchase a
couch, which you will take home today, and pay the $2,000 purchase price one year from now. If
interest rates are 4.5%, what is the NPV of this offer?
A) -$2000
B) $2000
C) $90
D) $0
E) $86.12
Answer: E
Explanation: E) NPV = $2,000 - $2,000/1.045 = $86.12
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
8) A furniture store offers no money down and no payment for two years. You decide to purchase a
table, which you will take home today, and pay the $1,500 purchase price two years from now. If
interest rates are 7%, what is the NPV of this offer?
A) -$1500
B) $189.84
C) $98.13
D) $0
E) $217.35
Answer: B
Explanation: B) NPV = $1,500 - $1,500/1.072 = $189.84
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
9) Which of the following formulas regarding net present value (NPV) is correct?
A) NPV + PV(benefits) = PV(Cost)
B) NPV - PV(costs) = PV(benefits)
C) NPV = PV(all project cash flows)
D) NPV = PV(benefits) + PV(costs)
E) NPV -PV(benefits) - PV(costs) = 0
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
10) You have an investment opportunity in Germany that requires an investment of $250,000 today and
will produce a cash flow of €208,650 in one year with no risk. Suppose the risk-free rate of interest in
Germany is 7% and the current competitive exchange rate is €0.78 to $1.00. What is the net present value
(NPV) of this project? Would you take the project?
A) NPV = 0; No
B) NPV = $2358; No
C) NPV = $2358; Yes
D) NPV = $13,650; Yes
E) NPV = $36,225; Yes
Answer: A
Explanation: A) NPV = -250,000 + (€208,650 / 1.07) × $1.00 / €0.78 = 0; so, since NPV is not > 0, reject.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
11) You have an investment opportunity in Germany that requires an investment of $250,000 today and
will produce a cash flow of €208,650 in one year with no risk. Suppose the risk-free rate of interest in
Germany is 6% and the current competitive exchange rate is €0.78 to $1.00. What is the net present value
(NPV) of this project? Would you take the project?
A) NPV = 0; No
B) NPV = 2358; No
C) NPV = 2358; Yes
D) NPV = 13,650; Yes
E) NPV = $36,225; Yes
Answer: C
Explanation: C) NPV = -250,000 + (€208,650 / 1.06) × $1.00 / €0.78 = 2358; so, since NPV > 0, accept.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
12) A car dealership offers a car for $14,000, with up to one year to pay for the car. If the interest rate is
7%, what is the net present value (NPV) of this offer to buyers who elect not to pay for the car for one
year?
A) $916
B) $1896
C) $13,084
D) $14,000
E) $980
Answer: A
Explanation: A) $14,000 / 1.07 = $13,084; $14,000 - $13,084 = $916
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
13) Martin is offered an investment where for $5000 today, he will receive $5250 in one year. He decides
to borrow $5000 from the bank to make this investment. What is the maximum interest rate the bank
needs to offer on the loan if Martin is at least to break even on this investment?
A) 3.2%
B) 4.8%
C) 5.0%
D) 5.6%
E) 2.5%
Answer: C
Explanation: C) ($5250 - $5000)/$5000 = $250/$5000 = 0.05 or 5.0%
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
14) A security firm is offered $80,000 in one year for providing CCTV coverage of a property. The cost of
providing this coverage to the security firm is $74,000, payable now, and the interest rate is 8.5%.
Should the firm take the contract?
A) Yes, since net present value (NPV) is positive.
B) It does not matter whether the contract is taken or not, since NPV = 0.
C) Yes, since net present value (NPV) is negative.
D) No, since net present value (NPV) is negative.
E) No, since net present value (NPV) is positive.
Answer: D
Explanation: D) NPV = $80,000/1.085 - $74,000 = -$267.28. Since NPV < 0, reject.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
15) A farmer sows a certain crop. It costs $250,000 to buy the seed, prepare the ground, and sow the
crop. In one year's time it will cost $110,000 to harvest the crop. If the crop will be worth $380,000, and
the interest rate is 8%, what is the net present value (NPV) of this investment?
A) -$21,000
B) -$220
C) $0
D) $23,100
E) $20,000
Answer: C
Explanation: C) NPV = ($380,000 - $110,000)/1.08 - $250,000 = 0
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
16) The cash flows for five investments have been identified as follows:
Investment
Cash Flow Today
in thousands of dollars
Cash Flow in One Year
in thousands of dollars
A
B
C
D
E
-8.0
-12.2
-6.0
-2.2
-5.0
9.4
14.3
7.05
2.59
6.97
Based on the above information, and with an interest rate of 6%, which is the best investment?
A) Investment A
B) Investment B
C) Investment C
D) Investment D
E) Investment E
Answer: E
Explanation: A) NPV = 0.868
B) NPV = 1.291
C) NPV = 0.651
D) NPV = 0.243
E) NPV = 1.575
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
17) A delivery service is buying 600 tires for its fleet of vehicles. One supplier offers to supply the tires
for $85 per tire, payable in one year. Another supplier will supply the tires for $20,000 down today, then
$50 per tire, payable in one year. What is the difference in PV between the first and the second offer,
assuming interest rates are 8.5%?
A) $1000
B) $276
C) $645
D) -$1000
E) -$645
Answer: C
Explanation: C) -$85 × 600 = -51,000;
PV1 = -51,000 / 1.085 = -47,005; -$50 × 600 = -$30,000;
PV2 = -20,000 - 30,000 / 1.085 = -$47,650;
PV1 - PV2 = -$47,005 + $47,650 = $645
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
18) Peter has a business opportunity that requires him to invest $10,000 today, and receive $12,000 in
one year. He can either use $10,000 that he already has for this investment or borrow the money from
his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs
to his home, repairs that will cost at least $15,000 if he delays them for a year. Should Peter undertake
the investment?
A) No, since the net present value (NPV) of the investment, should he take it, is less than the net present
value (NPV) of the home repairs if he delays them for one year.
B) Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business
opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the
loan.
C) Yes, since the net present value (NPV) of the investment is greater than zero he can invest the $10,000
in the business opportunity, and then next year use this money plus the benefit from this money to
make the necessary home repairs.
D) Yes, since the net present value (NPV) of the investment, should he take it, is greater than the net
present value (NPV) of the home repairs if he delays them for one year.
E) No, since the net present value (NPV) of both the investment and the repairs are the same.
Answer: B
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
Use the information for the question(s) below.
An independent film maker is considering producing a new movie. The initial cost for making this
movie will be $20 million today. Once the movie is completed, in one year, the movie will be sold to a
major studio for $25 million. Rather than paying for the $20 million investment entirely using its own
cash, the film maker is considering raising additional funds by issuing a security that will pay investors
$11 million in one year. Suppose the risk-free rate of interest is 10%.
19) Refer to the information above. Without issuing the new security, the net present value (NPV) for
this project is closest to what amount? Should the film maker make the investment?
A) $1.7 million; Yes
B) $1.7 million; No
C) $2.7 million; Yes
D) $2.7 million; No
E) $5.0 million; Yes.
Answer: C
Explanation: C) NPV = -20 + 25 / 1.10 = $2.7 million; since NPV > 0, take the investment.
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
20) Refer to the information above. Assuming that the film maker issues the new security, the net
present value (NPV) for this project is closest to what amount? Should the film maker make the
investment?
A) $1.7 million; Yes
B) $1.7 million; No
C) $2.7 million; Yes
D) $2.7 million; No
E) $5.0 million; Yes
Answer: C
Explanation: C) NPV = -10 + (25 - 11) / 1.10 = 2.7 million; since NPV > 0, then invest.
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
21) Refer to the information above. What is the net present value (NPV) of this project if the film maker
does not issue the new security? What is the net present value (NPV) if the film maker issues the new
security?
A) $1.7 million; $1.7 million
B) $1.7 million; $2.7 million
C) $2.7 million; $1.7 million
D) $2.7 million; $2.7 million
E) $5.0 million; $5.0 million
Answer: D
Explanation: D) NPV (no security) = -20 + 25 / 1.1 = $2.7
NPV(w/ security) = -10 + (25 - 11) / 1.10 = $2.7 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
22) What is the Net Present Value rule?
Answer: The Net Present Value rule states to accept a project if its net present value (NPV) is greater
than zero.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
23) How do you apply the Net Present Value rule when multiple projects are available and you have the
added constraint of accepting only one project?
Answer: When making an investment decision under the availability of multiple projects, take the
alternative with the highest net present value (NPV).
Diff: 2 Type: SA
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
24) Should personal preferences for cash today versus cash tomorrow play a role in the net present
value (NPV) decision-making process?
Answer: No; personal preferences for cash flow should not affect the decision-making process. A
manager should decide based on always maximizing the net present value (NPV).
Diff: 3 Type: SA
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
25) You have an investment opportunity in the United Kingdom that requires an investment of $500,000
today and will produce a cash flow of £320,000 in one year with no risk. Suppose the risk-free rate of
interest in the United Kingdom is 6% and the current competitive exchange rate is $1.70/£. What is the
net present value (NPV) of this project? Would you take the project?
Answer: NPV = -500,000 + (£320,000 / 1.06) × $1.70/£ = $13,208;, so, since NPV > 0, accept.
Diff: 2 Type: ES
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
8.2 Using the NPV Rule
1) The Net Present Value rule implies that we should compare a projects net present value (NPV) to zero.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
2) A brewery is considering adding a new line of craft beers to its product mix. The new beer will
require additional brewing and bottling capacity at a cost of $15 million, but is expected to generate new
sales of $5 million per year for the next 5 years. If the brewery has a cost of capital of 6%, what is the
NPV of this investment?
A) $6.1 million
B) $10 million
C) -$15 million
D) $8.6 million
E) $3.7 million
Answer: A
Explanation: A) Financial Calculator: CF0 = -15,000,000, CF1 = 5,000,000, F1 = 5, calculate NPV for I = 6%
NPV = 6.1 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
3) A restaurant is contemplating replacing its service staff with an electronic ordering process. Installing
computers at each table will cost $150,000, but is expected to generate a cost savings of $40,000 per year
for the next 10 years, when the computers will need to be replaced. If the restaurant has a cost of capital
of 10%, what is the NPV of this investment?
A) -$90,000
B) $250,000
C) $95,783
D) -$150,000
E) $213,636
Answer: C
Explanation: C) Financial Calculator: CF0 = -150,000 CF1 =40,000, F1 = 10, calculate NPV for I = 10%
NPV = $95,783
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
4) A steel company wishes to replace the lighting in its warehouse with an energy efficient LED system.
Installing the new lighting system will cost $1.5 million, but is expected to generate a cost savings of
$140,000 per year for the next 25 years, when the new lights will need to be replaced. If the steel
company has a cost of capital of 6%, what is the NPV of this investment?
A) $289,670
B) $2 million
C) -$1.5 million
D) $140,000
E) $1,789,670
Answer: A
Explanation: A) Financial Calculator: CF0 = -1,500,000 CF1 =140,000, F1 = 25, calculate NPV for I = 6%
NPV = $289,670
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
5) You wish to buy a new lawnmower and you are deciding between a gas powered lawn mower and
an electric mower. The electric mower costs $275 more than the gas mower, but you estimate that it will
save you $40 per year by using cheaper electricity relative to gasoline. If the expected lifetime of both
mowers is 30 years, and the cost of capital of 5%, what is the NPV of getting an electric mower instead
of a gas mower?
A) $40
B) $340
C) -$235
D) -$275
E) $925
Answer: B
Explanation: B) Financial Calculator: CF0 = -275 CF1 = 40, F1 = 30, calculate NPV for I = 5% NPV = $340
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
6) The owners of a chain of fast-food restaurants spend $28 million installing donut makers in all their
restaurants. This is expected to increase cash flows by $10 million per year for the next five years. If the
discount rate is 6.5%, were the owners correct in making the decision to install donut makers?
A) No, as it has a net present value (NPV) of -$2.25 million.
B) No, as it has a net present value (NPV) of-$1.68 million.
C) Yes, as it has a net present value (NPV) of $8.74 million.
D) Yes, as it has a net present value (NPV) of $13.56 million.
E) No, as it has a net present value (NPV) of-1.14 million.
Answer: D
Explanation: D) Using financial calculator, enter CF0 = -28,000,000, CF1 = 10,000,000, F1 = 5;
calculate NPV for I = 6.5% = $13,556,794.38.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
Use the information for the question(s) below.
7) The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase
her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value
(NPV) as a function of the discount rate. At what discount rate does her decision to renovate become
untenable?
A) 3.0%
B) 3.3%
C) 4.0%
D) 4.8%
E) 5.0%
Answer: B
Explanation: B) The point at which the graph cuts the Discount Rate axis
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
8) The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase
her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value
(NPV) as a function of the discount rate. If her discount rate is 6%, should she accept the project?
A) Yes, because the NPV is positive at that rate.
B) No, because the NPV is negative at that rate.
C) No, because the NPV is positive at that rate.
D) Yes, because the NPV is negative at that rate.
E) Cannot be determined from the information given.
Answer: B
Explanation: B) The NPV is negative at this Discount Rate.
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
9) The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase
her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value
(NPV) as a function of the discount rate. At what dollar value should the NPV profile cross the vertical
axis?
A) $780,000
B) $1,000,000
C) $220,000
D) The vertical axis crossing point cannot be calculated since the cash inflows are a perpetuity.
E) Cannot be determined because inadequate information is given.
Answer: D
Explanation: D) Since the $220,000 cash flows are perpetual, the sum of the cash flows (discount rate =
0%) is infinite.
Diff: 3 Type: MC
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
10) A mining company will spend $28 million in order to exploit a low-grade placer deposit of gold ore.
They estimate the deposit will produce profits of $6 million per year for six years. They calculate the net
present value (NPV) using an estimated cost of capital of 6%. What is the maximum that the cost of
capital can deviate from this estimate that still makes the decision to mine worthwhile?
A) 1.60%
B) 1.66%
C) 1.69%
D) 1.72%
E) 1.76%
Answer: C
Explanation: C) Calculate the internal rate of return (IRR) of the project and find the difference between
IRR and cost of capital. Using a financial calculator, enter CF0 = -28,000,000, CF1 = 6,000,000, F1 = 6;
calculate IRR = 7.69%; thus 7.69 - 6 = 1.69%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
11) A communications company installs cable to service a new area. They estimate the cost of installing
the cable is $17 million, but they will receive a cash flow of $1.4 million per year indefinitely. The net
present value (NPV) of this investment at a cost of capital of 6.5% indicates that this is a worthwhile
investment. By how much would the cost of capital have to increase for the NPV to be zero?
A) 0.83%
B) 1.74%
C) 3.25%
D) 5.37%
E) 8.24%
Answer: B
Explanation: B) Break even interest rate = 1.4/17 = 0.08235 = 8.235%;
interest increase = 8.235 - 6.5 = 1.735%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
12) A manufacturer of video games develops a new game over two years. This costs $850,000 per year
with one payment made immediately and the other at the end of two years. When the game is released,
it is expected to make $1.2 million per year for three years after that. What is the net present value
(NPV) of this decision if the cost of capital is 9%?
A) $991,220
B) $1,071,432
C) $1,564,559
D) $1,841,093
E) $1,234,870
Answer: A
Explanation: A) Using a financial calculator, enter CF0 = -850,000, CF1 = 0, F1 = 1, CF2 = -850,000, F2 = 1
CF3 = 1,2000,000, F3 = 3; calculate NPV for I = 9% = $991,220.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
13) A manufacturer of video games develops a new game over two years. This costs $850,000 per year
with one payment made immediately and the other at the end of two years. When the game is released,
it is expected to make $1.2 million per year for three years after that. The net present value (NPV) of this
investment at a cost of capital of 9% indicates that this is a worthwhile investment. By how much would
the cost of capital have to increase for the NPV to be zero?
A) 7%
B) 9%
C) 12%
D) 16%
E) 19%
Answer: E
Explanation: E) Using a financial calculator, enter CF0 = -850,000, CF1 = 0, F1 = 1, CF2 = -850,000, F2 = 1,
CF3 = 1,2000,000, F3 = 3; Calculate IRR = 27.99% thus 27.99 - 9 = 18.99%.
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
Use the table for the question(s) below.
Consider a project with the following cash flows:
Year
0
1
2
3
4
Cash
Flow
-10,000
4000
4000
4000
4000
14) If the appropriate discount rate for this project is 15%, then the net present value (NPV) is closest to:
A) $6000
B) -$867
C) $1420
D) $867
E) $3431
Answer: C
Explanation: C) NPV = -10,000 + 4000 / (1.15)1 + 4000 / (1.15)2 + 4000 / (1.15)3 + 4000 / (1.15)4 = 1419.91
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
15) Given the cash flows in the table above, the point at which the NPV profile crosses the vertical axis
is:
A) $6000
B) -$867
C) 22.0%
D) 15.0%
E) $0
Answer: A
Explanation: A) The sum of the cash flows (NPV at 0%) is $6,000.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
Use the table for the question(s) below.
Consider the following two projects:
Project
A
B
Year 0
Cash
Flow
-100
-73
Year 1
Cash
Flow
40
30
Year 2
Cash
Flow
50
30
Year 3
Cash
Flow
60
30
Year 4
Cash
Flow
N/A
30
Discount
Rate
0.15
0.15
16) The net present value (NPV) of project A is closest to:
A) 12.0
B) 12.6
C) 15.0
D) 42.9
E) 14.2
Answer: A
Explanation: A) NPV = -100 + 40 / (1.15)1 + 50 / (1.15)2 + 60 / (1.15)3 = 12.04
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
17) The net present value (NPV) of project B is closest to:
A) 12.6
B) 23.3
C) 12.0
D) 15.0
E) 14.2
Answer: A
Explanation: A) NPV = -73+ 30 / (1.15)1 + 30 / (1.15)2 + 30 / (1.15)3 + 30 / (1.15)4 = 12.6494
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
Use the information for the question(s) below.
The Sisyphean Company is planning on investing in a new project.This will involve the purchase of
some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project
as detailed below:
Year 1
$200,000
Year 2
$225,000
Year 3
$275,000
Year 4
$200,000
The appropriate discount rate for this project is 16%.
18) The net present value (NPV) for this project is closest to:
A) $176,270
B) $123,420
C) $450,000
D) $179,590
E) $497,062
Answer: A
Explanation: A) NPV = -450,000 + 200,000 / (1.16)1 +225,000 / (1.15)2 + 275,000 / (1.15)3 +200,000 / (1.15)4
= 176,265
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
Use the table for the question(s) below.
Consider the following two projects:
Project
Alpha
Beta
Year 0
C/F
-79
-80
Year 1
C/F
20
25
Year 2
C/F
25
25
Year 3
C/F
30
25
Year 4
C/F
35
25
Year 5
C/F
40
25
Year 6
C/F
N/A
25
Year 7
C/F
N/A
25
Discount
Rate
15%
16%
19) The net present value (NPV) for project alpha is closest to:
A) $20.96
B) $16.92
C) $24.01
D) $14.41
E) $12.06
Answer: B
Explanation: B) NPV = -79 + 20 / (1.15)1 + 25 / (1.15)2 + 30 / (1.15)3 + 35 / (1.15)4 + 40 / (1.15)5= 16.92
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
20) The net present value (NPV) for project beta is closest to:
A) $24.01
B) $16.92
C) $20.96
D) $14.41
E) $12.06
Answer: C
Explanation: C) NPV = -80 + 25 / (1.16)1 + 25 / (1.16)2 + 25 / (1.16)3 + 25 / (1.16)4 + 25 / (1.16)5 + 50 /
(1.16)6 + 25 / (1.16)7= 20.96
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.1 Define and use the NPV rule to make investment decisions
21) How can you calculate the y-intercept of a net present value (NPV) profile without using TVM
concepts?
Answer: The y-intercept of a net present value (NPV) profile is the algebraic sum of the project cash
flows, since the discount rate is zero at that point.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.1 Define and use the NPV rule to make investment decisions
8.3 Alternative Decision Rules
1) The payback rule is based on the idea that an opportunity that pays back its initial investment quickly
is a worthwhile opportunity.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
2) The internal rate of return (IRR) rule will agree with the Net Present Value rule even when positive
cash flows precede negative cash flows.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
3) According to Graham and Harvey's 2001 survey (Figure 7.2 in the text), the most popular decision
rules for capital budgeting used by CFOs are
A) NPV, Profitability index, payback period.
B) Profitability index, IRR, Payback period.
C) IRR, NPV, Payback period.
D) Profitability index, NPV, IRR.
E) NPV, IRR, discounted payback period.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
4) A convenience store owner is contemplating putting a large neon sign over his store. It would cost
$50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years.
Would this project be worthwhile if evaluated using a payback period of two years or less and if the
cost of capital is 10%?
A) Yes, since it will pay back its initial investment in two years.
B) Yes, since the value of the cash flows into the store, in present dollars, are greater than the initial
investment.
C) Yes, since the cash flows after two years are greater than the initial investment.
D) No, since the value of the cash flows over the first two years are less than the initial investment.
E) Yes, since the NPV is positive.
Answer: D
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
5) You are considering an investment opportunity that will cost you $20,000 up front, but return $5,000
per year for the next 10 years. What is the IRR for this investment?
A) 21.4%
B) 250%
C) 20%
D) 25%
E) 22.5%
Answer: A
Explanation: A) Financial calculator: CF0 = -20,000; CF1 = $5,000; F1 = 10. Compute IRR = 21.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
6) You are considering an investment opportunity that will cost you $8,000 up front, but return a single
cash flow of $18,000 6 years from now. What is the IRR for this investment?
A) 125%
B) 12.3%
C) 14.5%
D) 37.5%
E) 15%
Answer: C
Explanation: C) Financial calculator: CF0 = -8,000; CF1 = 0, F1 = 5, CF2 = 18,000; Compute IRR = 14.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
7) You are considering an investment opportunity that will cost you $15,000 up front, and return $5,000
per year for 10 years, with the first payment 5 years from today. What is the IRR for this investment?
A) 13.4%
B) 12.3%
C) 12.8%
D) 14.4%
E) 15%
Answer: D
Explanation: D) Financial calculator: CF0 = -15,000; CF1 = 0, F1 = 4, CF2 = 5,000, F2 = 10; Compute IRR =
14.4%
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
8) You are considering an investment opportunity that will cost you $50,000 up front, and return two
payments of $30,000, with the first payment 4 years from today. What is the IRR for this investment?
A) 3.4%
B) 4.1%
C) 7.6%
D) 20%
E) 15%
Answer: B
Explanation: B) Financial calculator: CF0 = -50,000; CF1 = 0, F1 = 3, CF2 = 30,000, F2 = 2; Compute IRR =
4.1%
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
Use the information for the question(s) below.
Time 0
Time 1
Time 2
Time 3
Project A
-10,000
5,000
4,000
3,000
Project B
-10,000
4,000
3,000
10,000
Project C
-10,000
3,000
4,000
5,000
Project D
-10,000
4,000
4,000
4,000
Project E
-10,000
2,000
6,000
10,000
9) If WiseGuy Inc. uses the payback period rule to choose projects, which of the projects will rank
highest?
A) Project A
B) Project B
C) Project C
D) Project D
E) Project E
Answer: A
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
10) If WiseGuy Inc. uses the IRR rule to choose projects, which of the projects will rank highest?
A) Project A
B) Project B
C) Project C
D) Project D
E) Project E
Answer: E
Explanation: E) IRRA = 10.7%, IRRB = 26.4%, IRRC = 8.9%, IRRD = 9.7%, IRRE = 28.0%
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
11) If WiseGuy Inc. uses the NPV rule with a cost of capital of 8% to choose projects, which of the
projects will rank highest?
A) Project A
B) Project B
C) Project C
D) Project D
E) Project E
Answer: E
Explanation: E) NPVA=$440.48, NPVB=$4214.04, NPVC=$176.29, NPVD=$308.39, NPVE=$4934.21
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
12) A florist is buying a number of motorcycles to expand its delivery service. These will cost $87,000,
but are expected to increase profits by $3000 per month over the next four years. What is the payback
period in this case?
A) 12 months
B) 18 months
C) 24 months
D) 29 months
E) 36 months
Answer: D
Explanation: D) Payback period = 87,000 / 3000 = 29 months
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
13) Investment A:
Year:
0
Cash flow: -$14,000
1
$6,000
2
$6,000
3
$6,000
4
$6,000
5
$6,000
Investment B:
Year:
0
Cash flow: -$15,000
1
$7,000
2
$7,000
3
$7,000
4
$7,000
5
$7,000
Investment C:
Year:
0
1
Cash flow: -$18,000 $12,000
2
$4,000
3
$4,000
4
$4,000
5
$4,000
Investment D:
Year:
0
1
Cash flow: -$20,000 $12,000
2
$7,000
3
$7,000
4
$7,000
5
$7,000
Investment E:
Year:
0
1
Cash flow: -$21,000 $12,000
2
$12,000
3
0
4
0
5
0
The cash flows for three projects are shown above. The cost of capital is 7.5%. If an investor decided to
take projects with a payback period two years or less, which of these projects would he take?
A) Investment A
B) Investment B
C) Investment C
D) Investment D
E) Investment E
Answer: E
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
14) A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years.
The winner calculates the internal rate of return (IRR) of taking the money at the end of each year and,
estimating that the discount rate across this period will be 6%, decides to take the money at the end of
each year. Was her decision correct?
A) Yes, because it agrees with the Net Present Value rule.
B) Yes, because it agrees with the payback rule.
C) Yes, because it agrees with both the Net Present Value rule and the payback rule.
D) No, because it disagrees with the Net Present Value rule.
E) No, because it disagrees with the payback rule.
Answer: A
Explanation: A) Using a financial calculator, enter PMT = 600,000, N = 16, I = 6%;
calculate PV = $6,063,537, which is greater than $6,000,000.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
15) Mary is in contract negotiations with a publishing house for her new novel. She has two options. She
may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each
of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the
following investment rules would indicate that she should take the former deal, given a discount rate of
8%?
Rule I:
The Net Present Value rule
Rule II: The Payback Rule with a payback period of two years
Rule III: The internal rate of return (IRR) Rule
A) Rule I only
B) Rule III only
C) Rules II and III
D) Rules I and II
E) Rules I and III
Answer: A
Explanation: A) Using a financial calculator, enter CF0 = 100,000, CF1 = 26,000, F1 = 5;
calculate NPV for I = 8% = $203,810, which is greater than $200,000.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
16) A local government awards a landscaping company a contract worth $1.2 million per year for five
years for maintaining public parks. The landscaping company will need to buy some new machinery
before they can take on the contract. If the cost of capital is 7%, what is the most that this equipment
could cost if the contract is to be worthwhile for the landscaping company?
A) $4.55 million
B) $4.61 million
C) $4.92 million
D) $5.26 million
E) $6.00 million
Answer: C
Explanation: C) Using a financial calculator, enter PMT = 1.2, N = 5, I = 7%; calculate PV = $4.92 million.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
17) A mining company plans to mine a beach for rutile. To do so will cost $10 million up front and then
produce cash flows of $3 million per year for five years. At the end of the sixth year the company will
incur shut-down and clean-up costs of $2 million. If the cost of capital is 11%, then what is the NPV for
this project?
A) -$99,212
B) $12,304
C) $18,409
D) $82,416
E) $111,389
Answer: C
Explanation: C) Using a financial calculator, enter CF0 = -10,000,000; CF1 = 3,000,000, F1 = 5;
CF2 = -2,000,000, F2 = 1, calculate NPV for I = 11% = $18,409
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
18) An investor is considering a project that will generate $800,000 per year for four years. In addition to
upfront costs, at the completion of the project at the end of the fifth year there will be shut-down costs
of $500,000. If the cost of capital is 5%, based on the NPV, at what upfront costs does this project cease to
be worthwhile?
A) $2.32 million
B) $2.44 million
C) $2.58 million
D) $2.84 million
E) $2.96 million
Answer: B
Explanation: B) Using a financial calculator, enter CF 0 = 0; CF1 = 800,000, F1 = 4;
CF2 = -500,000 calculate NPV at 5% = $2.44 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
Use the table for the question(s) below.
Consider a project with the following cash flows:
Year
0
1
2
3
4
Cash
Flow
-10,000
4000
4000
4000
4000
19) Assume the appropriate discount rate for this project is 15%. The payback period for this project is
closest to:
A) 3
B) 2.5
C) 2
D) 4
E) 1
Answer: B
Explanation: B) Payback = 10,000 / 4000 = 2.5
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
20) What is the IRR for this project?
A) 4.59%
B) 8.63%
C) 15.91%
D) 21.86%
E) 44.63%
Answer: D
Explanation: D) Using a financial calculator, enter CF 0 = -10,000; CF1 = 4,000, F1 = 4;
calculate IRR = 21.86%
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
Use the table for the question(s) below.
Consider the following two projects:
Project
A
B
Year 0
Cash
Flow
-100
-73
Year 1
Cash
Flow
40
30
Year 2
Cash
Flow
50
30
Year 3
Cash
Flow
60
30
Year 4
Cash
Flow
N/A
30
Discount
Rate
0.15
0.15
21) The payback period for project A is closest to:
A) 2.0 years
B) 2.4 years
C) 2.5 years
D) 2.2 years
E) 3.0 years
Answer: D
Explanation: D) Payback period. It is clear that the project is not paid off after two years since we have
only received 90 toward the 100 investment. To calculate the fraction of the third year, we take the $10
yet to be repaid ($100 investment - $40 (year 1) - $50 (year 2)) / $60 (cash flow in year 3) = 0.166667; so,
the payback is 2.166667 years.
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
22) The payback period for project B is closest to:
A) 2.5 years
B) 2.0 years
C) 2.2 years
D) 2.4 years
E) 3.0 years
Answer: D
Explanation: D) Payback = 73 / 30 = 2.43 years
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
Use the information for the question(s) below.
The Sisyphean Company is planning on investing in a new project.This will involve the purchase of
some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project
as detailed below:
Year 1
$200,000
Year 2
$225,000
Year 3
$275,000
Year 4
$200,000
The appropriate discount rate for this project is 16%.
23) The internal rate of return (IRR) for this project is closest to:
A) 18.9%
B) 22.7%
C) 34.1%
D) 39.1%
E) 42.3%
Answer: C
Explanation: C) CF0 = -450,000
CF1 = 200,000
CF2 = 225,000
CF3 = 275,000
CF4 = 200,000
Compute IRR = 34.12%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.2 Understand alternative decision rules and their drawbacks
24) What is the decision criteria while using the payback rule?
Answer: The payback rule does not have any decision criteria. Consequently, decision making using
payback rule is rather subjective.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
25) What is the decision criteria using the Net Present Value rule?
Answer: The decision criteria using the Net Present Value rule is to reject projects if their net present
value (NPV) is less than zero.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
26) What is the decision criteria using internal rate of return (IRR) rule?
Answer: The decision criteria using internal rate of return (IRR) rule for project type cash flows is to
accept projects if the internal rate of return (IRR) is greater than the cost of capital.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
27) What is the general shape of the net present value (NPV) profile?
Answer: The net present value (NPV) profile for most projects is a downward sloping graph cutting the
x-axis at the project internal rate of return (IRR).
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
28) Under what situation can the net present value (NPV) profile be upward sloping?
Answer: The net present value (NPV) profile can be upward sloping if the benefits of the cash flows
occurs before the costs. In that case the net present value (NPV) profile will be a rising function of
discount rates.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
29) What can you comment about the shape of the net present value (NPV) profile of a multiple IRR
project?
Answer: A multiple IRR project will have a net present value (NPV) profile that cuts the discount rate
axis as many times as there are IRRs because the point of intersections of the discount rate axis by the
net present value (NPV) profile curve are the IRRs of the project.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.2 Understand alternative decision rules and their drawbacks
8.4 Choosing Between Projects
1) When different investment rules give conflicting answers, then decisions should be based on the Net
Present Value rule, as it is the most reliable and accurate decision rule.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.3 Choose between mutually exclusive alternatives
2) Internal rate of return (IRR) can reliably be used to choose between mutually exclusive projects.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.3 Choose between mutually exclusive alternatives
3) When comparing mutually exclusive projects which have different scales, you must know the dollar
impact of each investment rather than percentage returns.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.3 Choose between mutually exclusive alternatives
4) The cash flows for four projects are shown below, along with the cost of capital for these projects. If
these projects are mutually exclusive, which one should be taken?
A)
Year:
0
1
Cash flow: -$20,000 $6000
Cost of Capital: 8%
B)
Year:
0
1
Cash flow: -$15,000 $4000
Cost of Capital: 7%
2
$6000
3
$6000
4
$6000
5
$6000
2
$4000
3
$4000
4
$4000
5
$4000
C)
Year:
0
1
Cash flow: -$18,000 $5000
Cost of Capital: 7.5%
2
$5000
3
$5000
4
$5000
5
$5000
D)
Year:
0
1
Cash flow: -$12,000 $4000
Cost of Capital: 5%
2
$4000
3
$4000
4
$4000
5
$4000
E)
Year:
0
1
2
3
4
5
Cash flow: -$13,000 $5000 $5000 $5000 $5000 $5000
Cost of Capital: 12%
Answer: D
Explanation: D) NPV = $5318;
NPV(A) = $3956; NPV(B) = $1401; NPV(C) = $2229; NPV(E) = $5024
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
Use the information for the question(s) below.
Time 0
Time 1
Time 2
Time 3
Project A
-10,000
5,000
4,000
3,000
Project B
-10,000
4,000
3,000
10,000
Project C
-10,000
3,000
4,000
5,000
Project D
-10,000
4,000
4,000
4,000
Project E
-10,000
2,000
6,000
10,000
5) If WiseGuy Inc is choosing one of the above mutually exclusive projects (Project A or Project B), given
a discount rate of 8%, which should the company choose?
A) Project A
B) Project B
C) Neither project, - both have a NPV of 0.
D) Both projects - both have positive NPV.
E) Neither project - both have negative NPV.
Answer: B
Explanation: B) NPVA = $440.48, NPVB = $4,214.04
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
6) The cash flows for four projects are shown below, along with the cost of capital for these projects. If
these projects are mutually exclusive, which one should be taken?
A)
Year:
0
1
2
3
4
5
Cash flow:
$5000
$2000
$2000 $2000 $2000
$2000
Cost of Capital: 6%
B)
Year:
0
1
2
3
4
5
Cash flow:
$6000
$2500
$2500 $2500 $2500
$2500
Cost of Capital: 7%
C)
Year:
0
1
2
3
4
5
Cash flow:
$7000
$3000
$3000 $3000 $3000
$3000
Cost of Capital: 8%
D)
Year:
0
1
2
3
4
5
Cash flow:
$8000
$3200
$3200 $3200 $3200
$3200
Cost of Capital: 9%
E)
Year:
0
1
2
3
4
5
Cash flow:
$7500
$3100
$3100 $3100 $3100
$3100
Cost of Capital: 8%
Answer: C
Explanation: C) NPV = $4978;
NPV(A) = $3425; NPV(B) = $4250; NPV(D) = $4447 ; NPV(E) = $4877
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
7) An investor has the opportunity to invest in four new retail stores. The amount that can be invested
in each store, along with the expected cash flow at the end of the first year, the growth rate of the
concern, and the cost of capital is shown for each case. It is assumed each investment will operate in
perpetuity after the initial investment. Which investment should the investor choose?
A) Initial investment: $100,000; Cash flow in year 1: $12,000; Growth Rate: 1.25%; Cost of Capital: 9.0%
B) Initial investment: $90,000; Cash flow in year 1: $10,000; Growth Rate: 1.50%; Cost of Capital: 9.0%
C) Initial investment: $80,000; Cash flow in year 1: $8000; Growth Rate: 1.75%; Cost of Capital:8.0%
D) Initial investment: $60,000; Cash flow in year 1: $6000; Growth Rate: 2.50%; Cost of Capital: 7.5%
E) Initial investment: $50,000; Cash flow in year 1: $5,000; Growth rate: 2.00%; Cost of Capital: 7.0%
Answer: D
Explanation: D) NPV project D= -60,000 + 6000/(0.075 - 0.025) = $60,000
NPV project A = -100,000 + 12,000/(0.09 - 0.0125) = $54,839
NPV project B = -90,000 + 10,000/(0.09 - 0.015) = $43,333
NPV project C = -80,000 + 8000/(0.08 - 0.0175) = $48,000
NPV project E = -50,000 + 5000/(0.07 - 0.02) = $50,000
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
8) The following show four mutually exclusive investments. Which is the best investment?
A) Initial investment: $1.1 million; Cash flow in year 1: $160,000; Annual Growth Rate: 2%; Cost of
Capital: 9.0%
B) Initial investment: $1.2 million; Cash flow in year 1: $150,000; Annual Growth Rate: 2%; Cost of
Capital:7.0%
C) Initial investment: $1.3 million; Cash flow in year 1: $160,000; Annual Growth Rate: 1%; Cost of
Capital: 6%
D) Initial investment: $1.4 million; Cash flow in year 1: $150,000; Annual Growth Rate: 2%; Cost of
Capital: 8%
E) Initial investment: $1.5 million; Cash flow in year 1: $160,000; Annual Growth Rate: 1.5%; Cost of
Capital: 7%
Answer: C
Explanation: C) NPV project C = -1,300,000 + 160,000 / (0.06 - 0.01) = $1,900,000
NPV project A = -1,100,000 + 160,000 / (0.09 - 0.02) = $1,185,714
NPV project B = -1,200,000 + 150,000 / (0.07 - 0.02) = $1,800,000
NPV project D = -1,400,000 + 150,000 / (0.08 - 0.02) = $1,100,000
NPV project E = -1,500,000 + 160,000 / (0.07 - 0.015) = $1,409,091
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
9) Two mutually exclusive investment opportunities require an initial investment of $5 million.
Investment A then generates $1.5 million per year in perpetuity, while investment B pays $1 million in
the first year, with cash flows increasing by 3% per year after that. At what cost of capital would an
investor regard both opportunities as being equivalent?
A) 3%
B) 6%
C) 9%
D) 10%
E) 12%
Answer: C
Explanation: C) -5 + 1.5 / r = -5 + 1 / (r - 0.03); r = 9%
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
10) Two mutually exclusive investment opportunities require an initial investment of $8 million.
Investment A then generates $1 million per year in perpetuity, while investment B pays $500,000 in the
first year, with cash flows increasing by 5% per year after that. Determine the NPV for which an
investor would regard both opportunities as being equivalent.
A) -$1 million
B) $0
C) $1 million
D) $2 million
E) $8 million
Answer: D
Explanation: D) First solve for the cost of capital: -8 + 1 / r = -8 + .5 / (r - 0.05); r = 10%;
NPV = -8 + 1/.1 = $2 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
11) A company has identified the following investments as looking promising. Each requires an initial
investment of $1.2 million. Which is the best investment?
A) a perpetuity that generates a cash flow at the end of year 1 of $100,000, has a growth rate of 1.25%,
and a cost of capital of 10%
B) a perpetuity that generates a cash flow at the end of year 1 of $800,000, has a growth rate of 2.25%,
and a cost of capital of 12%
C) an investment that generates a cash flow of $400,000 at the end of each of the next five years, when
the cost of capital is 6%
D) an investment that generates a cash flow of $200,000 at the end of each of the next ten years, when
the cost of capital is 6%
E) an investment that generates a cash flow of $200,000 at the end of each of the next ten years, when the
cost of capital is 2%
Answer: B
Explanation: B) NPV (B) = -1.2 + 0.8 / (0.12 - 0.0225) = $7.005 million
NPV (A) = -1.2 + 0.1 / (0.1 - 0.0125) = -$0.057 million
NPV (C) = using a financial calculator = $0.485 million
NPV (D) = using a financial calculator = $0.272 million
NPV (E) = using a financial calculator = $0.597 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
12)
Time:
Investment A:
Investment B:
0
-$1 million
-$1 million
1
$300,000
$500,000
2
$400,000
$400,000
3
$500,000
$300,000
An investor is considering the two investments shown above. Her cost of capital is 9%. Which of the
following statements about these investments is true?
A) The investor should take investment A since it has a greater net present value (NPV).
B) The investor should take investment A since it has a greater internal rate of return (IRR).
C) The investor should take investment B since it has a greater net present value (NPV).
D) The investor should take investment B since it has a greater internal rate of return (IRR).
E) The investor should take investment B since it has a shorter payback period.
Answer: C
Explanation: C) Using a financial calculator, NPV(A) = -$0.002 million, IRR(A) = 8.896%,
NPV(B) = $0.027, IRR(B) = 10.652%;
use NPV to decide mutually exclusive projects.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
Time:
Investment A:
Year 0
-$1.5 million
Year 1
$300,000
Year 2
$300,000
Year 3
$300,000
Year 4
$500,000
Year 5
$500,000
Investment B:
-$1.3 million
$500,000
$400,000
$300,000
$200,000
$100,000
Discount
Rate
8%
7%
13) An investor is considering the two investments shown above. Which of the following statements
about these investments is true?
A) The investor should take investment A since it has a greater net present value (NPV).
B) The investor should take investment A since it has a greater internal rate of return (IRR).
C) The investor should take investment B since it has a greater net present value (NPV).
D) The investor should take investment B since it has a greater internal rate of return (IRR).
E) Neither investment should be taken since they both have a negative net present value (NPV).
Answer: E
Explanation: E) Using a financial calculator, NPV(A) = -$0.01906 million, IRR(A) = 7.56%,
NPV(B) = -$0.014567, IRR(B) = 6.46%;
use NPV to decide mutually exclusive projects.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
14) You are trying to decide between three mutually exclusive investment opportunities. The most
appropriate tool for identifying the correct decision is
A) net present value (NPV).
B) profitability index.
C) internal rate of return (IRR).
D) incremental internal rate of return (IRR).
E) payback period.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.3 Choose between mutually exclusive alternatives
Use the table for the question(s) below.
Consider the following two projects:
Project
A
B
Year 0
Cash
Flow
-100
-73
Year 1
Cash
Flow
40
30
Year 2
Cash
Flow
50
30
Year 3
Cash
Flow
60
30
Year 4
Cash
Flow
N/A
30
Discount
Rate
0.15
0.15
15) Assume that projects A and B are mutually exclusive. The correct investment decision and the best
rationale for that decision is to
A) invest in project A, since NPVB < NPVA.
B) invest in project B, since IRRB > IRRA.
C) invest in project B, since NPVB > NPVA.
D) invest in project A, since NPVA > 0.
E) invest in project A, since IRRA > IRRB.
Answer: C
Explanation: C) NPVA = -100 + 40 / (1.15)1 + 50 / (1.15)2 + 60 / (1.15)3 = 12.04
NPVB = -73+ 30 / (1.15)1 + 30 / (1.15)2 + 30 / (1.15)3 + 30 / (1.15)4 = 12.64
IRR A
CF0 = -100
CF1 = 40
CF2 = 50
CF3 = 60
Compute IRR = 21.65%.
IRR B
CF0 = -73
CF1 = 30
CF2 = 30
CF3 = 30
CF4 = 30
Compute IRR = 23.34%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
Use the table for the question(s) below.
Consider the following two projects:
Project
Alpha
Beta
Year 0
C/F
-79
-80
Year 1
C/F
20
25
Year 2
C/F
25
25
Year 3
C/F
30
25
Year 4
C/F
35
25
Year 5
C/F
40
25
Year 6
C/F
N/A
25
Year 7
C/F
N/A
25
Discount
Rate
15%
16%
16) Assume that projects Alpha and Beta are mutually exclusive. The correct investment decision and
the best rational for that decision is to
A) invest in project Beta, since NPVBeta > 0.
B) invest in project Alpha, since NPVBeta < NPVAlpha.
C) invest in project Beta, since IRRBeta > IRRAlpha.
D) invest in project Beta, since NPVBeta > NPVAlpha > 0.
E) invest in project Alpha, since IRRAlpha > IRRBeta.
Answer: D
Explanation: D) NPV Alpha
NPV = -79 + 20 / (1.15)1 + 25 / (1.15)2 + 30 / (1.15)3 + 35 / (1.15)4 + 40 / (1.15)5 = 16.92
NPV Beta
NPV = -80 + 25 / (1.16)1 + 25 / (1.16)2 + 25 / (1.16)3 + 25 / (1.16)4 + 25 / (1.16)5 +
50 / (1.16)6 + 25 / (1.16)7 = 20.96
IRR Alpha
CF0 = -79
CF1 = 20
CF2 = 25
CF3 = 30
CF4 = 35
CF5 = 40
Compute IRR = 22.68.
IRR Beta
PV = -80
PMT = 25
FV = 0
N=7
Compute I = 24.52.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.3 Choose between mutually exclusive alternatives
17) What is a safe method to use when confronted with mutually exclusive projects?
Answer: Generally the net present value (NPV) method will give the correct decision in case of
mutually exclusive projects.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.3 Choose between mutually exclusive alternatives
18) Why is the internal rate of return (IRR) inadequate when comparing mutually exclusive investments
of different scale?
Answer: Because IRR is a return, you cannot tell how much value has actually been created without
knowing the basis for the return.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.3 Choose between mutually exclusive alternatives
19) Why is the internal rate of return (IRR) inadequate when comparing mutually exclusive investments
with different timing of the cash flows?
Answer: A high-IRR project with cash flows paid back quickly may have a lower NPV than a project
with a lower IRR whose cash flows are paid back over a longer period.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 8.3 Choose between mutually exclusive alternatives
8.5 Evaluating Projects with Different Lives
1) You can evaluate alternative projects with different lives by calculating and comparing their
equivalent annual annuity.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
2) When using equivalent annual annuities to compare the costs of projects with different lives, you
should not consider any changes in the expected replacement cost of equipment.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
3) When comparing two projects with different lives, why do you compute an annuity with an
equivalent present value (PV) to the net present value (NPV)?
A) so that you can see which project has the greatest net present value (NPV)
B) so that the projects can be compared on their cost or value created per year
C) to reduce the danger that changes in the estimate of the discount rate will lead to choosing the project
with a shorter time frame
D) to ensure that cash flows from the project with a longer life that occur after the project with the
shorter life has ended are considered
E) to avoid complications arising from alternating cash inflows and outflows
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
4) A janitorial services firm is considering two brands of industrial vacuum cleaner to equip their staff.
Option A will cost $1500, will require servicing of $200 per year, and last five years. Option B will cost
$1000, require servicing of $100 per year, and last three years. If the cost of capital is 8%, which is the
better option, given that the firm has an ongoing requirement for vacuum cleaners?
A) Option A, since it has a lower equivalent annual annuity.
B) Option B, since it has a lower equivalent annual annuity.
C) Option A, since it has a greater equivalent annual annuity.
D) Option B, since it has a greater equivalent annual annuity.
E) Both options have the same equivalent annual annuity.
Answer: D
Explanation: D) Using a financial calculator,
NPV(A) = -$2298.54 eq ann annuity (A) = -$575.68
NPV(B) = -$1257.71 eq ann annuity (A) = -$488.03
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
5) A garage is comparing the cost of buying two different car hoists. Hoist A will cost $20,000, will
require servicing of $1000 every two years, and last ten years. Hoist B will cost $15,000, require servicing
of $800 per year, and last eight years. If the cost of capital is 7%, which is the better option, given that
the firm has an ongoing requirement for a hoist?
A) Hoist A, since it has a greater present value (PV).
B) Hoist B, since it has a greater present value (PV).
C) Hoist A, since it has a greater equivalent annual annuity.
D) Hoist B, since it has a greater equivalent annual annuity.
E) Hoist A, since it has a lower equivalent annual annuity.
Answer: D
Explanation: D) Using a financial calculator,
NPV(A) = -$23,393 eq ann annuity (A) = -$3331
NPV(B) = -$19,777 eq ann annuity (A) = -$3312
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
6) A security company offers to provide CCTV coverage for a parking garage for ten years for an initial
payment of $50,000 and additional payments of $20,000 per year. What is the equivalent annual annuity
of this deal, given a cost of capital of 6%?
A) -$14,720
B) -$19,720
C) -$20,000
D) -$26,793
E) -$31,011
Answer: D
Explanation: D) Using a financial calculator,
NPV = -$197,202 eq ann annuity = -$26,793
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
7) A firm decides to purchase a 3D printer at a cost of $25,000, with an estimated useful life of 10 years.
The printer will require servicing at a cost of $1,500 per year. What is the equivalent annual annuity of
this deal, given a cost of capital of 8%?
A) $5,226
B) $4,000
C) $3,704
D) $1,500
E) $35,065
Answer: A
Explanation: A) Using a financial calculator,
NPV = -$35,065.12, eq ann annuity = -$5,226
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
8) You are looking for a car and have narrowed your choice down to two options. You can buy a new
car at a cost of $23,995, which has an estimated life of 12 years and annual maintenance costs of $750 per
year. Your second option is a used car at a cost of $14,225, with an estimated remaining life of 7 years
and annual maintenance costs of $1,800 per year. Which is the cheaper option, given your borrowing
cost of 7%?
A) The new car, since its costs have a lower PV
B) The used car, since its costs have a lower PV
C) The new car, since it has a lower equivalent annual annuity.
D) The used car, since it has a lower equivalent annual annuity.
E) The used car, since it has a higher equivalent annual annuity.
Answer: C
Explanation: C) New car NPV = -$29,952, eq ann annuity = -$3,771
Used car NPV = -$23,926, eq ann annuity = -$4,440
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
9) A lawn maintenance company compares two ride-on mowers—the Excelsior, which has an expected
working-life of six years, and the Grassassinator, which has a working life of four years. After
examining the equivalent annual annuities of each mower, the company decides to purchase the
Excelsior. Which of the following, if true, would be most likely to make them change that decision?
A) Fuel prices are expected to rise and raise the annual running costs of all mowers.
B) The mower is only expected to be needed for three years.
C) The prices of equivalent mowers are expected to grow in the future as lawnmower manufacturers
consolidate.
D) The number of customers requiring lawn-mowing services is expected to sharply increase in the near
future.
E) Mower technology is expected to improve significantly in the near future.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
10) Jenkins Security has learned that a rival has offered to supply a parking garage with security for ten
years for $50,000 up front and a further $20,000 per year. If Jenkins Security offers to provide security
for eight years for an upfront cost of $70,000 and a separate yearly payment, what is the maximum that
this yearly payment can be so that Jenkins' offer matches the equivalent annual annuity of their rival's
offer? (Assume a cost of capital of 6%.)
A) $13,095
B) $13,458
C) $13,995
D) $15,521
E) $16,112
Answer: D
Explanation: D) Using a financial calculator,
spreading $50,000 over 10 years = $6,793; thus, EAA = -26,793;
spreading $50,000 over 8 years = -$11,272.52; thus, the difference = $15,521.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
11) A consultancy calculates that it can supply crude oil assaying services to a small oil producer for
$120,000 per year for five years. There are some upfront costs the consultancy will require the oil
producer to absorb. What is the maximum that these upfront costs could be, if the equivalent annual
annuity to the oil company is to be under $150,000, given that the cost of capital is 10%?
A) $30,000
B) $113,724
C) $128,698
D) $150,000
E) $94,784
Answer: B
Explanation: B) Annual difference = $150,000 - $120,000 = $30,000; PV over 5 years at 10% = $113,724
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
8.6 Choosing Among Projects When Resources Are Limited
1) When different projects put different demands on a limited resource, then net present value (NPV) is
always the best way to choose the best project.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
2) The profitability index can break down completely when dealing with multiple resource restraints.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
3)
Project A
Project B
Project C
Project D
Initial Investment
$5 million
$3 million
$2 million
$3 million
Cash flow
$2 million per year for four years
$1 million per year for five years
$1 million per year for four years
$1.5 million per year for three years
An investor has a budget of $5 million. He can invest in the projects shown above. If the cost of capital is
6%, what investment or investments should he make?
A) Project A
B) Project B
C) Project D
D) Project B and Project C
E) Project C and Project D
Answer: D
Explanation: D)
Initial
NPV/Initial
Project
Investment
NPV
Inv
Rank Decision
A
5
1.93
0.3860
4
B
3
1.212
0.4041
2
select
C
2
1.465
0.7326
1
select
D
3
1.0095
0.3365
3
Select B and C.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
4)
Project A
Project B
Project C
Project D
Initial Investment
$7 million
$6 million
$5 million
$4 million
Cash flow
$4 million per year for three years
$3 million per year for three years
$2 million per year for six years
$1.5 million per year for eight years
An investor has a budget of $10 million. He can invest in the projects shown above. If the cost of capital
is 6%, what investment or investments should he make?
A) Project A
B) Project B
C) Project C
D) Project B and Project D
E) Project C and Project D
Answer: E
Explanation: E)
Initial
NPV/Initial
Project
Investment
NPV
Inv
Rank Decision
A
7
3.692
0.5274
3
B
6
2.019
0.3365
4
C
5
4.8346
0.9669
2
select
D
4
5.3147
1.3287
1
select
Select C and D.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
5)
Investment B:
0
$1 million
1
$500,000
2
$400,000
3
$300,000
The timeline of an investment is shown above. If the cost of capital is 5%, what is the profitability index
of this investment?
A) 0.098
B) 0.105
C) 0.256
D) 0.368
E) 0.412
Answer: A
Explanation: A) Using a financial calculator, NPV = 0.098; PI = NPV/Initial Inv = 0.098
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
6) The owner of a number of gas stations is considering installing coffee machines in his gas stations. It
will cost $280,000 to install the coffee machines, and they are expected to boost cash flows by $120,000
per year for their five-year working life. What must the cost of capital be if this investment has a
profitability index of 1?
A) 1.06%
B) 2.34%
C) 4.69%
D) 5.28%
E) 3.67%
Answer: B
Explanation: B) Using a financial calculator, PMT = 120,000, N= 5, PV = 560,000, compute I = 2.34%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
7)
Book
Prep for the College Entry Test
Prep for the Dental School Entry Test
Prep for the Grad School Entry Test
Prep for the Law School Entry Test
Prep for the Medical School Entry Test
NPV
$800,000
$250,000
$450,000
$320,000
$400,000
Number of
writers
needed
24
8
12
9
10
A company that creates education products is planning to create a suite of books to help customers
prepare for high-stakes tests for entry into college and grad school. They have 33 in-house writers to
create these books. Due to the expertise needed in creating this content it will not be possible to hire
temporary writers within the planned time-frame. Which projects should be undertaken?
A) Prep for the College Entry Test and Prep for the Law School Entry Test
B) Prep for the College Entry Test and Prep for the Grad School Entry Test
C) Prep for the Dental School Entry Test, Prep for the Grad School Entry Test, and Prep for the Medical School
Entry Test
D) Prep for the Grad School Entry Test, Prep for the Law School Entry Test, and Prep for the Medical School
Entry Test
E) Prep for the Dental School Entry Test, Prep for the Grad School Entry Test, and Prep for the Law School
Entry Test
Answer: D
Explanation: D)
Cumulative
Book
NPV
HC
NPV/HC Rank
HC
College
0.8
24
.033
3
Dental
0.25
8
0.0313
4
Grad
0.45
12
0.0375
2
22
Law
0.32
9
0.0356
3
31
Medical
0.40
10
0.04
1
10
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
8)
Outstanding Job
Job A
Job B
Job C
Job D
Job E
Hours to Print
Job
6
9
12
16
2
Penalty for not completing
job in 24 hours
-$120
-$200
-$360
-$400
-$50
A print shop has contracted to print a number of jobs within 24 hours. Any jobs not completely printed
within this time will result in a penalty, as shown in the table above. However too many jobs have been
accepted, and not all can be printed. Which jobs should be printed in the next 24 hours?
A) Job D and Job A
B) Job C and Job B
C) Job C, Job B, and Job E
D) Job D, Job A, and Job E
E) Job C, Job D, and Job E
Answer: C
Explanation: C)
Cumulative
Job
Hours
Penalty
Penalty/HR
Rank
Hours
A
6
-120
-20
B
9
-200
-22
3
23
C
12
-360
-30
1
12
D
16
-400
-25
E
2
-50
-25
2
14
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
9)
Department
Pet
Fabrics
Book
Luggage
Hardware
Watches
Shoe Repair
Yearly Profit
$600,000
$1,000,000
$320,000
$360,000
$900,000
$300,000
$30,000
Space Required
(square feet)
6000
7000
4000
3000
6000
2000
1000
A small department store in a mall has the opportunity to rent an additional 20,000 square feet of space
for five years. It can divide up this space between the above new departments. Each department will
require a different amount of space, and each department is expected to make a yearly profit as shown,
for each of the next five years. The discount rate is 10%. Based on this information, what departments
should be added?
A) Pet, Fabrics, Hardware, and Shoe Repair
B) Fabrics, Luggage, Hardware, Watches, and Shoe Repair
C) Pets, Fabrics, Book, and Luggage
D) Pet, Fabrics, Luggage, Hardware, and Shoe Repair
E) Fabrics, Book, Luggage and Shoe Repair
Answer: B
Explanation: B)
Cumulative
Dept
Profit Space Profit/Space Rank Space
Pet
0.6
6
0.1
Fabrics
1.0
7
0.1429
2
15
Book
0.32
4
0.08
Luggage
0.36
3
0.12
3
18
Hardware
0.9
6
0.15
1
6
Watches
0.3
2
0.15
1
8
Shoe Repair
0.03
1
0.03
4
19
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
10)
Project
I
II
III
IV
V
Capital Investment
$7 million
$12 million
$16 million
$10 million
$11 million
Cash Flows from Investment
$1.2 million per year in perpetuity
$1.5 million per year in perpetuity
$2.2 million per year in perpetuity
$1.4 million per year in perpetuity
$1.6 million per year in perpetuity
A company has four projects it wishes to undertake. Which of these investments should be the lowest
priority, given a discount rate of 5%?
A) Project I
B) Project II
C) Project III
D) Project IV
E) Project V
Answer: B
Explanation: B)
NPV of
Cash
Project
Investment
Inflows
NPV/Investm Rank
I
7
24
3.43
1
II
12
30
2.5
5
III
16
44
2.75
4
IV
10
28
2.8
3
V
11
32
2.9
2
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
11) You are opening up a brand new retail strip mall. You presently have more potential retail outlets
wanting to locate in your mall than you have space available. What is the most appropriate tool to use if
you are trying to determine the optimal allocation of your retail space?
A) internal rate of return (IRR)
B) payback period
C) net present value (NPV)
D) profitability index
E) discounted payback period
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
Use the table for the question(s) below.
Consider a project with the following cash flows:
Year
0
1
2
3
4
Cash
Flow
-10,000
4000
4000
4000
4000
12) Assume the appropriate discount rate for this project is 15%. The profitability index for this project
is closest to:
A) 0.14
B) 0.22
C) 0.60
D) 0.15
E) 0.31
Answer: A
Explanation: A) NPV = -10,000 +
+
+
+
= $1420
PI = NPV / investment = 1420 / 10,000 = 0.1420
Diff: 1 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
the table for the question(s) below.
Use the table for the question(s) below.
Consider the following two projects:
Project
A
B
Year 0
Cash
Flow
-100
-73
Year 1
Cash
Flow
40
30
Year 2
Cash
Flow
50
30
Year 3
Cash
Flow
60
30
Year 4
Cash
Flow
N/A
30
Discount
Rate
0.15
0.15
13) The profitability index for project A is closest to:
A) 0.12
B) 21.65
C) 0.17
D) 12.04
E) 1.14
Answer: A
Explanation: A) PI = NPV / Investment (or resources consumed)
NPV = -100 + 40 / (1.15)1 + 50 / (1.15)2 + 60 / (1.15)3 = 12.04
So, PI = 12.04 / 100 = 0.1204
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
14) The profitability index for project B is closest to:
A) 23.34
B) 12.64
C) 0.17
D) 0.12
E) 1.14
Answer: C
Explanation: C) PI = NPV / Investment (or resources consumed)
NPV = -73 + 30 / (1.15)1 + 30 / (1.15)2 + 30 / (1.15)3 + 30 / (1.15)4 = 12.64
So, PI = 12.64 / 73 = 0.1732
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
Use the table for the question(s) below.
Consider the following list of projects:
Project
A
B
C
D
E
F
G
H
I
Investment
135,000
200,000
125,000
150,000
175,000
75,000
80,000
200,000
50,000
NPV
6,000
30,000
20,000
2,000
10,000
10,000
9,000
20,000
4,000
15) Assuming that your capital is constrained, which investment tool should you use to determine the
correct investment decisions?
A) profitability index
B) incremental IRR
C) net present value (NPV)
D) internal rate of return (IRR)
E) payback period
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
16) Assuming that your capital is constrained, which project should you invest in first?
A) Project C
B) Project G
C) Project B
D) Project F
E) Project H
Answer: A
Explanation: A)
Project
A
B
C
D
E
F
G
H
I
Investment
135,000
200,000
125,000
150,000
175,000
75,000
80,000
200,000
50,000
NPV
6,000
30,000
20,000
2,000
10,000
10,000
9,000
20,000
4,000
Profitability
Index
0.0444
0.1500
0.1600
0.0133
0.0571
0.1333
0.1125
0.1000
0.8000
Rank
8
2
1
9
7
3
4
5
6
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
17) Assuming that your capital is constrained, what is the fifth project that you should invest in?
A) Project H
B) Project I
C) Project B
D) Project A
E) Project C
Answer: A
Explanation: A)
Project
A
B
C
D
E
F
G
H
I
Investment
135,000
200,000
125,000
150,000
175,000
75,000
80,000
200,000
50,000
NPV
6,000
30,000
20,000
2,000
10,000
10,000
9,000
20,000
4,000
Profitability
Index
0.0444
0.1500
0.1600
0.0133
0.0571
0.1333
0.1125
0.1000
0.8000
Rank
8
2
1
9
7
3
4
5
6
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
18) Assuming that your capital is constrained, which project should you invest in last?
A) Project A
B) Project I
C) Project D
D) Project C
E) Project E
Answer: C
Explanation: C)
Project
A
B
C
D
E
F
G
H
I
Investment
135,000
200,000
125,000
150,000
175,000
75,000
80,000
200,000
50,000
NPV
6,000
30,000
20,000
2,000
10,000
10,000
9,000
20,000
4,000
Profitability
Index
0.0444
0.1500
0.1600
0.0133
0.0571
0.1333
0.1125
0.1000
0.8000
Rank
8
2
1
9
7
3
4
5
6
Diff: 2 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
19) Assuming that your capital is constrained, so that you only have $600,000 available to invest in
projects, which project should you invest in and in what order?
A) CBFH
B) CBGF
C) BCFG
D) CBFG
E) CBGH
Answer: A
Explanation: A)
Project
A
B
C
D
E
F
G
H
I
Investment
135,000
200,000
125,000
150,000
175,000
75,000
80,000
200,000
50,000
NPV
6,000
30,000
20,000
2,000
10,000
10,000
9,000
20,000
4,000
Profitability
Index
0.0444
0.1500
0.1600
0.0133
0.0571
0.1333
0.1125
0.1000
0.8000
Rank
8
2
1
9
7
3
4
5
6
This is a tricky problem in that, by the rankings, CBFG seem optimal, but this combination leaves
$120,000 on the table uninvested. By replacing G with H, the full $600,000 is invested and the NPV of
the combination of projects is increased by $11,000. Therefore you should invest in projects C, B, F, and
H.
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
20) Assume that your capital is constrained, so that you only have $600,000 available to invest in
projects. If you invest in the optimal combination of projects given your capital constraint, then the total
net present value (NPV) for all the projects you invest in will be closest to:
A) $65,000
B) $80,000
C) $69,000
D) $111,000
E) $70,000
Answer: B
Explanation: B)
Project
A
B
C
D
E
F
G
H
I
Investment
135,000
200,000
125,000
150,000
175,000
75,000
80,000
200,000
50,000
NPV
6,000
30,000
20,000
2,000
10,000
10,000
9,000
20,000
4,000
Profitability
Index
0.0444
0.1500
0.1600
0.0133
0.0571
0.1333
0.1125
0.1000
0.8000
Rank
8
2
1
9
7
3
4
5
6
This is a tricky problem in that, by the rankings, CBFG seem optimal, but this combination leaves
$120,000 on the table uninvested. By replacing G with H, the full $600,000 is invested and the NPV of
the combination of projects is increased by $11,000. Therefore you should invest in projects C, B, F, and
H.
NPV = NPVC + NPVB + NPVF + NPVH = 20,000 + 30,000 + 10,000 + 20,000 = $80,000
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
21) Assume that your capital is constrained, so that you only have $500,000 available to invest in
projects. If you invest in the optimal combination of projects given your capital constraint, then the total
net present value (NPV) for all the projects you invest in will be closest to:
A) $111,000
B) $69,000
C) $80,000
D) $58.000
E) $90,000
Answer: B
Explanation: B)
Project
A
B
C
D
E
F
G
H
I
Investment
135,000
200,000
125,000
150,000
175,000
75,000
80,000
200,000
50,000
NPV
6,000
30,000
20,000
2,000
10,000
10,000
9,000
20,000
4,000
Profitability
Index
0.0444
0.1500
0.1600
0.0133
0.0571
0.1333
0.1125
0.1000
0.8000
Rank
8
2
1
9
7
3
4
5
6
The optimal combination based upon PI rankings is CBFG, so the total
NPV = 20,000 + 30,000 + 10,000 + 9000 = $69,000
Diff: 3 Type: MC
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
Use the information for the question(s) below.
Your firm is preparing to open a new retail strip mall and you have multiple businesses that would like
lease space in it. Each business will pay a fixed amount of rent each month plus a percentage of the
gross sales generated each month. The cash flows from each of the businesses has approximately the
same amount of risk. The business names, square footage requirements, and monthly expected cash
flows for each of the businesses that would like to lease space in your strip mall are provided below:
Square Feet
Business Name
Required
Videos Now
4,000
Gords Gym
3,500
Pizza Warehouse
2,500
Super Clips
1,500
30 1/2 Flavors
1,500
S-Mart
12,000
WalVerde Drugs
6,000
Multigular Wireless
1,000
Expected
Monthly Cash
Flow
70,000
52,500
52,500
25,500
28,500
180,000
147,000
22,250
22) If your new strip mall will have 15,000 square feet of retail space available to be leased, to which
businesses should you lease and why?
Answer:
Expected
Square Feet
Monthly Cash
C/F per Project
Business Name
Required
Flow
S.F.
Rank
Videos Now
4,000
70,000
17.5
5
Gords Gym
3,500
52,500
15
7
Pizza Warehouse
2,500
52,500
21
3
Super Clips
1,500
25,500
17
6
30 1/2 Flavors
1,500
28,500
19
4
S-Mart
12,000
180,000
15
8
WalVerde Drugs
6,000
147,000
24.5
1
Multigular Wireless
1,000
22,250
22.25
2
So we select projects based upon their ranking until we run out of space. The optimal combination is
shown below:
WalVerde Drugs
Multigular Wireless
Pizza Warehouse
30 1/2 Flavors
Videos Now
Total
6,000
1,000
2,500
1,500
4,000
15,000
147,000
22,250
52,500
28,500
70,000
$320,250
24.5
22.25
21
19
17.5
1
2
3
4
5
Diff: 3 Type: ES
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
23) If your new strip mall will have 16,000 square feet of retail space available to be leased, to which
businesses should you lease and why?
Answer:
Expected
Square Feet
Monthly Cash
C/F per Project
Business Name
Required
Flow
S.F.
Rank
Videos Now
4,000
70,000
17.5
5
Gords Gym
3,500
52,500
15
7
Pizza Warehouse
2,500
52,500
21
3
Super Clips
1,500
25,500
17
6
30 1/2 Flavors
1,500
28,500
19
4
S-Mart
12,000
180,000
15
8
WalVerde Drugs
6,000
147,000
24.5
1
Multigular Wireless
1,000
22,250
22.25
2
So we select projects based upon their ranking until we run out of space. This combination is shown
below:
WalVerde Drugs
Multigular Wireless
Pizza Warehouse
30 1/2 Flavors
Videos Now
Total
6,000
1,000
2,500
1,500
4,000
15,000
147,000
22,250
52,500
28,500
70,000
$320,250
24.5
22.25
21
19
17.5
1
2
3
4
5
But notice that this combination leaves 1,000 square feet unleased. We therefore should look to see if
there is a combination that leases more space and offers a higher monthly cash flow. If we forgo renting
to Videos Now and instead rent to both Super Clips and Gords Gym, we will obtain a higher monthly
cash flow. The optimal combination is shown below:
WalVerde Drugs
Multigular Wireless
Pizza Warehouse
30 1/2 Flavors
Super Clips
Gords Gym
Total
6,000
1,000
2,500
1,500
1,500
3,500
16,000
147,000
22,250
52,500
28,500
25,500
52,500
$328,250
24.5
22.25
21
19
17
15
1
2
3
4
6
7
Diff: 3 Type: ES
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
24) Consider the following list of projects:
Project
A
B
C
D
E
F
G
H
I
J
Investment
405,000
600,000
375,000
450,000
525,000
225,000
240,000
600,000
150,000
270,000
NPV
18,000
90,000
60,000
6,000
30,000
30,000
27,000
60,000
12,000
30,000
You are given a budget of only $1,800,000 to invest in projects. Which projects will you select, in what
order will you select them, and why?
Answer:
Project
Investment
NPV
PI
Rank
A
405,000
18,000
0.0444
9
B
600,000
90,000
0.1500
2
C
375,000
60,000
0.1600
1
D
450,000
6,000
0.0133
10
E
525,000
30,000
0.0571
8
F
225,000
30,000
0.1333
3
G
240,000
27,000
0.1125
4
H
600,000
60,000
0.1000
6
I
150,000
12,000
0.0800
7
J
270,000
30,000
0.1111
5
Beginning
1,800,000
1,425,000
825,000
300,000
Project
C
B
F
J
Cost
375,000
600,000
525,000
270,000
Ending
1,425,000
825,000
300,000
30,000
Normally we would want to take projects C, B, F, and G. However, we can do better by dumping G and
taking J instead. Allow it has a lower profitability index, it has a higher net present value (NPV) and
allows more capital to be invested.
Diff: 3 Type: ES
Skill: Analytical
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
8.7 Putting It All Together
1) Net present value (NPV) is usefully supplemented by internal rate of return (IRR), since IRR gives a
good indication of the sensitivity of any decision made to changes in the discount rate.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
2) When an alternative decision rule disagrees with the net present value (NPV), the NPV should be
followed.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
3) Which of the following best describes the Net Present Value rule?
A) Take any investment opportunity where the net present value (NPV) is not negative; turn down any
opportunity when it is negative.
B) Take any investment opportunity where the net present value (NPV) exceeds the opportunity cost of
capital; turn down any opportunity where the cost of capital exceeds the net present value (NPV).
C) When choosing among any list of investment opportunities where resources are limited, always
choose those projects with the highest net present value (NPV).
D) If the difference between the present cost of an investment and the present value (PV) of its benefits
after a fixed number of years is positive the investment should be taken, otherwise it should be rejected.
E) If the NPV is positive and the initial investment will be recovered within a certain time period, the
investment should be taken.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
4) Which of the following is a disadvantage of the Net Present Value rule?
A) Can be misleading if inflows come before outflows
B) Not necessarily consistent with maximizing shareholder wealth
C) Ignores cash flows after the cutoff point
D) Relies on accurate estimate of the discount rate
E) Often an incorrect decision will result
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
5) Which of the following decision rules is best defined as the amount of time it takes to pay back the
initial investment?
A) internal rate of return (IRR)
B) profitability index
C) net present value (NPV)
D) payback period
E) incremental IRR
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
6) Which of the following decision rules might best be used as a supplement to net present value (NPV)
by a firm that favours liquidity?
A) profitability index
B) IRR
C) equivalent annual annuity
D) payback period
E) incremental IRR
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
7) Which of the following is true regarding the profitability index?
A) It does not use the net present value (NPV) to assess benefits.
B) It is very simple to compute.
C) Attention must be taken when using it to make sure that all of the constrained resource is utilized.
D) It is unreliable when used for choosing between different projects.
E) It ignores cash flows after the cutoff
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
8) A firm is considering several mutually exclusive investment opportunities. The best way to choose
between them is which of the following?
A) profitability index
B) payback period
C) net present value (NPV)
D) internal rate of return (IRR)
E) discounted payback period
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 8.4 Rank projects when a company's resources are limited so that it cannot take all positive-NPV projects
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 9 Fundamentals of Capital Budgeting
9.1 The Capital Budgeting Process
1) Capital budgeting is the process of allocating funds to the firm's investment projects.
Answer: FALSE
Diff: 1 Type: TF
Skill: Definition
Objective: 9.1 Identify the types of cash flows needed in the capital budgeting process
2) The ultimate goal of capital budgeting is to determine the effect of a project on the firm's cash flows
and the consequences of accepting or rejecting a project for the firm's value.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.1 Identify the types of cash flows needed in the capital budgeting process
3) How does the capital budgeting process begin?
A) by analyzing alternate projects
B) by evaluating the net present value (NPV) of each project's cash flows
C) by compiling a list of potential projects
D) by forecasting the future consequences for the firm of each potential project
E) by calculating the incremental earnings of a project
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.1 Identify the types of cash flows needed in the capital budgeting process
4) What is the ultimate goal of the capital budgeting process?
A) to determine how the consequences of making a particular decision affects the firms revenues and
costs
B) to list the projects and investments that a company plans to undertake in the future
C) to forecast the consequences of a list of future projects to the firm
D) to determine the effect of the decision to accept or reject a project on the firms cash flows
E) to calculate the incremental earnings of a project
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.1 Identify the types of cash flows needed in the capital budgeting process
5) Which of the following best defines incremental earnings?
A) cash flows arising from a particular investment decision
B) the amount by which a firm's earnings are expected to change as the result of an investment decision
C) the earnings arising from all projects that a company plans to undertake in a fixed timespan
D) the net present value (NPV) of earnings that a firm is expected to receive as the result of an
investment decision
E) the increase in cash flows resulting from a new product
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.1 Identify the types of cash flows needed in the capital budgeting process
6) Which of the following best describes why the predicted incremental earnings arising from a given
decision are not sufficient in and of themselves to determine whether that decision is worthwhile?
A) They do not tell how the decision affects the firm's reported profits from an accounting perspective.
B) They are not easily predicted from historical financial statements of a firm and its competitors.
C) These earnings are not actual cash flows.
D) They do not show how the firm's earnings are expected to change as the result of a particular
decision.
E) They do not tell us how profits change from an accounting perspective.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.1 Identify the types of cash flows needed in the capital budgeting process
7) What is the ultimate goal of capital budgeting?
Answer: The ultimate goal of capital budgeting is to determine the effect of the decision to accept or
reject a project on the firm's cash flows, and evaluate the NPV of these cash flows to assess the
consequences of the decision for the firm's value.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.1 Identify the types of cash flows needed in the capital budgeting process
9.2 Forecasting Incremental Earnings
1) When evaluating the effectiveness of an improved manufacturing process we should evaluate the
total sales and costs generated by this process.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
2) Interest and other financing-related expenses are excluded when determining a project's unlevered
net income.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
3) The capital cost allowance (CCA) is only used for financial reporting purposes, and usually not for
tax purposes.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
4) Cameron Industries is purchasing a new chemical vapour depositor in order to make silicon chips. It
will cost $6 million to buy the machine and $10,000 to have it delivered and installed. Building a clean
room in the plant for the machine will cost an additional $3 million. The machine is expected to have a
working life of six years. Which of these activities will be reported as an operating expense?
A) the delivery and install cost only
B) the cost of the depositor only
C) the redesign of the plant only
D) the delivery and install cost and the cost of the depositor
E) the install cost only
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
5) Longbow Lumber is purchasing a new horizontal resaw at a cost of $450,000. There is an additional
$15,000 delivery and installation cost. The machine has a capital cost allowance (CCA) rate of 25%. What
is the incremental undepreciated capital cost (UCC) for year 1?
A) $232,500
B) $450,000
C) $225,000
D) $465,000
E) $435,000
Answer: A
Explanation: A) UCC1 = 0.5 × CapEx = 0.5 × (450,000 + 15,000) = $232,500
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
6) Longbow Lumber is purchasing a new horizontal resaw at a cost of $375,000. There is an additional
$10,000 delivery and installation cost. The machine has a capital cost allowance (CCA) rate of 20%. What
is the incremental undepreciated capital cost (UCC) for year 2?
A) $375,000
B) $337,500
C) $385,000
D) $346,500
E) $192,500
Answer: D
Explanation: D) Calculate UCC1 = 0.5 × CapEx = 0.5 × (375,000 + 10,000) = $192,500;
Then calculate CCA1 = UCC1 × d = (192,500 × 0.20) =$38,500
UCC2 = 0.5 × CapEx + UCC1 - CCA1 = 192,500 + 192,500 - 38,500 = $346,500
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
7) Longbow Lumber is purchasing a new horizontal resaw at a cost of $390,000. There is an additional
$20,000 delivery and installation cost. The machine has a capital cost allowance (CCA) rate of 15%. What
will be the CCA deduction for year 1?
A) $195,000
B) $205,000
C) $61,500
D) $29,250
E) $30,750
Answer: E
Explanation: E) Calculate UCC1 = 0.5 × CapEx = 0.5 × (390,000 + 20,000) = $205,000;
Then calculate CCA1 = UCC1 × d = (205,000 × 0.15) = $30,750
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
8) Athabasca Ag is purchasing 1,000 grain bins at a cost of $40,000 each. Each bin also has a $5,000
delivery and installation cost, and the bins have a capital cost allowance (CCA) rate of 25%. What is the
total incremental undepreciated capital cost (UCC) for year 1?
A) $40 million
B) $45 million
C) $22.5 million
D) $20 million
E) $15 million
Answer: C
Explanation: C) UCC1 = 0.5 × CapEx = 0.5 × (1,000 × 45,000) = $22.5 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
9) Athabasca Ag is purchasing 1,000 grain bins at a cost of $40,000 each. Each bin also has a $5,000
delivery and installation cost, and the bins have a capital cost allowance (CCA) rate of 25%. What will
be the CCA deduction for year 1?
A) $11,250,000
B) $5,625,000
C) $5,000,000
D) $10,000,000
E) $7,750,000
Answer: B
Explanation: B) UCC1 = 0.5 × CapEx = 0.5 × (1,000 × 45,000) = $22.5 million
CCA1 = UCC1 × d = (22,500,000 × 0.25) = $5,625,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
10) Athabasca Ag is purchasing 1,000 grain bins at a cost of $40,000 each. Each bin also has a $5,000
delivery and installation cost, and the bins have a capital cost allowance (CCA) rate of 25%. What will
be the incremental undepreciated capital cost (UCC) for year 2?
A) $39,375,000
B) $45,000,000
C) $16,875,000
D) $22,500,000
E) $5,625,000
Answer: A
Explanation: A) UCC1 = 0.5 × CapEx = 0.5 × (1,000 × 45,000) = $22.5 million
CCA1 = UCC1 × d = (22,500,000 × 0.25) = $5,625,000
UCC2 = 0.5 × CapEx + UCC1 - CCA1 = $22.5 million + $22.5 million - $5,625,000 = $39,375,000
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
11) A small manufacturer that makes clothespins and other household products buys new injection
moulding equipment for a cost of $500,000. This will allow the manufacturer to make more clothespins
in the same amount of time with an estimated increase in sales of 15%. If the manufacturer currently
makes 75 tons of clothespins per year, which sell at $18,000 per ton, what will be the increase in revenue
next year from the new equipment?
A) $20,700
B) $80,500
C) $202,500
D) $857,000
E) $1,350,000
Answer: C
Explanation: C) Incremental revenue = 0.15 × 75 × 18,000 = $202,500
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
12) A brewer is launching a new product:: brewed ginger ale with a low alcohol content. The brewer
plans to spend $4 million promoting this product this year, which is expected to expand its sales of this
product to $10 million this year and $8 million next year. They do expect there will be loss of sales of $1
million this year and next year in their other products as customers switch to drinking the new ginger
ale. The gross profit margin for the new ginger ale is 40%, the gross profit margin of all of the brewer's
other products is 30%, and the brewer's marginal corporate tax rate is 35%. What are incremental
earnings arising from the promotional campaign this year?
A) $1.95 million
B) $4.290 million
C) $4.68 million
D) $5.28 million
E) $8.00 million
Answer: A
Explanation: A) 10 - 4 - 1 = 5; 5 × 0.6 = 3; 3 × 0.65 = $1.95 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
13) A stationery company plans to launch a new type of indelible ink pen. Advertising for the new
product will be heavy and will cost the company $10 million, although the company expects general
revenues of $280 million next year from sources other than sales of the new pen. If the company has a
corporate tax of 40% on its pretax income, what effect will the advertising for the new pen have on its
taxes?
A) increase taxes by $10 million
B) increase taxes by $4 million
C) It will have no effect on taxes.
D) reduce taxes by $4 million
E) reduce taxes by $10 million
Answer: D
Explanation: D) 10 × 0.4 = $4 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
Use the information for the question(s) below.
Ford Motor Company is considering launching a new line of hybrid diesel-electric SUVs. The heavy
advertising expenses associated with the new SUV launch would generate operating losses of $35
million next year. Without the new SUV, Ford expects to earn pretax income of $80 million from
operations next year. Ford pays a 30% tax rate on its pretax income.
14) The amount that Ford Motor Company owes in taxes next year without the launch of the new SUV
is closest to:
A) $24.0 million
B) $56.0 million
C) $31.5 million
D) $13.5 million
E) $10.5 million
Answer: A
Explanation: A) $80 × 0.30 = $24 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
15) The amount that Ford Motor Company owes in taxes next year with the launch of the new SUV is
closest to:
A) $13.5 million
B) $31.5 million
C) $56.0 million
D) $24.0 million
E) $10.5 million
Answer: A
Explanation: A) (80 - 35) × 0.30 = 13.5 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
16) Why does capital budgeting focus on incremental revenues and costs, instead of the projected total
revenues and costs of the firm?
Answer: Since the goal is to evaluate how the project will change the cash flows of the firm, we must
ignore any sales and costs that are using existing firm resources.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
17) How do we handle interest expense when making a capital budgeting decision?
Answer: We do not generally include interest expense when making capital budgeting decisions.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
18) Why does the Canada Revenue Agency (CRA) have a half-year rule for capital cost allowance (CCA)
calculations?
Answer: The half-year rule is meant to compensate for the fact that sometimes assets are bought at the
beginning of the year and other times they are bought at the end of the year.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.2 Forecast incremental earnings in a pro forma earnings statement for a project
9.3 Determining Incremental Free Cash Flow
1) To evaluate a capital budgeting decision, it is sufficient to determine its consequences for the firms
earnings.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
2) The cash flow effect from a change in Net Working Capital is always equal in size and opposite in
sign to the changes in Net Working Capital.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
3) An announcement by the government that they will decrease corporate marginal tax rates in the
future would increase the capital cost allowance (CCA) tax shield.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
4) Athabasca Ag is purchasing 1,000 grain bins at a cost of $40,000 each. Each bin also has a $5,000
delivery and installation cost, and the bins have a capital cost allowance (CCA) rate of 25%. The bins are
expected to increase gross profit by $12 million per year, starting at the end of the first year, with annual
associated costs of $1.5 million per year. Athabasca has a marginal tax rate of 30%. What are the
incremental free cash flows associated with the new bins in year 2?
A) $7.35 million
B) $10.3 million
C) $9.04 million
D) $12 million
E) $9.5 million
Answer: B
Explanation: B) UCC1 = 0.5 × CapEx = 0.5 × (1,000 × 45,000) = $22.5 million
CCA1 = UCC1 × d = (22,500,000 × 0.25) = $5,625,000
UCC2 = $22.5 million + $22.5 million - $5.625 million = $39.375 million; CCA 2 = 39.375 × 0.25 = 9.84 million;
12 - 1.5 - 9.84 = 0.66 million;
0.66 million × 0.7 = 462,000; add back CCA to get $10.3 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
5) Athabasca Ag is purchasing 1,000 grain bins at a cost of $40,000 each. Each bin also has a $5,000
delivery and installation cost, and the bins have a capital cost allowance (CCA) rate of 25%. The bins are
expected to increase gross profit by $12 million per year, starting at the end of the first year, with annual
associated costs of $1.5 million per year. Athabasca has a marginal tax rate of 30%. What are the
incremental free cash flows associated with the new bins in year 1?
A) -34.5 million
B) -$32.8 million
C) -$45 million
D) -$43.3 million
E) -$22.5 million
Answer: D
Explanation: D) UCC1 = 0.5 × CapEx = 0.5 × (1,000 × 45,000) = $22.5 million
CCA1 = UCC1 × d = (22,500,000 × 0.25) = $5,625,000
CCA Tax shield = 5.625 million × 0.30 = 1,687,500
-45,000 × 1,000 + 1,687,500 = -$43.3 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
Use the information for the question(s) below.
The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an
estimated life of three years. The cost of the machine is $30,000 and the machine falls under asset class
43 and has a capital cost allowance (CCA) rate of 30%.
The cane manufacturing machine will result in sales of 2000 canes in year 1. Sales are estimated to grow
by 10% per year each year through year 3. The price per cane that Sisyphean will charge its customers is
$18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will require an increase
in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2%
of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in
inventory, and 5% of its annual sales in accounts payable. The firm is in the 35% tax bracket and has a
cost of capital of 10%.
6) The CCA tax shield for the Sisyphean Corporation's project in the first year is closest to:
A) $8000
B) $1575
C) $2800
D) $5200
E) $4500
Answer: B
Explanation: B) UCC1 = 30,000 × 0.5 = 15,000; CCA1 = 15,000 × 0.3 = 4,500;
CCA tax shield = 4,500 × 0.35 = $1575
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
7) The CCA tax shield for the Sisyphean Corporation's project in the second year is closest to:
A) $4230
B) $3150
C) $7650
D) $1575
E) $2678
Answer: E
Explanation: E) UCC1 = 30,000 × 0.5 = 15,000; CCA1 = 15,000 × 0.3 = 4,500;
UCC2 = 15,000 + 15,000 - 4500 = 25,500; CCA1 = 25,500 × 0.3 = 7,650;
CCA tax shield = 7,650 × 0.35 = $2678
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
8) Which of the following formulas will correctly calculate Net Working Capital?
A) Cash + Inventory + Receivables + Payables
B) Cash + Inventory + Receivables - Payables
C) Cash + Inventory - Receivables + Payables
D) Cash - Inventory + Receivables + Payables
E) Cash - Inventory + Receivables - Payables
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
9) CathFoods will release a new range of candies which contain antioxidants. New equipment to
manufacture the candy will cost $2 million. The new equipment falls under asset class 43 and has a
capital cost allowance (CCA) rate of 30%. It is expected that the range of candies will bring in revenues
of $4 million per year for five years with production and support costs of $1.5 million per year. If
CathFood's marginal tax rate is 35%, what are the incremental free cash flows in the first year of this
project?
A) -$0.27 million
B) $1.43 million
C) $1.46 million
D) $2.50 million
E) $4.0 million
Answer: A
Explanation: A) UCC1 = 2 × 0.5 = 1. CCA1 = 1 × 0.3 = 0.3;
earnings = 4 - 1.5 - 0.3 = 2.2;
earnings after tax = 2.2 × 0.65 = 1.43;
add back CCA, subtract CapEx = 1.43 + 0.3 - 2 = -0.27 million.
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
Use the table for the question(s) below.
Balance Sheet
Assets
Current Assets
Cash
Accounts receivable
Inventories
Total current assets
50
22
17
89
Liabilities
Current Liabilities
Accounts payable
Total current liabilities
42
42
Long-Term Assets
Net property, plant, and
equipment
Total long-term assets
Long-Term Liabilities
121
121
Long-term debt
Total long-term liabilities
128
128
Total Assets
210
Total Liabilities
Stockholders Equity
Total Liabilities and
Stockholders Equity
170
40
210
10) The balance sheet for a small firm is shown above. All amounts are in thousands of dollars. What is
this firm's Net Working Capital?
A) $30,000
B) $40,000
C) $47,000
D) $89,000
E) $42,000
Answer: C
Explanation: C) Current assets - current liabilities = $89,000 - $42,000 = $47,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
11) A firm reports that in a certain year it had unlevered net income of $4.5 million, a capital cost
allowance (CCA) deduction of $2.8 million, capital expenditures of $2.3 million, and net working capital
decreased by $1.5 million. What is the firm's free cash flow for that year?
A) $2.4 million
B) $6.5 million
C) $8.1 million
D) $11.1 million
E) $5.5 million
Answer: B
Explanation: B) 4.5 + 2.8 - 2.3 + 1.5 = $6.5 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
12) A firm reports that in a certain year it had revenues of $4.5 million, costs of $1.2 million, a capital
cost allowance (CCA) deduction of $2.8 million, capital expenditures of $2.3 million, and net working
capital decreased by $1.5 million. If the firm's marginal corporate tax rate is 30%, what is the firm's free
cash flow for that year?
A) $5.3 million
B) -$0.65 million
C) $1.75 million
D) $2.15 million
E) $2.35 million
Answer: E
Explanation: E) (4.5 - 1.2 - 2.8) × (1 - .30) + 2.8 - 2.3 + 1.5 = $2.35 million
Diff: 2 Type: MC
Skill: Conceptual
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
13) A company buys tracking software for its warehouse which, along with the computer system and
ancillaries to run it, will cost $1.8 million. The new equipment and software falls under asset class 50
and has a capital cost allowance (CCA) rate of 55%. It is expected that the software will reduce
inventory by $10.5 million at the end of the first year after it is installed, though there will be an annual
cost of $120,000 per year to run the system. If the company's marginal tax rate is 40%, how will the
purchase of this item change the company's free cash flows in the first year?
A) $10,020,000
B) $10,278,000
C) $10,422,000
D) $10,566,000
E) $10,578,000
Answer: E
Explanation: E) UCC = 1.8 × 0.5 = 0.9; CCA = 0.9 × 0.55 = 0.495
10.5 - 0.12 + 0.4 × 0.495 = $10.578 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
14)
Year 0
Revenues
Costs of Goods Sold
Gross Profit
Selling, General and
Admin
Capital Cost
Allowance
EBIT
Income tax (35%)
Incremental Earnings
Capital Purchases
Changes to NWC
Year 1
800,000
-320,000
480,000
Year 2
800,000
-320,000
480,000
Year 3
800,000
-320,000
480,000
-105,000
-105,000
-105,000
-150,000
225,000
-78,750
146,250
-225,000
150,000
-52,500
97,500
-112,500
262,500
-91,875
170,625
-12,000
-12,000
-12,000
-600,000
Cromwell Industries is considering a new project which will have costs, revenues, etc. as shown by the
data above. If the cost of capital is 8.5%, what is the net present value (NPV) of this project?
A) -$278,832
B) -$153,046
C) $199,300
D) $300,691
E) $313,154
Answer: C
Explanation: C) CF0 = -600,000
CF1 = 146,250 + 150,000 + 12,000 = 308,250;
CF2 = 97,500 + 225,000 + 12,000 = 334,500;
CF3 = 170,625 + 112,500 + 12,000 = 295,125;
calculate NPV at 8.5% = $199,300.
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
15)
Year 0
Revenues
Costs of Goods Sold
Gross Profit
Selling, General and
Admin
Capital Cost
Allowance
EBIT
Income tax (35%)
Incremental Earnings
Capital Purchases
Changes to NWC
Year 1
120,000
-60,000
60,000
Year 2
400,000
-200,000
200,000
Year 3
400,000
-200,000
200,000
Year 4
300,000
-150,000
150,000
-6,000
-6,000
-6,000
-6,000
-42,000
12,000
-4,200
7,800
-71,400
122,600
-42,910
79,690
-49,980
144,020
-50,407
93,613
-34,986
109,014
-38,155
70,859
-5,000
-5,000
-5,000
-5,000
-280,000
A garage is installing a new "bubble-wash" car wash. It will promote the car wash as a fun activity for
the family, and it is expected that the novelty of this approach will boost sales in the medium term. If
the cost of capital is 10%, what is the net present value (NPV) of this project?
A) -$214,525
B) -$145,283
C) $76,607
D) $108,306
E) $86,167
Answer: E
Explanation: E) CF0 = -280,000
CF1 = 7,800 + 42,000 + 5000 = 54,800;
CF2 = 79,690 + 71,400 + 5000 = 156,090;
CF3 = 93,613 + 49,980 + 5000 = 148,593;
CF4 = 70,859 + 34,986 + 5000 = 110,845;
using a financial calculator: calculating NPV at 10% = $86,167.
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
16) You are considering adding a microbrewery onto one of your firm's existing restaurants. This will
entail an increase in inventory of $8000, an increase in accounts payable of $2500, and an increase in
property, plant, and equipment of $40,000. All other accounts will remain unchanged. The change in net
working capital resulting from the addition of the microbrewery is:
A) $45,500
B) $10,500
C) $6,500
D) $5,500
E) $0
Answer: D
Explanation: D) NWC = CA - CL = $8000 - $2500 = $5500
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
17) You are considering adding a microbrewery onto one of your firm's existing restaurants. This will
entail an investment of $40,000 in new equipment. The new equipment falls under asset class 43 and has
a capital cost allowance (CCA) rate of 30%. If your firm's marginal corporate tax rate is 35%, then what
is the value of the microbrewery's CCA tax shield in the first year of operation?
A) $2100
B) $14,000
C) $5200
D) $26,000
E) $6000
Answer: A
Explanation: A) UCC = 40,000 × 0.5 = 20,000; CCA = 20,000 × 0.3 = 6,000;
tax shield = 6,000 × .35 = 2100.
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
18) The Sisyphean Company is considering a new project that will have a CCA deduction of $2.5 million
in the first year. If Sisyphean's marginal corporate tax rate is 40% and its average corporate tax rate is
30%, then what is the value of the CCA tax shield on the company's new project in year 1?
A) $750,000
B) $1,000,000
C) $1,500,000
D) $1,750,000
E) $2,500,000
Answer: B
Explanation: B) Here we need to use the marginal tax rate.
So, CCA tax shield = $2,500,000 × 0.40 = $1 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
Use the information for the question(s) below.
The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an
estimated life of three years. The cost of the machine is $30,000 and the machine falls under asset class
43 and has a capital cost allowance (CCA) rate of 30%.
The cane manufacturing machine will result in sales of 2000 canes in year 1. Sales are estimated to grow
by 10% per year each year through year 3. The price per cane that Sisyphean will charge its customers is
$18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will require an increase
in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2%
of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in
inventory, and 5% of its annual sales in accounts payable. The firm is in the 35% tax bracket and has a
cost of capital of 10%.
19) The required net working capital in the first year for the Sisyphean Corporation's project is closest
to:
A) $3600
B) $3960
C) $2880
D) $5400
E) $2160
Answer: A
Explanation: A) Net Working Capital Forecast
Year
1
2
3
Units
2000
2200
2420
Sales (units × $18)
36,000
39,600
43,560
Cash (2% of sales)
720
792
871.2
Accounts Receivable (4% of sales)
1440
1584
1742.4
Inventory (9% of sales)
3240
3564
3920.4
Accounts Payable (5% of sales)
1800
1980
2178
NWC (Cash + Inventory+ AR - AP)
3600
3960
4356
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
20) The required net working capital in the second year for the Sisyphean Corporation's project is
closest to:
A) $3960
B) $4360
C) $3190
D) $5940
E) $2160
Answer: A
Explanation: A) Net Working Capital Forecast
Year
1
2
3
Units
2,000
2,200
2,420
Sales (units × $18)
36,000
39,600
43,560
Cash (2% of sales)
720
792
871.2
Accounts Receivable (4% of sales)
1440
1584
1742.4
Inventory (9% of sales)
3240
3564
3920.4
Accounts Payable (5% of sales)
1800
1980
2178
NWC (Cash + Inventory+ AR - AP)
3600
3960
4356
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
21) The change in net working capital from year 1 to year 2 is closest to:
A) a decrease of $360
B) an increase of $360
C) an increase of $396
D) a decrease of $396
E) an increase of $756
Answer: B
Explanation: B) Networking Capital Forecast
Year
1
2
3
Units
2000
2200
2420
Sales (units × $18)
36,000
39,600
43,560
Cash (2% of sales)
720
792
871.2
Accounts Receivable (4% of sales)
1440
1584
1742.4
Inventory (9% of sales)
3240
3564
3920.4
Accounts Payable (5% of sales)
1800
1980
2178
NWC (Cash + Inventory+ AR - AP)
3600
3960
4356
Change = 3960 - 3600 = 360
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
22) Bubba Ho-Tep Company reported net income of $300 million for the most recent fiscal year. The
firm had a capital cost allowance (CCA) of $125 million and capital expenditures of $150 million.
Although it had no interest expense, the firm did have an increase in net working capital of $20 million.
What is Bubba Ho-Tep's free cash flow?
A) $170 million
B) $255 million
C) $150 million
D) $5 million
E) $25 million
Answer: B
Explanation: B) FCF = NI + CCA - Capital Ex - chg NWC
= 300 + 125 - 150 - 20 = 255
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
Use the information for the question(s) below.
Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a
temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this
facility to various agencies and groups providing relief services to the area. THSI estimates that this
project will initially cost $5 million to set up and will generate $20 million in revenues during its first
and only year in operation (paid in one year). Operating expenses are expected to total $12 million
during this year and the capital cost allowance will be another $3 million. THSI will require no working
capital for this investment. THSI's marginal tax rate is 35%.
23) Ignoring the original investment of $5 million, what is THSI's free cash flow for the first and only
year of operation?
A) $5.0 million
B) $3.75 million
C) $8.0 million
D) $6.25 million
E) $7.5 million
Answer: D
Explanation: D) FCF = (revenues - expenses - CCA) × (1 - tax rate) + CCA
FCF = (20 - 12 - 3) × (1 - 0.35) + 3 = 6.25
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
24) Assume that THSI's cost of capital for this project is 15%. The net present value (NPV) of this
temporary housing project is closest to:
A) $435,000
B) -$650,000
C) $1,960,000
D) -$435,000
E) $1,250,000
Answer: A
Explanation: A) FCF = (20 - 12 - 3) × (1 - 0.35) + 3 =6.25
So, NPV = -5.0 + 6.25 / 1.15 = 0.434782 or $434,782
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
Use the information for the question(s) below.
Shepard Industries is evaluating a proposal to expand its current distribution facilities. Management
has projected the project will produce the following cash flows for the first two years (in millions).
Year
Revenues
Operating expense
Capital Cost Allowance
Increase in working capital
Capital expenditures
Marginal corporate tax rate
1
1200
450
240
60
300
30%
2
1400
525
280
70
350
30%
25) The CCA tax shield for Shepard Industries project in year 1 is closest to:
A) $84
B) $168
C) $96
D) $72
E) $100
Answer: D
Explanation: D) $240 × 0.30 = $72
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
26) The CCA tax shield for Shepard Industries project in year 2 is closest to:
A) $84
B) $196
C) $72
D) $96
E) $100
Answer: A
Explanation: A) $280 × 0.30 = $84
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
Use the information for the question(s) below.
Epiphany Industries is considering a new capital budgeting project that will last for three years.
Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it
has prepared the following incremental cash flow projects:
Year
Sales (Revenues)
- Cost of Goods Sold (50% of Sales)
- Capital Cost Allowance
= EBIT
- Taxes (35%)
= unlevered net income
+ Capital Cost Allowance
+ changes to working capital
- capital expenditures
0
-90,000
1
100,000
50,000
13,500
36,500
12,775
23,725
13,500
-5000
2
100,000
50,000
22,950
27,050
9468
17,582
22,950
-5000
3
100,000
50,000
16,065
33,935
11,877
22,058
16,065
10,000
27) The free cash flow for the first year of Epiphany's project is closest to:
A) $43,000
B) $25,000
C) $32,225
D) $45,000
E) $35,532
Answer: C
Explanation: C)
Year
0
1
2
3
Sales (Revenues)
100,000 100,000 100,000
- Cost of Goods Sold (50% of
Sales)
50,000 50,000 50,000
- Capital Cost Allowance
13,500 22,950 16,065
= EBIT
36,500 27,050 33,935
- Taxes (35%)
12,775
9468 11,877
= unlevered net income
23,725 17,582 22,058
+ Capital Cost Allowance
13,500 22,950 16,065
+ changes to working capital
-5000
-5000 10,000
- capital expenditures
-90,000
= Free Cash Flow
-90,000
32,225 35,532 48,123
PV of FCF (FCF / (1 + I)n
discount rate
NPV = 1351
IRR = 12.81%
-90,000
0.12
28,772
28,326
34,253
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
28) The free cash flow for the last year of Epiphany's project is closest to:
A) $48,123
B) $35,532
C) $32,225
D) $43,000
E) $34,253
Answer: A
Explanation: A)
Year
0
1
2
3
Sales (Revenues)
100,000 100,000 100,000
- Cost of Goods Sold (50% of
Sales)
50,000 50,000 50,000
- Capital Cost Allowance
13,500 22,950 16,065
= EBIT
36,500 27,050 33,935
- Taxes (35%)
12,775
9468 11,877
= unlevered net income
23,725 17,582 22,058
+ Capital Cost Allowance
13,500 22,950 16,065
+ changes to working capital
-5000
-5000 10,000
- capital expenditures
-90,000
= Free Cash Flow
-90,000
32,225 35,532 48,123
PV of FCF (FCF / (1 + I)n
discount rate
NPV = 1351
IRR = 12.81%
-90,000
0.12
28,772
28,326
34,253
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
29) The net present value (NPV) for Epiphany's Project is closest to:
A) $4825
B) $28,772
C) $1351
D) -$4825
E) $0
Answer: C
Explanation: C)
Year
0
1
2
3
Sales (Revenues)
100,000 100,000 100,000
- Cost of Goods Sold (50% of
Sales)
50,000 50,000 50,000
- Capital Cost Allowance
13,500 22,950 16,065
= EBIT
36,500 27,050 33,935
- Taxes (35%)
12,775
9468 11,877
= unlevered net income
23,725 17,582 22,058
+ Capital Cost Allowance
13,500 22,950 16,065
+ changes to working capital
-5000
-5000 10,000
- capital expenditures
-90,000
= Free Cash Flow
-90,000
32,225 35,532 48,123
PV of FCF (FCF / (1 + I)n
discount rate
NPV = 1351
IRR = 12.81%
-90,000
0.12
28,772
28,326
34,253
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
30) A firm is considering changing their credit terms. It is estimated that this change would result in
sales increasing by $1,000,000. This in turn would cause inventory to increase by $150,000, accounts
receivable to increase by $100,000, and accounts payable to increase by $75,000. What is the firm's
expected change in net working capital?
A) $1,175,000
B) $325,000
C) $250,000
D) $175,000
E) $150,000
Answer: D
Explanation: D) $150,000 + $100,000 - $75,000 = $175,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
31) A firm is considering investing in a new machine that will cost $600,000 and will be be under asset
class 43 with a CCA rate of 30%. If the firm's marginal tax rate is 39%, what is the CCA tax shield in the
first year?
A) $120,000
B) $35,100
C) $300,000
D) $234,000
E) $90,000
Answer: B
Explanation: B) UCC = 600,000 × 0.5 = 300,000; CCA = 300,000 × 0.3 = 90,000, $90,000 × 0.39 = $ 35,100
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
32) A firm is considering a new project that will generate cash revenue of $1,000,000 and cash expenses
of $700,000 per year for five years. The equipment necessary for the project will cost $200,000 and will
fall under asset class 43 with a CCA rate of 30%. What is the expected free cash flow in the second year
of the project if the firm's marginal tax rate is 35%?
A) $195,000
B) $162,500
C) $212,850
D) $245,000
E) $161,850
Answer: C
Explanation: C) UCC1 = 200,000 × 0.5 = 100,000; CCA1 = 100,000 × 0.3 = 30,000;
UCC2 = 100,000 + 100,000 - 30,000 = 170,000; CCA2 = 170,000 × 0.3 = 51,000;
Free Cash Flow ($1,000,000 - $700,000 - $51,000) × ( 1 - .35) + $51,000 = $212,850
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.3 Convert forecasted earnings to free cash flows and compute a project's NPV
9.4 Other Effects on Incremental Free Cash Flows
1) Which of the following costs would you consider when making a capital budgeting decision?
A) sunk cost
B) opportunity cost
C) interest expense
D) fixed overhead cost
E) past research and development expenditures
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
2) A decrease in the sales of a current project because of the launching of a new project is
A) cannibalization.
B) a sunk cost.
C) an overhead expense.
D) a past research and development expenditure.
E) an opportunity cost.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
3) A company spends $20 million researching whether it is possible to create a durable plastic from the
process waste from feedstock preparation. How should the $20 million best be considered?
A) as a sunk cost
B) as an opportunity cost
C) as a fixed overhead expense
D) as a capital cost
E) as a project externality
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
4) Which of the following is an example of cannibalization?
A) A toothpaste manufacturer adds a new line of toothpaste (that contains baking soda) to its product
line.
B) A grocery store begins selling T-shirts featuring the local university's mascot.
C) A basketball manufacturer adds basketball hoops to its product line.
D) A convenience store begins selling pre-paid cell phones.
E) A gas station starts selling diesel fuel.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
Use the information for the question(s) below.
Food For Less (FFL), a grocery store, is considering offering one-hour photo developing in their store.
The firm expects that sales from the new one-hour machine will be $150,000 per year. FFL currently
offers overnight film processing with annual sales of $100,000. While many of the one-hour photo sales
will be to new customers, FFL estimates that 60% of their current overnight photo customers will switch
and use the one-hour service.
5) The level of incremental sales associated with introducing the new one hour photo service is closest
to:
A) $90,000
B) $150,000
C) $60,000
D) $120,000
E) $0
Answer: A
Explanation: A) $150,000 - (cannibalized sales) = 150,000 - 0.60 × 100,000 = $90,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
6) Joe pre-orders a non-refundable movie ticket. He then reads a number of reviews of the movie in
question that make him realize that he will not enjoy it. He goes to see it anyway, rationalizing that
otherwise his money will have been wasted. Is Joe succumbing to the Sunk Cost Fallacy, and why?
A) Yes, since he invested a valuable asset, his time, in a project based on its previous costs.
B) No, because the cost of the movie was not recoverable and would have been lost whatever action he
took.
C) No, because going to see the movie means that the product of his initial investment was realized as
originally planned.
D) No, because he incurred no further costs by going to see the movie.
E) No, because he won't know for sure if he enjoys the movie until he sees it.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
7) Luther Industries has outstanding tax loss carryforwards of $70 million from losses over the past four
years. If Luther earns $15 million per year in pretax income from now on, in how many years will
Luther first pay taxes?
A) 7 years
B) 2 years
C) 4 years
D) 5 years
E) 6 years
Answer: D
Explanation: D) The number of years the tax loss carryforwards will last can be calculated as the tax
loss carryforward dividend by the annual pretax income or:
years with no tax =
= 4.67 years, so Luther won't have to pay taxes for the next four years,
but will have to start paying some taxes five years from now.
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
8) A restaurant invests $240,000 in a new food truck for mobile lunch sales. The truck will have a capital
cost allowance (CCA) rate of 20%. If the opportunity cost of capital is 8.5%, and the restaurant's
marginal tax rate is 30%, what is the present value of the CCA tax shield?
A) $48,547
B) $48,000
C) $50,526
D) $35,938
E) $14,400
Answer: A
Explanation: A) PV = [(240,000 × 0.2 × 0.3)/(0.085 + 0.2)] × [(1 + .085/2)/(1 + 0.085)] = $48,547
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
9) A restaurant invests $240,000 in a new food truck for mobile lunch sales. The truck will have a capital
cost allowance (CCA) rate of 20%. The opportunity cost of capital is 8.5%, and the restaurant's marginal
tax rate is 30%. If the company sells the truck at the end of 5 years for $120,000, what is the present value
of the lost CCA tax shields from the sale of the asset?
A) $12,437
B) $16,801
C) $33,602
D) $35,938
E) $24,874
Answer: B
Explanation: B) PV = [(120,000 × 0.2 × 0.3)/(.085 + .2)] / (1 + .085) 5 = $16,801
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
est problem is simply to monitor the firm's managers closely. new crane. The crane will have a capital
10) A construction company spends $1.4 million to purchase a new crane. The crane will have a capital
cost allowance (CCA) rate of 25%. If the opportunity cost of capital is 7%, and the company's marginal
tax rate is 20%, what is the present value of the CCA tax shield?
A) $70,000
B) $350,000
C) $211,595
D) $250,779
E) $218,750
Answer: C
Explanation: C) PV = [(1.4 × 0.25 × 0.2)/(0.07 + 0.25)] × [(1 + .07/2)/(1 + 0.07)] = $211,595
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
11) A textile company invests $12 million in an open-end spinning machine. The machine belongs to
asset class 43 and has a capital cost allowance (CCA) rate of 30%. If the company sold it immediately
after the end of year 3 for $8 million, what would be the present value of the lost CCA tax shields from
the sale of this asset, given a tax rate of 40%, and a cost of capital of 12%?
A) $654,336
B) $928,910
C) $1,452,613
D) $1,626,926
E) $2,285,714
Answer: D
Explanation: D) PV = [(8 × .30 × .40)/(.12 + .30)] / (1 + .12) 3 = $1,626,926
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
12) A textile company invests $12 million in an open-end spinning machine. The machine belongs to
asset class 43 and has a capital cost allowance (CCA) rate of 30%. If the company sold it immediately
after the end of year 3 for $8 million, what would be the overall present value of the CCA tax shields
from this asset, given a tax rate of 40%, and a cost of capital of 12%?
A) $912,310
B) $1,076,346
C) $1,617,972
D) $2,432,211
E) $3,244,898
Answer: C
Explanation: C) PV = [(12 × .30 × .40)/(.12 + .30)] × [(1 + .12/2)/(1 + .12)]
- [(8 × .30 × .40)/(.12 + .30)] / (1 + .12)3 = $1,617,972
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
13) A textile company invests $12 million in an open-end spinning machine. The machine belongs to
asset class 43 and has a capital cost allowance (CCA) rate of 30%. It is expected that the new machine
will increase revenues by $9 million per year with production and support costs of $0.5 million per year.
If the company sold it immediately after the end of year 3 for $8 million, what would be the net present
value (NPV) of owning the asset, given a tax rate of 40%, and a cost of capital of 12%?
A) $7,561,553
B) $5,231,801
C) $1,867,311
D) $249,339
E) -$152,244
Answer: A
Explanation: A) First calculate PV of free cash flow without CCA tax shield:
CF0 = -12 million
CF1 = (9 million - 0.5 million) × (1 - .40) = 5.1 million; F1 = 2;
CF3 = 5.1 million + 8 million = 13.1 million
I = 12%
PV = $5,943,581
Then calculate PV of CCA tax shield:
PV = [(12 × .30 × .40)/(.12 + .30)] × [(1 + .12/2)/(1 + .12)
- [(8 × .30 × .40)/(.12 + .30)] / (1 + .12)3 = $1,617,972
NPV = $5,943,581 + $1,617,972 = $7,561,553
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
14) A bakery invests $30,000 in a light delivery truck. The truck belongs to asset class 10 and has a
capital cost allowance (CCA) rate of 30%. If the company sold it immediately after the end of year 2 for
$22,000, what would be the present value of the lost CCA tax shields, given a tax rate of 40% and a cost
of capital of 8%?
A) $5,184
B) $8,122
C) $9,474
D) $5,956
E) $6,947
Answer: D
Explanation: D) PV = [(22,000 × .30 × .40)/(.08 + .30)] / (1 + .08) 2 = $5956
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
15) A bakery invests $30,000 in a light delivery truck. The truck belongs to asset class 10 and has a
capital cost allowance (CCA) rate of 30%. If the company sold it immediately after the end of year 2 for
$22,000, what would be the present value of the overall CCA tax shields, given a tax rate of 40% and a
cost of capital of 8%?
A) $5,184
B) $8,122
C) $9,123
D) $3,167
E) $6,947
Answer: D
Explanation: D) PV = [(30,000 × .30 × .40)/(.08 + .30)] × [(1 + .08/2)/(1 + .08)]
- [(22,000 × .30 × .40)/(.08 + .30)] / (1 + .08) 2 = $3167
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
Use the table for the question(s) below.
Year 0
Revenues
-Cost of Goods Sold
=EBIT
-Taxes (35%)
=Unlevered net income
-Additions to Net Working Capital
-Capital Expenditures
=Free Cash Flow
Year 1
400,000
-140,000
260,000
-91,000
169,000
-11,000
Year 2
400,000
-140,000
260,000
-91,000
169,000
-11,000
Year 3
400,000
-140,000
260,000
-91,000
169,000
-11,000
158,000
158,000
158,000
-300,000
16) Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive
research, they come up with the above estimates of free cash flow from this project. The cars belong to
asset class 10 and have a capital cost allowance (CCA) rate of 30%. The cars will be sold at the end of 3
years for $150,000. What is the present value of the lost CCA tax shields of the project, given that the
cost of capital is 10%, and the company faces a marginal tax rate of 25%?
A) $8342
B) $21,131
C) $10,112
D) $25,912
E) $28,125
Answer: B
Explanation: B) PV = [(150,000 × .30 × .25)/(.10 + .30)] / (1 + .10) 3 = $21,131
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
Use the table for the question(s) below.
Year 0
Revenues
-Cost of Goods Sold
=EBIT
-Taxes (35%)
=Unlevered net income
-Additions to Net Working Capital
-Capital Expenditures
=Free Cash Flow
Year 1
400,000
-180,000
220,000
-77,000
143,000
-20,000
Year 2
400,000
-180,000
220,000
-77,000
143,000
-20,000
Year 3
400,000
-180,000
220,000
-77,000
143,000
-20,000
123,000
123,000
123,000
-300,000
17) Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive
research, they come up with the above estimates of free cash flow from this project. The cars belong to
asset class 10 and have a capital cost allowance (CCA) rate of 30%. What is the present value of the
overall CCA tax shields, given that the cost of capital is 10%, and the company faces a marginal tax rate
of 25%?
A) $32,562
B) $53,693
C) $93,465
D) $150,000
E) $162,452
Answer: A
Explanation: A) PV = [(300,000 × .30 × .25)/(.10 + .30)] × [(1 + .10/2)/(1 + .10)]
- [(150,000 × .30 × .25)/(.10 + .30)] / (1 + .10) 3 = $32,562
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
18) Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive
research, they come up with the above estimates of free cash flow from this project. The cars belong to
asset class 10 and have a capital cost allowance (CCA) rate of 30%. What is the net present value (NPV)
of the project, given that the cost of capital is 10%, and the company faces a marginal tax rate of 25%?
A) $66,373
B) $78,564
C) $118,580
D) $151,142
E) $167,549
Answer: D
Explanation: D) First calculate PV of free cash flow without CCA tax shield:
CF0 = -300,000
CF1 = 123,000; F1 = 2;
CF3 = 123,000 + 150,000 = 273,000
I = 10%
PV = $118,580
Then calculate PV of CCA tax shield:
PV = [(300,000 × .30 × .25)/(.10 + .30)] × [(1 + .10/2)/(1 + .10)]
- [(150,000 × .30 × .25)/(.10 + .30)] / (1 + .10) 3 = $32,562
NPV = $118,580 + $32,562 = $151,142
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
19) A machine is purchased for $500,000 and is used through the end of Year 2. The machine falls under
asset class 43 with a capital cost allowance (CCA) rate of 30%. At the end of Year 2, the machine is sold
for $75,000. What is the present value of the lost CCA tax shields if the firm's marginal tax rate is 40%
and its cost of capital is 5%?
A) $37,050
B) $15,180
C) $37,950
D) $23,324
E) $25,714
Answer: D
Explanation: D) PV = [(75,000 × .30 × .40)/(.05 + .30)] / (1 + .05) 2 = $23,324
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
20) A machine is purchased for $500,000 and is used through the end of Year 2. The machine falls under
asset class 43 with a capital cost allowance (CCA) rate of 30%. At the end of Year 2, the machine is sold
for $75,000. What is the present value of the overall CCA tax shields if the firm's marginal tax rate is
40% and its cost of capital is 5%?
A) $232,128
B) $201,334
C) $175,997
D) $167,347
E) $144,023
Answer: E
Explanation: E) PV = [(500,000 × .30 × .40)/(.05 + .30)] × [(1 + .05/2)/(1 + .05)]
- [(75,000 × .30 × .40)/(.05 + .30)] / (1 + .05) 2 = $144,023
Diff: 2 Type: MC
Skill: Analytical
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
21) If a business owner is using the extra space at home for his business, does it imply a zero
opportunity cost for the space?
Answer: As long as there is an alternative use of the place, it has an opportunity cost. Opportunity cost
of idle assets is often mistaken as zero, but that is inaccurate.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
22) What are project externalities?
Answer: Project externalities are indirect effects of the project that may influence the cash flows of other
activities of the firm.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
23) What are sunk costs?
Answer: Sunk costs are payments already made or that will be made that are independent of the
project under discussion. These are costs for which the firm is already liable.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.4 Recognize common pitfalls that arise in identifying a project's incremental free cash flows
9.5 Analyzing the Project
1) The most difficult part of the capital budgeting process is accurately estimating cash flows and cost of
capital.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
Use the figure for the question(s) below.
2) A consumer good company is developing a new brand of organic toothpaste. Above is the sensitivity
analysis for this product. The assumptions regarding which parameter should be scrutinized most
carefully in the estimation process?
A) units sold
B) sales price
C) cost of goods
D) cost of capital
E) net working capital
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
rm value is unlikely to be the same for every firm, or even for different executives of e sensitivity
3) A consumer good company is developing a new brand of organic toothpaste. Above is the sensitivity
analysis for this product. If the best-case assumptions for Net Working Capital are met, what will the
net present value (NPV) of this project be?
A) $0.65 million
B) $1.7 million
C) $2 million
D) $3 million
E) -$0.2 million
Answer: B
Explanation: B) As observed from the given graph
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
4) A company planning to market a new model of motor scooter analyzes the effect of changes in the
selling price of the motor scooter, the number of units that will be sold, the cost of making the motor
scooter, the effect on Net Working Capital, and the cost of capital for the project. They predict that the
break-even point for sales price for the motor scooter is $2480. What does this mean?
A) If the motor scooter is sold for $2480, then the project will make a profit.
B) If the motor scooter is sold for $2480, then the net present value (NPV) for the product will be zero.
C) The predicted selling price of the motor scooter is $2480.
D) The maximum that the motor scooter can sell for and still make the project have a positive net
present value (NPV) is $2480.
E) If the motor scooter is sold for $2480, the company will not go bankrupt.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
Use the figure for the question(s) below.
5) The graph above shows the break-even analysis for the cost of making a certain good. Based on this
chart, which of the following is true?
A) The net present value (NPV) of the project increases with increased cost of goods sold.
B) The project should not be undertaken if the predicted cost of goods sold is less than $110.
C) The net present value (NPV) of the project will be positive if the cost of good sold is greater than
$110.
D) If the good costs $110 to make, the net present value (NPV) of the project will be zero.
E) The cost of goods sold should not be a factor in deciding whether to undertake the project.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
6) The EBIT break even point can be calculated using which of the following formulas?
A) (Units Sold × Sale Price) - (Units Sold × Cost per unit) - SG&A - R&D - CCA = 0
B) (Units Sold × Sale Price) + (Units Sold × Cost per unit) - SG&A - R&D - CCA = 0
C) (Units Sold × Sale Price) - (Units Sold × Cost per unit) + SG&A + R&D - CCA = 0
D) (Units Sold × Sale Price) + (Units Sold × Cost per unit) + SG&A - R&D - CCA = 0
E) (Units Sold × Sale Price) - (Units Sold × Cost per unit) + SG&A + R&D + CCA = 0
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
can act to reduce the agency conflict to sell 500,000 games at a price of $49 per game. These units cost
7) A maker of computer games expects to sell 500,000 games at a price of $49 per game. These units cost
$12 to produce. Selling, general, and administrative expenses are $1.2 million and the CCA deduction is
$280,000. What is the EBIT break-even point for the number of games sold in this case?
A) 24,865
B) 30,192
C) 30,204
D) 40,000
E) 44,740
Answer: D
Explanation: D) units sold = 1,480,000 / 37 = 40,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
8) A maker of kitchenware is planning on selling a new chef-quality kitchen knife. The manufacturer
expects to sell 1.6 million knives at a price of $120 each. These knives cost $80 each to produce. Selling,
general, and administrative expenses are $500,000. The machinery required to produce the knives cost
$1.4 million, depreciated by straight-line depreciation over five years. The maker determines that the
EBIT break-even point for units sold and sale price is less than these estimates and that the EBIT breakeven point for costs per unit, SG&A, and depreciation are greater than these estimates, so decides to go
ahead with manufacturing the knife. Was this the correct decision?
A) No, since the cost per unit should be greater than the EBIT-break even point for cost of goods if the
project is to have a positive EBIT.
B) Yes, since if the estimates for each parameter are correct , the EBIT will be positive.
C) Yes, since a positive EBIT ensures that the project will have a positive net present value (NPV).
D) No, since NPV will be negative.
E) It cannot be determined whether the decision was correct, since other factors contributing to the
project's net present value (NPV), such as the upfront investment, have not been included in the
analysis.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
9) The manufacturer of a brand of kitchen knives is investigating the likely effects that an increase in the
cost of the raw materials required to make these knives will have on the the cost of manufacturing the
knives, the selling price of the knives, the number of knives that will then be sold, and the project's net
present value (NPV). Which of the following best describes what type of analysis the manager is
performing?
A) scenario analysis
B) sensitivity analysis
C) break-even analysis
D) EBIT-break even analysis
E) EPS analysis
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
Use the table for the question(s) below.
Year 0
Revenues
-Manufacturing Expenses
-Marketing Expenses
-Capital Cost Allowance
=EBIT
-Taxes (40%)
=Unlevered net income
+Capital Cost Allowance
-Additions to Net Working Capital
-Capital Expenditures
=Free Cash Flow
Years 1 to 10
3.50
-0.5
-0.25
-0.8
1.95
-0.78
1.17
+0.8
-0.2
-8.00
1.77
10) Panjandrum Industries, a manufacturer of industrial piping, is evaluating whether it should expand
into the sale of plastic fittings for home garden sprinkler systems. It has made the above estimates of
free cash flows resulting from such a decision. There are concerns of the sensitivity of this project to
changes in the cost of capital. For approximately what cost of capital does this project break even?
A) 12%
B) 14%
C) 16%
D) 18%
E) 20%
Answer: D
Explanation: D) Using a financial calculator, CF0 = -8, CF1 = 1.77, F1 = 10;
calculate IRR = 17.84%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
11) Panjandrum Industries, a manufacturer of industrial piping, is evaluating whether it should expand
into the sale of plastic fittings for home garden sprinkler systems. It has made the above estimates of
free cash flows resulting from such a decision (all quantities in millions of dollars). There are some
concerns that estimates of manufacturing expenses may be low, due to the rising cost of raw materials.
What is the break-even point for manufacturing expenses, if all other estimates are correct and the cost
of capital is 10%?
A) $0.78 million
B) $0.88 million
C) $0.97 million
D) $1.22 million
E) $1.36 million
Answer: A
Explanation: A) Using a financial calculator, CF0 = -8, CF1 = 1.77, F1 = 10 ;
calculate NPV at 10% equals 2.8758838;
using TVM keys, PV = 2.8758838, N = 10, I = 10; calculate PMT = 0.46804.
Pretax manufacturing expenses = 0.46804 / 0.6 = $0.78 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
12) Panjandrum Industries, a manufacturer of industrial piping, is evaluating whether it should expand
into the sale of plastic fittings for home garden sprinkler systems. It has made the above estimates of
free cash flows resulting from such a decision (all quantities in millions of dollars). It is thought that if
marketing expenses are increased by 40%, then revenues will rise. By how much will revenues have to
rise for the net present value (NPV) of the project to increase?
A) at least 2.0%
B) at least 2.9%
C) at least 3.2%
D) at least 3.8%
E) at least 4.1%
Answer: B
Explanation: B) New marketing expenses = 1.4 × 0.25 = 0.35;
increase in marketing expenses = 0.35 - 0.25 = 0.10;
thus, revenues have to increase at least by 0.10 or 0.10/3.5 = 2.9%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
Use the table for the question(s) below.
Year 0
Revenues
-Cost of Goods Sold
=EBIT
-Taxes (35%)
=Unlevered net income
-Additions to Net Working Capital
-Capital Expenditures
=Free Cash Flow
Year 1
400,000
-140,000
260,000
-91,000
169,000
-11,000
Year 2
400,000
-140,000
260,000
-91,000
169,000
-11,000
Year 3
400,000
-140,000
260,000
-91,000
169,000
-11,000
158,000
158,000
158,000
-300,000
13) Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive
research, they come up with the above estimates of free cash flow from this project. By how much could
the discount rate rise before the net present value (NPV) of this project is zero, given that it is currently
10%?
A) by 17%
B) by 22%
C) by 25%
D) by 27%
E) by 30%
Answer: A
Explanation: A) Using a financial calculator, CF0 = -0.3, CF1 = 0.158, F1 = 3;
calculate IRR = 26.89, rounded to 27%;
thus, rise in discount rate = 27 - 10 = 17%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
14) Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive
research, they come up with the above estimates of free cash flow from this project. Visby learns that a
competitor is thinking of offering similar services, thus reducing Visby's sales. By how much could sales
fall before the net present value (NPV) was zero, given that the cost of capital is 10%, and that cost of
goods sold is 35% of revenues?
A) by 12%
B) by 18%
C) by 24%
D) by 22%
E) by 31%
Answer: D
Explanation: D) Using a financial calculator, CF0 = -300,000, CF1 = 158,000, F1 =3 ;
calculate NPV at 10% = 92,922.61;
using TVM keys, PV = 92,922.61, N = 3, I = 10, compute PMT = 37,366;
pretax EBIT = 37,366 / 0.65 = 57,485
change in revenue incorporating cost of goods sold = 57,485 / 0.65 = 88,439
percentage change = 88,439 / 400,000 = 22%
Diff: 3 Type: MC
Skill: Analytical
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
15) The difference between scenario analysis and sensitivity analysis is:
A) Scenario analysis is based upon the internal rate of return (IRR) and sensitivity analysis is based
upon net present value (NPV).
B) Only sensitivity analysis allows us to change our estimated inputs of our net present value (NPV)
analysis.
C) Scenario analysis considers the effect on net present value (NPV) of changing multiple project
parameters.
D) Only scenario analysis breaks the net present value (NPV) calculation into its component
assumptions.
E) Sensitivity analysis allows for variations in many of the underlying assumptions simultaneously.
Answer: C
Diff: 2 Type: MC
Skill: Definition
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
16) An exploration of the effect of changing multiple project parameters on net present value (NPV) is
called
A) scenario analysis.
B) internal rate of return (IRR) analysis.
C) accounting break-even analysis.
D) sensitivity analysis.
E) EBIT break-even analysis
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
17) An analysis that breaks the net present value (NPV) calculation into its component assumptions and
shows how the net present value (NPV) varies as one of the underlying assumptions changes is called
A) scenario analysis.
B) internal rate of return (IRR) analysis.
C) accounting break-even analysis.
D) sensitivity analysis.
E) EBIT break-even analysis.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
18) Which of the following will cause the EBIT break-even for sales to increase?
A) a decrease in the sales price
B) a decrease in the capital cost allowance
C) a decrease in selling, general, and administrative expenses
D) a decrease in the number of units sold
E) a decrease in the cost per unit
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
19) What are the most difficult parts of capital budgeting?
Answer: The most difficult part of capital budgeting is deciding how to estimate the cash flows and the
cost of capital.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
20) What is the most important function of sensitivity analysis?
Answer: Sensitivity analysis shows how the net present value (NPV) varies as the underlying
assumptions change. Thus we understand the critical assumptions underlying the project.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
21) What do you understand by break-even analysis?
Answer: Break-even analysis is an extension of sensitivity analysis basically telling us the minimum
level of different parameters that would give a zero net present value (NPV).
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
22) What is the major difference between scenario analysis and sensitivity analysis?
Answer: Sensitivity analysis focuses on the impact of changing one variable, holding all other variables
constant. Scenario analysis allows for multiple variables to change at once, typically such that the
change will impact NPV in the same direction (all change such that NPV increases or all change such
that NPV decreases.)
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.5 Assess the sensitivity of a project's NPV to changes in your assumptions
9.6 Real Options in Capital Budgeting
1) A real option is the obligation to take a particular business action.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 9.6 Identify the most common options available to managers in projects and understand why these
options can be valuable
2) Jim owns a farm that he wants to sell. He learns that a highway will be built near the farm in the
future, giving access to the farmland from a nearby city and thus making the land attractive to housing
developers. Expecting the net present value (NPV) of the sale to be greater after the highway is built, he
decides not to sell at this time. What real option is Jim taking?
A) option to delay
B) option to expand
C) option to abandon
D) option to switch
E) option to sell
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.6 Identify the most common options available to managers in projects and understand why these
options can be valuable
3) After research into where to place a new restaurant, Burger Billies, a small fast-food chain, plans to
open a new store near a small college. The anticipated customer base is students attending the college.
They learn that a major fast-food chain will be opening a franchise within the college, which leads the
owners of Burger Billies to revise their estimate of sales to one below the break-even point. Which of the
following is most likely the best real option for Burger Billies to take with regard to the proposed
restaurant site?
A) option to delay
B) option to expand
C) option to abandon
D) option to switch
E) option to sell
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.6 Identify the most common options available to managers in projects and understand why these
options can be valuable
4) A manufacturer of peripheral devices for PCs decides to try and capture some of the PC gaming
market by creating gaming versions of its traditional peripheral devices. It decides to start with a
gaming version of its standard keyboard, increasing the number of macro keys, adding a small LCD
screen to display game data, and giving the user the ability to backlight keys in different colors. If this
device is a success, the manufacturer plans to release gaming versions of its trackballs and other
peripherals. What option is the manufacturer gaining by the release of the new keyboard?
A) option to delay
B) option to expand
C) option to abandon
D) option to switch
E) option to sell
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 9.6 Identify the most common options available to managers in projects and understand why these
options can be valuable
5) Why does the option to abandon a project have value?
Answer: The option to abandon a project can add value because it allows a firm to drop a project if the
project turns out to be unsuccessful. This allows the firm to "cut its losses."
Diff: 1 Type: SA
Skill: Conceptual
Objective: 9.6 Identify the most common options available to managers in projects and understand why these
options can be valuable
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 10 Risk and Return in Capital Markets
10.1 A First Look at Risk and Return
1) On average, stocks have delivered higher returns than bonds in the long run.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
2) In Canada over the long term, small stocks on the S&P/TSX have provided the highest return
followed by long-term Government of Canada bonds.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
3) Stocks with high returns are expected to have
A) high variability.
B) low variability.
C) no relation to variability.
D) inverse relationship with variability.
E) no variability.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
4) Historically, stocks have delivered a ________ return on average compared to Treasury bills but have
experienced ________ fluctuations in values.
A) higher, higher
B) higher, lower
C) lower, higher
D) lower, lower
E) higher, similar
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
5) Investors demand a higher return for investments that have larger fluctuations in values because
A) they do not like risk.
B) they are risk seeking.
C) they invest for the long term.
D) they are more expensive.
E) they have higher transaction costs.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
6) Which of the following investments offered the lowest overall return over the past fifty years?
A) S&P/TSX Composite Index
B) Treasury bills
C) S&P 500
D) corporate bonds
E) long-term Government of Canada bonds
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
7) Which of the following investments offered the highest overall return over the past fifty years?
A) Treasury bills
B) S&P 500
C) S&P/TSX Composite Index
D) corporate bonds
E) long-term Government of Canada bonds
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
8) Which of the following investments had the largest fluctuations in overall return over the past fifty
years?
A) S&P/TSX Composite Index
B) S&P 500
C) corporate bonds
D) Treasury bills
E) long-term Government of Canada bonds
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
9) Why must riskier investments offer higher expected returns?
Answer: Because investors are risk averse, and would prefer to avoid fluctuations in the value of their
investments, risker investments must offer higher expected returns.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.1 Identify which types of securities have historically had the highest returns and which have been the
most volatile
10.2 Historical Risks and Returns of Stocks
1) Suppose you invested $60 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend
of $0.70 today and then you sold it for $65. What was your return on the investment?
A) 8.25%
B) 9.00%
C) 9.50%
D) 9.75%
E) 10.00%
Answer: C
Explanation: C) $(65 + 0.7) - 60 = 5.7; 5.7 / 60 = 9.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
2) Suppose you invested $55 in CIBC stock one month ago. Today, it paid a dividend of $0.35, and then
you sold it for $56.25. What was the return on your investment?
A) 2.9%
B) 2.3%
C) 2.2%
D) 2.8%
E) 1.6%
Answer: A
Explanation: A) 0.35/55 + (56.25 - 55)/55 = 2.9%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
3) Suppose you invested $7.55 in Big Rock Brewery one month ago. Today, it paid a dividend of $0.10,
and then you sold it for $7.35. What was the return on your investment?
A) 1%
B) -1%
C) -1.3%
D) 4.2%
E) 1.1%
Answer: C
Explanation: C) 0.10/7.55 + (7.35 - 7.55)/7.55 = -1.3%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
4) Greg purchased stock in Bear Stearns and Co. at a price of $89 per share. The company was acquired
by JP Morgan at a price of $10 per share. What is Greg's return on his investment?
A) -88.76%
B) -96.25%
C) -79.00%
D) -85.45%
E) -90.21%
Answer: A
Explanation: A) 10 - 89 = - 79; -79 / 89 = -88.76%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
5) You own shares in Yahoo that were purchased at a price of $21 per share. Microsoft has offered to
purchase Yahoo and buy your shares at a price of $31 per share. What will be your return if you tender
your shares to Microsoft and the deal is completed?
A) 47.62%
B) 33.45%
C) 49.65%
D) 43.34%
E) 37.71%
Answer: A
Explanation: A) 31 - 21 = 10; 10 / 21 = 47.62%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
6) Suppose you invested $98 in the Ishares High Yield Fund (HYG) a month ago. It paid a dividend of
$0.47 today and then you sold it for $99. What was your dividend yield and capital gains yield on the
investment?
A) 0.45%, 1.09%
B) 0.48%, 1.02%
C) 0.48%, 1.08%
D) 1.02%, 1.12%
E) 0.75%, 0.98%
Answer: B
Explanation: B) Div yld = 0.47 / 99 = 0.48%; cap gain = 99 - 98 = 1; 1 / 98 = 1.02%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
7) Suppose you invested $45 in TD Bank one month ago. It paid a dividend of $0.60, and you sold it
right after the dividend was paid for $44.90. What was your dividend yield and capital gains yield on
the investment?
A) 1.3%, -0.2%
B) -0.2%, 1.3%
C) 1.3%, 1.1%
D) 1.1%, -0.2%
E) 1.1%, 0.2%
Answer: A
Explanation: A) Div yld = 0.60 / 45 = 1.3%; cap gain = (44.9 - 45)/45 = -0.2%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
8) Suppose you invested $150 in Tesla Motors one month ago. It paid a dividend of $1.55, and you sold
it right after the dividend was paid for $162. What was your realized return from holding the stock?
A) 6%
B) 1%
C) 9%
D) 8%
E) 7%
Answer: C
Explanation: C) Div yld = 1.55 / 150 = 1%; cap gain =(162 - 150)/150 = 8%
Realized return = 1% + 8% = 9%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
9) Suppose you invested $33 in Pfizer one month ago. It paid a dividend of $0.88 and you sold it right
after the dividend was paid for $31.14. What was your realized return from holding the stock?
A) 2.7%
B) 8.7%
C) 8.3%
D) -2.9%
E) -5.6%
Answer: D
Explanation: D) Div yld = 0.88 / 33 = 2.7%; cap gain = (31.14 - 33)/33 = -5.6%
Realized return = 2.7 - 5.6 = -2.9%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
10) Your investment over one year yielded a capital gains yield of 5% and no dividend yield. If the sale
price was $119 per share, what was the cost of the investment?
A) $126.25
B) $111.67
C) $113.33
D) $117.25
E) $115.57
Answer: C
Explanation: C) 119 / 1.05 = 113.33
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
11) Your investment over one year yielded a capital gains yield of 7% and a dividend yield of 4%. If the
sale price was $86 per share, what was the cost of the investment?
A) $79.98
B) $86.00
C) $82.69
D) $77.47
E) $80.37
Answer: E
Explanation: E) Capital gain yield = 7%, 86/1.07 = 80.37
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
12) Your investment over one year had a realized return of 9% and a dividend yield of 6%. If the sale
price was $45 per share, what was the cost of the investment?
A) $41.28
B) $43.69
C) $44.21
D) $45.00
E) $46.35
Answer: B
Explanation: B) Capital Gain Yield = 9 -6 = 3%; 45/1.03 = $43.69
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
13) Your investment over one year had a realized return of 7% and a dividend of $1.25. If the sale price
was $36 per share, what was the cost of the investment?
A) $32.15
B) $32.78
C) $33.64
D) $34.81
E) $34.90
Answer: D
Explanation: D) (36 + 1.25)/1.07 = $34.81
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
14) Amazon.com stock prices gave a realized return of 5%, -5%, 10%, and -10% over four successive
quarters. What is the annual realized return for Amazon.com for the year?
A) -1.25%
B) 2.50%
C) 0.00%
D) 1.25%
E) 1.00%
Answer: A
Explanation: A) 1.05 × 0.95 × 1.10 × 0.9 = 0.9875; 0.9875 - 1 = -1.25%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
15) Tesla Motors stock had a realized return of 18%, 4%, -12%, and -6% over four successive quarters.
What is your annual realized return if you bought Tesla at the beginning of the year and sold it at the
end of the year?
A) 1.5%
B) 1%
C) 4%
D) 2.5%
E) 0%
Answer: A
Explanation: A) 1.18 × 1.04 × 0.88 × 0.94 - 1 = 1.5%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
16) Lululemon Athletica stock had a realized return of 7%, -2%, -3%, and -8% over four successive
quarters. What is your annual realized return if you bought Lululemon at the beginning of the year and
sold it at the end of the year?
A) -1.5%
B) 21.4%
C) -6%
D) -6.4%
E) 0%
Answer: D
Explanation: D) 1.07 × .98 × .97 × .92 - 1 = -6.4%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
17) IGM Realty had a price of $30, $30, $35, $33, and $25 at the end of the last five quarters. If IGM pays
a dividend of $2 at the end of each quarter, what is the annual realized return on IGM?
A) 8.61%
B) 7.6%
C) 7.10%
D) 8.09%
E) 8.24%
Answer: B
Explanation: B)
Cumulative
Date
Price Dividend
Return
Return
1
$30
$2
2
$30
$2
6.667%
3
$35
$2
23.333%
1.3154%
4
$33
$2
0%
1.3154%
5
$25
$2
-18.1819%
1.076%
Ann. Ret =
7.6%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
18) You purchased Enron stock at a price of $30 per share. Its price was $20 after six months and the
company declared bankruptcy at the end of the next six months. The realized return over the last year
is:
A) -99%
B) -75%
C) -150%
D) -100%
E) -125%
Answer: D
Explanation: D) 0 - 30 / 30 = -100%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
19) The S&P TSX Composite index delivered a return of 14.48%, 24.13%, 17.26% and 9.83% over four
successive years. What is the arithmetic average annual return per year?
A) 16.43%
B) 20.8%
C) 14.48%
D) 18.54%
E) 15.96%
Answer: A
Explanation: A) (14.48 + 24.13 + 17.26 + 9.83)/4 = 16.43%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
20) The S&P TSX Composite index delivered annual returns of 17.61%, -8.71%, 7.19% and 12.99% from
2010 to 2013. What was the average compound annual return per year?
A) 7.5%
B) 7.3%
C) 6.8%
D) 7%
E) 6.6%
Answer: C
Explanation: C) $1 grows to 1 × 1.1762 × 0.9129 × 1.0719 × 1.1299 = $1.30 over 4 years.
1.30^(1/4) - 1 = 6.8%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
21) The S&P TSX Composite index delivered annual returns of 17.61%, -8.71%, 7.19% and 12.99% from
2010 to 2013. If you invested $10,000 in the index at the beginning of 2010, what amount would your
investment have been worth at the end of 2013?
A) $13,256
B) $13,005
C) $12,908
D) $12.974
E) $14.388
Answer: B
Explanation: B) $10000 grows to 10000 × 1.1762 × 0.9129 × 1.0719 × 1.1299 = $13,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
22) The S&P TSX Composite index delivered annual returns of 17.61%, -8.71%, 7.19% and 12.99% from
2010 to 2013. What is the standard deviation of the index returns over these four years?
A) 131.67%
B) 8.14%
C) 7.27%
D) 9.94%
E) 11.47%
Answer: E
Explanation: E) Average return = (17.61 - 8.71 + 7.19 + 12.99) / 4 = 7.27;
Variance = ((17.61 - 7.27)^2 + (-8.71 - 7.27)^2 + (7.19 - 7.27)^2 + (12.99 - 7.27)^2 ))/(4 - 1) = 131.67
Standard deviation = 131.67^0.5 = 11.47%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
23) The S&P TSX Composite index delivered annual returns of 17.61%, -8.71%, 7.19% and 12.99% from
2010 to 2013. What is a 95% confidence interval for the 2014 return?
A) 4.2% to 11.47%
B) 7.27% to 11.47%
C) -4.2% to 18.74%
D) -2.67% to 17.21%
E) 6.91% to 7.63%
Answer: C
Explanation: C) Average return = (17.61 - 8.71 + 7.19 + 12.99) / 4 = 7.27;
Variance = ((17.61 - 7.27)^2 + (-8.71 - 7.27)^2 + (7.19 - 7.27)^2 + (12.99 - 7.27)^2 ))/(4 - 1) = 131.67
Standard deviation = 131.67^0.5 = 11.47%
Average +/- 2 × standard deviation = 7.27 - 11.47 to 7.27 + 11.47 = -4.2% to 18.74%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
24) You purchase a 30-year, zero-coupon bond for a price of $20. The bond will pay back $100 after 30
years and make no interim payments. The annual compounded return (geometric average return) on
this investment is:
A) 5.31%
B) 6.54%
C) 4.78%
D) 5.51%
E) 4.96%
Answer: D
Explanation: D) Using a financial calculator: N = 30, PV = -20, FV = 100; CPT = I/Y; I/Y = 5.51%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
25) Suppose that a stock gave a realized return of 20% over a two-year time period and a 10% return
over the third year. The geometric average annual return is:
A) 9.70%
B) 11.20%
C) 14.96%
D) 15.00%
E) 16.55%
Answer: E
Explanation: E) 1.2 × 1.2 × 1.1 = 1.584; geometric average = (1.584)^0.333 = 1.1655; hence = 16.55%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
26) Suppose the quarterly arithmetic average return for a stock is 5% per quarter and the stock gives a
return of 10% each over the next two quarters. The arithmetic average return over the six quarters is:
A) 9%
B) 6.67%
C) 7.5%
D) 10%
E) 12%
Answer: B
Explanation: B) (5 + 5 + 5 + 5 + 10 + 10) / 6 = 6.67%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
27) The geometric average annual return for a large capitalization stock portfolio is 12% for ten years
and 5% per year for the next five years. The geometric average annual return for the entire 15-year
period is:
A) 9.95%
B) 9.62%
C) 9.11%
D) 10.23%
E) 10.97%
Answer: B
Explanation: B) Compound return for first ten years = (1.12)^10 = 3.1058;
compound return for next 5 years = (1.05)^5 = 1.27628;
total return over 15 years = 3.1058 × 1.27628 = 3.9639;
geometric average annual return = (3.9639)^(1/15) = 1.0962; hence answer = 9.62%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
28) Ford Motor Company had realized returns of 10%, 20%, 20%, and 10% over four quarters. What is
the quarterly standard deviation of returns for Ford calculated from this sample?
A) 5.77%
B) 5.11%
C) 5.99%
D) 5.00%
E) 6.12%
Answer: A
Explanation: A) Average return = (10 + 20 + 20 +10) / 4 = 15;
Variance = ((10 - 15)^2 + (20 - 15)^2 + (20 - 15)^2 + (10 - 15)^2 ))/(4 - 1) = 33.33
Standard deviation = 33.33^0.5 = 5.77%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
29) Ivanhoe Energy Inc had realized returns of 5.5%, -3.6%, 8%, and 7.5% over four quarters. What is the
quarterly standard deviation of returns for Ivanhoe?
A) 21.95%
B) 29.26%
C) 5.41%
D) 4.68%
E) 4.35%
Answer: C
Explanation: C) Average return = (5.5 - 3.6 + 8 + 7.5) / 4 = 4.35;
Variance = ((5.5 - 4.35)^2 + (-3.6 - 4.35)^2 + (8 - 4.35)^2 + (7.5 -4.35)^2 ))/(4 - 1) = 29.26
Standard deviation =29.26^0.5 = 5.41%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
30) Bombardier Inc had realized returns of -3%, -2%, -5%, and -7% over four quarters. What is the
quarterly standard deviation of returns for Bombardier?
A) 1.9%
B) 3.7%
C) 4.9%
D) 2.2%
E) 3.4%
Answer: D
Explanation: D) Average return = (-3 -2 -5 -7) / 4 = -4.25;
Variance = ((-3 + 4.25)^2 + (-2 + 4.25)^2 + (-5 + 4.25)^2 + (-7 + 4.25)^2 ))/(4 - 1) = 4.92
Standard deviation = 4.92^0.5 = 2.2%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
31) The standard deviation of returns of:
I. small capitalization stocks is higher than that of large capitalization stocks.
II. large capitalization stocks is lower than that of corporate bonds.
III. corporate bonds is higher than that of Treasury bills.
Which statement is true?
A) I and III
B) I, II, and III
C) I and II
D) I only
E) II only
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
32) Treasury bill returns are 5%, 4%, 3%, and 6% over four years. The standard deviation of returns of
Treasury bills is:
A) 1.51%
B) 1.11%
C) 1.00%
D) 1.29%
E) 1.43%
Answer: D
Explanation: D) Average return = (5 + 4 + 3 + 6) / 4 = 4.5;
standard deviation = (( 5 - 4.5)^2 + (4 - 4.5)^2 + (3 - 4.5)^2 + ( 6 - 4.5)^2 )) / (4 - 1) = 1.29%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
33) If asset A's return is exactly two times asset B's return, then following risk return tradeoff, the
standard deviation of asset A should be ________ times the standard deviation of asset B.
A) 3
B) 2
C) 1
D) 4
E) 5
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
34) If the returns on a stock index can be characterized by a normal distribution with mean 12%, the
probability that returns will be lower than 12% over the next period equals:
A) 50%
B) 25%
C) 46%
D) 33%
E) 70%
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
35) The probability mass between two standard deviations around the mean for a normal distribution
is:
A) 66%
B) 90%
C) 75%
D) 95%
E) 50%
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
36) The Ishares Bond Index fund (TLT) has a mean and annual standard deviation of returns of 7% and
10%, respectively. What is the 66% confidence interval for the returns on TLT?
A) -5%,10%
B) 7%,10%
C) -3%, 17%
D) -10%,10%
E) -5%, 15%
Answer: C
Explanation: C) 66% confidence interval = mean - standard deviation, mean + standard deviation;
7 - 10 = -3%; 7 + 10 = 17%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
37) The average annual return over the period 1886-2006 for stocks that comprise the S&P 500 is 10%,
and the standard deviation of returns is 20%. Based on these numbers, what is a 95% confidence interval
for 2007 returns?
A) -15%,25%
B) -20%,40%
C) -30%, 50%
D) -30%,40%
E) -10%, 30%
Answer: C
Explanation: C) 10 - 2 × 20 = -30%; 10 + 2 × 20 = 50%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
38) The average annual return over the period 1886-2006 for stocks that comprise the S&P 500 is 12%,
and the standard deviation of returns is 20%. Based on these numbers, what is a 95% confidence interval
for 2007 returns?
A) -28%, 52%
B) -10%,40%
C) -20%,35%
D) -15%, 35%
E) -5%, 25%
Answer: A
Explanation: A) 12 - 2 × 20 = -28%; 12 + 2 × 20 = 52%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
39) The average annual return over the period 1886-2006 for stocks that comprise the S&P 500 is 10.5%,
and the standard deviation of returns is 18.5%. Based on these numbers, what is a 95% confidence
interval for 2007 returns?
A) -18.5%, 18.5%
B) -10%, 10%
C) -26.5%, 47.5%
D) -37%, 37%
E) -8%, 29%
Answer: C
Explanation: C) 10.5 - 2 × 18.5 = -26.5%; 10.5 + 2 × 18.5 = 47.5%
Diff: 2 Type: MC
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
40) If a stock pays dividends at the end of each quarter, with realized returns of R1, R2, R3, and R4 each
quarter, then the annual realized return is calculated as:
A) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) - 1
B) Rannual = R1 + R2 + R3 + R4
C) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4)
D) Rannual =
E) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) + 1
Answer: A
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
Use the table for the question(s) below.
Consider the following price and dividend data for Ford Motor Company:
Date
December 31, 2004
January 26, 2005
April 28, 2005
July 29, 2005
October 28, 2005
December 30, 2005
Price ($)
$14.64
$13.35
$9.14
$10.74
$8.02
$7.72
Dividend
($)
$0.10
$0.10
$0.10
$0.10
41) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004
and sold it after the dividend had been paid at the closing price on January 26, 2005. Your dividend
yield for this period is closest to:
A) -8.15%
B) -8.80%
C) 0.70%
D) 0.75%
E) 1.25%
Answer: C
Explanation: C) div / P0 = 0.10 / 14.64 = 0.0068
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
C42) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004
42) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004
and sold it after the dividend had been paid at the closing price on January 26, 2005. Your capital gains
rate (yield) for this period is closest to:
A) 0.70%
B) 0.75%
C) -8.80%
D) -8.15%
E) 1.25%
Answer: C
Explanation: C) (P1 - P0) / P0 = (13.35 - 14.64) / 14.64 = -0.088115
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
43) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2004
and sold it after the dividend had been paid at the closing price on January 26, 2005. Your total return
rate (yield) for this period is closest to:
A) 0.70%
B) -8.13%
C) -8.80%
D) 0.75%
E) 1.25%
Answer: B
Explanation: B) (P1 + D1 - P0) / P0 = (13.35 + 0.10 - 14.64) / 14.64 = -0.08128
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
44) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2014
and sold it at the closing price on December 30, 2015. Your realized annual return is for the year 2015 is
closest to:
A) -44.5%
B) -45.1%
C) -47.3%
D) -48.5%
E) -46.3%
Answer: B
Explanation: B)
Price
(1 +
Date
($)
Dividend ($)
Return
return)
December 31, 2014 $14.64
1
1
January 26, 2015
$13.35
$0.10
-8.13%
0.918716
0.918716
April 28, 2015
$9.14
$0.10
-30.79%
0.692135
0.635875
July 29, 2015
$10.74
$0.10
18.60%
1.185996
0.754145
October 28, 2015
$8.02
$0.10
-24.39%
0.756052
0.570173
December 30, 2015 $7.72
-3.74%
0.962594
0.548845
The Product of
(1 + returns) - 1 =
-0.45116
The last column in the table contains the cumulative product of (1 + returns)
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
Use the table for the question(s) below.
Consider the following realized annual returns:
Year-end
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
S&P 500
Realized
Return
23.6%
24.7%
30.5%
9.0%
-2.0%
-17.3%
-24.3%
32.2%
4.4%
7.4%
IBM
Realized
Return
46.3%
26.7%
86.9%
23.1%
0.2%
-3.2%
-27.0%
27.9%
-5.1%
-11.3%
45) The average annual return on the S&P 500 from 1996 to 2005 is closest to:
A) 8.75%
B) 4.00%
C) 7.10%
D) 9.75%
E) 5.85%
Answer: A
Explanation: A) Rannual =
=
=
= 8.82%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
46) The average annual return on IBM from 1996 to 2005 is closest to:
A) 18.2%
B) 16.40%
C) 18.7%
D) 29.9%
E) 20.24%
Answer: B
Explanation: B) Rannual =
=
=
= 16.45%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
The average annual return over the period 1926-2009 for the S&P 500 is 11.7%, and the standard
47) The average annual return over the period 1926-2009 for the S&P 500 is 11.7%, and the standard
deviation of returns is 20.5%. Based on these numbers, what is a 95% confidence interval for 2010
returns?
A) 1.5%,, 22.0%
B) -8.8%, 32.2%
C) -29.3%, 52.7%
D) -29.3%, 73.2%
E) -14.4%, 26.2%
Answer: C
Explanation: C) 11.7% - (2 × 20.5%) = -29.3%; 11.7% +( 2 × 20.5%) = 52.7%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
48) The average annual return over the period 1926-2009 for the S&P 500 is 11.7%, and the standard
deviation of returns is 20.5%. Based on these numbers, what is a 67% confidence interval for 2010
returns?
A) 1.5%,, 22.0%
B) -8.8%, 32.2%
C) -29.3%, 52.7%
D) -29.3%, 73.2%
E) -12.6%, 29.8%
Answer: B
Explanation: B) 11.7% - (1 × 20.5%) = -8.8%; 11.7% +( 1 × 20.5%) = 32.2%
Diff: 3 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
49) The average annual return over the period 1926-2009 for small stocks is 22.1%, and the standard
deviation of returns is 22.1%. Based on these numbers, what is a 95% confidence interval for 2010
returns?
A) 11.1%, 33.2%
B) 0%, 44.2%
C) -22.1%, 44.2%
D) -22.1%, 66.3%
E) -12.5%, 45.7%
Answer: D
Explanation: D) 22.1% - (2 × 22.1%) = -22.1%; 22.1% +( 2 × 22.1%) = 66.3%
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
50) What are the two components of realized return from a stock investment?
Answer: The total realized return earned from a stock investment comprises two components: dividend
yield and capital gains yield.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
51) Which type of investment has historically had the highest volatility?
Answer: Investments in small stocks have historically witnessed the highest volatility.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
52) Which type of investment has historically had the lowest volatility?
Answer: Investments in Treasury bills have historically witnessed the lowest volatility.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.2 Compute the average return and volatility of returns from a set of historical asset prices
10.3 The Historical Tradeoff between Risk and Return
1) Rational investors may be willing to choose an investment that has additional risk but does not offer
additional reward.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
2) Historical evidence on the returns of large portfolios of stock and bonds shows that investments with
higher volatility have rewarded investors with higher returns.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
3) There is a clear link between the volatility of returns for individual stocks and and the returns for
individual stocks.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
4) For large portfolios, investors should expect a higher return for higher volatility, but this does not
hold true for individual stocks.
Answer: TRUE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
5) While ________ seems to be a reasonable measure of risk when evaluating a large portfolio, the
________ of an individual security does not explain the size of its average return.
A) volatility, volatility
B) the mean return, standard deviation
C) mode, volatility
D) volatility, compound annual return
E) volatility, mean return
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
6) There is an overall relationship between ________ and ________—larger stocks have a lower volatility
overall.
A) size, risk
B) mean, standard deviation
C) risk aversion, size
D) volatility, mean
E) return, size
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
7) Which of the following statements is true?
A) On average, smaller stocks have lower volatility than Treasury bills.
B) Portfolios of smaller stocks are typically less volatile than individual small stocks.
C) On average, smaller stocks have lower returns than larger stocks.
D) On average, Treasury bills have higher returns than world stocks.
E) Portfolios of large stocks are typically more volatile than individual small stocks.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
8) Is volatility a reasonable measure of risk when evaluating large portfolios?
Answer: Yes, volatility is a reasonable measure of risk for large portfolios, once they are fully
diversified.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
9) When looking at investment portfolios historically, was there a pattern between returns and
volatility?
Answer: Yes, there is a direct relationship between return and volatility—i.e., high volatility
investments have generally yielded higher returns.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
10) Is volatility a reasonable measure of risk when evaluating the investment in a single stock?
Answer: No. In the case of an investment in a single stock, the volatility does not explain the size of its
average return, because the stock has its own unique risk that can still be diversified away.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.3 Understand the trade-off between risk and return for large portfolios versus individual stocks
10.4 Common Versus Independent Risk
1) The risk that inflation rates are likely to increase in the next year is an example of common risk.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.4 Describe the difference between common and independent risk
2) A portfolio of stocks where each stock has a large component of independent risk benefits when such
stocks are held in a portfolio, because the independent risks are averaged out. This is also referred to as
diversification of risks.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.4 Describe the difference between common and independent risk
3) Risk that is linked across outcomes is called
A) diversifiable risk.
B) common risk.
C) uncorrelated risk.
D) independent risk.
E) systematic risk.
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 10.4 Describe the difference between common and independent risk
Use the information for the question(s) below.
Big Cure and Little Cure are both pharmaceutical companies. Big Cure presently has a potential
"blockbuster" drug before the Food and Drug Administration (FDA) waiting for approval. If approved,
Big Cure's blockbuster drug will produce $1 billion in net income for Big Cure. Little Cure has ten
separate, less important drugs before the FDA waiting for approval. If approved, each of Little Cure's
drugs would produce $100 million in net income for Little Cure. The probability of the FDA approving
a drug is 50%.
4) What is the expected payoff for Big Cure's Blockbuster drug?
A) $100 million
B) $0
C) $1 billion
D) $500 million
E) $50 million
Answer: D
Explanation: D) expected payoff = prob of payoff × amount if successful
= 0.5 × $1 billion = $500 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.4 Describe the difference between common and independent risk
5) What is the expected payoff for Little Cure's ten drugs?
A) $500 million
B) $100 million
C) $1 billion
D) $0
E) $50 million
Answer: A
Explanation: A) expected payoff = prob of payoff × amount if successful
= 0.5 × $100 = $50 million for each drug
$50 million × 10 drugs = $500 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.4 Describe the difference between common and independent risk
10.5 Diversification in Stock Portfolios
1) Independent risks can be diversified by holding a large number of uncorrelated assets with
independent risks.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
2) A stock whose return does not depend on overall economic conditions has a low systematic risk.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
3) Investors should earn a risk premium for bearing unsystematic risk.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
4) Stocks have both diversifiable risk and undiversifiable risk, but only diversifiable risk is rewarded
with higher expected returns.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
5) In general, it is possible to eliminate ________ risk by holding a large portfolio of assets.
A) unsystematic
B) systematic
C) unsystematic and systematic
D) unwanted
E) market
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
6) Apple computer's stock price jumped when it announced that its revenue had increased because of
the successful launch of iPhone and the increased sales of Macintosh computers. This is an example of
A) market risk.
B) unsystematic risk.
C) systematic risk.
D) common risk.
E) unwanted risk.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
7) The risk premium of a security is determined by its ________ risk and does not depend on its
________ risk.
A) systematic, undiversifiable
B) systematic, unsystematic
C) diversifiable, diversifiable
D) diversifiable, unsystematic
E) unsystematic, diversifiable
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
8) The risk premium is the difference between the average return on a security and the average return
for
A) long-term Government of Canada bonds.
B) a portfolio of securities with similar risk.
C) a broad-based market portfolio like the S&P 500 index.
D) Treasury bills.
E) corporate bonds.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
Use the table for the question(s) below.
Consider the following average annual returns:
Investment
Small Stocks
S&P 500
Corporate Bonds
Treasury Bonds
Treasury Bills
Average Return
23.2%
13.2%
7.5%
6.2%
4.8%
9) What is the risk premium for the portfolio of small stocks?
A) 10.0%
B) 15.7%
C) 18.4%
D) 17.0%
E) 17.5%
Answer: C
Explanation: C)
Average Return Investment
Average Return
Treasury Bill Return
Small Stocks
23.2%
18.40%
S&P 500
13.2%
8.40%
Corporate Bonds
7.5%
2.70%
Treasury Bonds
6.2%
1.40%
Treasury Bills
4.8%
0.0%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
10) What is the risk premium for the S&P 500?
A) 5.7%
B) 7.0%
C) 0%
D) 8.4%
E) 4.5%
Answer: D
Explanation: D)
Investment
Small Stocks
S&P 500
Corporate Bonds
Treasury Bonds
Treasury Bills
Average Return
23.2%
13.2%
7.5%
6.2%
4.8%
Average Return Treasury Bill Return
18.40%
8.40%
2.70%
1.40%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
11) What is the risk premium for corporate bonds?
A) 2.7%
B) 1.3%
C) -5.7%
D) 0%
E) 8.4%
Answer: A
Explanation: A)
Average Return Investment
Average Return
Treasury bill Return
Small Stocks
23.2%
18.40%
S&P 500
13.2%
8.40%
Corporate Bonds
7.5%
2.70%
Treasury Bonds
6.2%
1.40%
Treasury Bills
4.8%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
12) What is the risk premium for Treasury bills?
A) 0%
B) -8.4%
C) -2.7%
D) -1.4%
E) -18.4%
Answer: A
Explanation: A)
Average Return Investment
Average Return
Treasury bill Return
Small Stocks
23.2%
18.40%
S&P 500
13.2%
8.40%
Corporate Bonds
7.5%
2.70%
Treasury Bonds
6.2%
1.40%
Treasury Bills
4.8%
0.00%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
13) When investing for a long horizon, investors care about the volatility of ________ returns and not
the volatility of ________ returns.
A) average, cumulative
B) cumulative, average
C) mean, cumulative
D) mean, average
E) average, mean
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
14) Many former employees at Enron, an energy trading and supply company, had a large part of their
portfolio invested in Enron stock. These employees were bearing a high degree of ________ risk.
A) unsystematic
B) systematic
C) market specific
D) non-diversifiable
E) common
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
15) Which of the following is a systematic risk?
A) the risk that oil prices rise, increasing production costs
B) the risk that the CEO is killed in a plane crash
C) the risk of a key employee being hired away by a competitor
D) the risk of a product liability lawsuit
E) the risk of an equipment failure
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
16) Which of the following is a diversifiable risk?
A) the risk that oil prices rise, increasing production costs
B) the risk that the economy slows, reducing demand for your firm's products
C) the risk that your new product will not receive regulatory approval
D) the risk that the Bank of Canada raises interest rates
E) the risk that a new government is elected and raises corporate taxes
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
Use the information for the question(s) below.
Consider an economy with two types of firms, S and I. S firms always move together, but I firms move
independently of each other. For both types of firms there is a 70% probability that the firm will have a
20% return and a 30% probability that the firm will have a -30% return.
17) What is the expected return for an individual firm?
A) 3%
B) 5%
C) 14%
D) -5%
E) 0%
Answer: B
Explanation: B) expected return = 0.7(20%) + 0.3(-30%) = 5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
18) The standard deviation for the return on an individual firm is closest to:
A) 23.0%
B) 5.25%
C) 15.0%
D) 10.0%
E) 25.0%
Answer: A
Explanation: A) expected return = 0.7(20%) + 0.3(-30%) = 5%
standard deviation =
= 0.2291
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
19) The standard deviation for the return on an portfolio of 20 type S firms is closest to:
A) 15.0%
B) 23.0%
C) 5.25%
D) 5.10%
E) 20.0%
Answer: B
Explanation: B) expected return = 0.7(20%) + 0.3(-30%) = 5%
standard deviation =
= 0.2291
Since all these firms move the same, there is no adjustment to the standard deviation.
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
20) The standard deviation for the return on an portfolio of 20 type I firms is closest to:
A) 5.25%
B) 15.0%
C) 5.10%
D) 23.0%
E) 20.0%
Answer: C
Explanation: C) expected return = 0.7(20%) + 0.3(-30%) = 5%
standard deviation =
= 0.2291
Since all these firms move independently,
stdev = stdev(single firm) /
= 0.2291 /
= 0.0512
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
21) If the Bank of Canada were to change from an expansionary to contractionary monetary policy, this
21) If the Bank of Canada were to change from an expansionary to contractionary monetary policy, this
would be an example of
A) unsystematic risk.
B) systematic risk.
C) independent risk.
D) diversification risk.
E) unwanted risk.
Answer: B
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
22) Independent risk is more closely related to
A) unsystematic risk.
B) systematic risk.
C) common risk.
D) diversification risk.
E) unwanted risk.
Answer: A
Diff: 2 Type: MC
Skill: Analytical
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
23) What is the difference between systematic and unsystematic risk?
Answer: Systematic risk refers to fluctuations of a stock's return that are due to market-wide news
which affects all stocks simultaneously. Unsystematic risk refers to fluctuations of a stock's return that
are due to company or industry-specific news, which are unrelated across stocks.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
24) How does diversification affect systematic and unsystematic risk?
Answer: Diversification does not affect systematic risk, since all stocks are affected by this type of risk,
and increasing the number of stocks in a portfolio will not eliminate systematic risk. Volatility declines
as the number of firms in a portfolio increases, until eventually diversification will eliminate
unsystematic risk.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
25) Explain why investors do not receive a risk premium for exposure to unsystematic risk.
Answer: Since investors can eliminate unsystematic risk through diversification, any stock that paid an
additional risk premium for unsystematic risk would be bought until the share price rose sufficiently to
eliminate the risk premium.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 10.5 Explain how diversified portfolios remove independent risk, leaving common risk as the only risk
requiring a risk premium
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 11 Systematic Risk and the Equity Risk Premium
11.1 The Expected Return of a Portfolio
1) A portfolio comprises two stocks, A and B, with equal amounts of money invested in each. If stock
A's stock price increases and that of stock B decreases, the weight of stock A in the portfolio will
increase.
Answer: TRUE
Diff: 3 Type: TF
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
2) A portfolio has three stocks — 200 shares of Yahoo (YHOO), 100 Shares of General Motors (GM), and
50 shares of Standard and Poor's Index Fund (SPY). If the price of YHOO is $30, the price of GM is $30,
and the price of SPY is $130, calculate the portfolio weight of YHOO and GM.
A) 38.7%, 19.4%
B) 21.3%, 35.2%
C) 11.7%, 12.7%
D) 36.2%, 21.6%
E) 57.1%, 28.6%
Answer: A
Explanation: A) Compute the value of each stock in the portfolio by multiplying stock price by number
of shares of each. Compute total portfolio value by adding each component in part A. Divide YHOO
value by portfolio value to compute weight and similarly for GM.
Thus, total portfolio value = 200 × 30 + 100 × 30 + 50 × 130 = 15,500;
weight of YHOO = 6000 / 15,500 = 38.7%; weight of GM = 3000 / 15,500 = 19.4%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
3) A portfolio has three stocks — 300 shares of Yahoo (YHOO), 300 Shares of General Motors (GM), and
100 shares of Standard and Poor's Index Fund (SPY). If the price of YHOO is $20, the price of GM is $30,
and the price of SPY is $150, calculate the portfolio weight of YHOO and GM.
A) 10%, 20%
B) 15%, 25%
C) 20%, 30%
D) 20%, 40%
E) 43%, 43%
Answer: C
Explanation: C) Compute the value of each stock in the portfolio by multiplying stock price by number
of shares of each. Compute total portfolio value by adding each component in part A. Divide YHOO
value by portfolio value to compute weight and similarly for GM.
Thus total portfolio value = 300 × 20 + 300 × 30 + 100 × 150 = 30,000;
weight of YHOO = 6000 / 30,000 = 20%; weight of GM = 9000 / 30,000 = 30%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
4) A portfolio has three stocks — 100 shares of Yahoo (YHOO), 200 Shares of General Motors (GM), and
50 shares of Standard and Poor's Index Fund (SPY). If the price of YHOO is $20, the price of GM is $20,
and the price of SPY is $130, calculate the portfolio weight of YHOO and GM.
A) 12%, 17%
B) 11%, 31%
C) 15%, 29%
D) 16%, 32%
E) 29%, 57%
Answer: D
Explanation: D) Compute the value of each stock in the portfolio by multiplying stock price by number
of shares of each. Compute total portfolio value by adding each component in part A. Divide YHOO
value by portfolio value to compute weight and similarly for GM.
Thus total portfolio value = 100 × 20 + 200 × 20 + 50 × 130 = 12,500;
weight of YHOO = 2000 / 12,500 = 16%; weight of GM = 4000 / 12,500 = 32%.
Diff: 3 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
5) Suppose you buy 50 shares of RBC at $90 per share, and 70 shares of TD at $78 per share. If RBC's
stock goes up to $94 per share and TD's stock falls to $72 per share, what is your portfolio return?
A) -2.2%
B) 0%
C) 6.4%
D) 4.4%
E) -7.7%
Answer: A
Explanation: A) Initial portfolio value = 50 × 90 + 70 × 78 = $9,960
New portfolio value = 50 × 94 + 70 × 72 = $9,740
Portfolio return = (9,740 - 9,960)/9,960 = -2.2%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
6) Suppose you buy 100 shares of RBC at $85 per share, and 80 shares of TD at $75 per share. If RBC's
stock goes up to $88.50 per share and TD's stock goes up to $77 per share, what is your portfolio return?
A) 2%
B) 0%
C) 3.5%
D) 3%
E) 4.5%
Answer: C
Explanation: C) Initial portfolio value = 100 × 85 + 80 × 75 = $14,500
New portfolio value = 100 × 88.50 + 80 × 77 = $15,010
Portfolio return = (15,010 - 14,500)/14,500 = 3.5%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
7) Suppose you have $10,000 in cash to invest. You decide to sell short $5000 worth of Kinston stock and
invest the proceeds from your short sale plus your $10,000 into one-year Treasury bills earning 5%. At
the end of the year, you decide to liquidate your portfolio. Kinston Industries has the following realized
returns:
Kinston
P0
Div1
P1
$25.00
$1.00
$29.00
The return on your portfolio is closest to:
A) -0.5%
B) 13.5%
C) -2.5%
D) 14.5%
E) 5.0%
Answer: C
Explanation: C) You short sold $5000 / $25 = 200 shares of Kinston and invested the $5000 + $10,000 in
T-notes. In one year you will have (15,000)(1.05) = $15,750 - 200 × ($29 + $1) = $9750.
So, your total return is equal to
= -0.025 or -2.5%
Diff: 3 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
8) Your investment portfolio contains 200 shares of RBC and 450 shares of Air Canada. The price of RBC
is currently $92 per share, and the price of Air Canada is currently $11 per share. If you expect the
return on RBC to be 6% in the next year, and the return on Air Canada to be 8%, what is the expected
return for your portfolio?
A) 6.4%
B) 7%
C) 6%
D) 8%
E) 6.8%
Answer: A
Explanation: A) Initial portfolio value = 200 × 92 + 450 × 11 = $23,350.
Final portfolio value = 200 × 92 × 1.06 + 450 × 11 × 1.08 = $24,850.
Portfolio return = (24,850 - 23,350)/23,350 = 0.064 or 6.4%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
utsiders investment portfolio contains 100 shares of RBC, 75 shares of TD, and 200 shares of WestJet.
9) Your investment portfolio contains 100 shares of RBC, 75 shares of TD, and 200 shares of WestJet. The
price of RBC is currently $75 per share, the price of TD is $55 and the price of WestJet is currently $21
per share. If you expect the return on RBC to be 5% in the next year, the return on TD to be 6.5%, and
the return on WestJet to be 10%, what is the expected return for your portfolio?
A) 6.4%
B) 6.7%
C) 7.2%
D) 6%
E) 6.5%
Answer: B
Explanation: B) Initial portfolio value =100 × 75 + 75 × 55 + 200 × 21 = $15,825
Final portfolio value = 100 × 75 × 1.05 + 75 × 55 × 1.065 + 200 × 21 × 1.10 = $16,888
Portfolio return = (16,888 - 15,825)/15,825 = 6.7%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
10) You have invested $25,000 in RBC stock and $18,000 in TD stock. If you expect the return on RBC to
be 6% in the next year, and the return on TD to be 4%, what is the expected return for your portfolio?
A) 4%
B) 5%
C) 5.2%
D) 6%
E) 4.8%
Answer: C
Explanation: C) Portfolio return = (25,000 × .06)/(25,000 + 18,000) + (18,000 × .04)/(25,000 + 18,000) = 5.2%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
11) You have invested $10,000 in RBC stock and $21,000 in TD stock. If you expect the return on RBC to
be 5% in the next year, and the return on TD to be 6.5%, what is the expected return for your portfolio?
A) 5.75%
B) 5%
C) 6.5%
D) 6%
E) 5.5%
Answer: D
Explanation: D) Portfolio return = (10,000 × 0.05)/(10,000 + 21,000) + (21,000 × 0.065)/(10,000 + 21,000) =
6%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
12) You have invested $5,000 in RBC stock, $12,000 in TD stock, and $18,000 in WestJet stock. If you
expect the return on RBC to be 4% in the next year, the return on TD to be 5%, and the return on WestJet
to be 6%, what is the expected return for your portfolio?
A) 5.4%
B) 5%
C) 4.8%
D) 6%
E) 5.2%
Answer: A
Explanation: A) Portfolio return = (5 × 0.04)/(5 + 12 + 18) + (12 × 0.05)/(5 + 12 + 18) + (18 × 0.06)/(5 + 12 +
18) = 5.4%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
13) You have invested $12,000 in RBC stock, $8,000 in TD stock, and $6,000 in WestJet stock. If you
expect the return on RBC to be 5% in the next year, the return on TD to be 3%, and the return on WestJet
to be 8%, what is the expected return for your portfolio?
A) 5.4%
B) 4.8%
C) 5.1%
D) 5.33%
E) 5.2%
Answer: C
Explanation: C) Portfolio return = (12 × 0.05)/(12 + 8 + 6) + (8 × 0.03)/(12 + 8 + 6) + (6 × 0.08 )/(12 + 8 + 6) =
5.1%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
Use the information for the question(s) below.
Suppose you invest $20,000 by purchasing 200 shares of Abbott Labs (ABT) at $50 per share, 200 shares
of Lowes (LOW) at $30 per share, and 100 shares of Ball Corporation (BLL) at $40 per share.
14) The weight of Abbott Labs in your portfolio is:
A) 50%
B) 40%
C) 30%
D) 20%
E) 10%
Answer: A
Explanation: A) Value of portfolio = 200 × $50 + 200 × $30 + 100 × $40 = $20,000
xi = value of security / value of portfolio = (200 × $50) / $20000 = 0.50 or 50%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
15) The weight of Lowes in your portfolio is:
A) 40%
B) 20%
C) 50%
D) 30%
E) 10%
Answer: D
Explanation: D) Value of portfolio = 200 × $50 + 200 × $30 + 100 × $40 = $20,000
xi = value of security / value of portfolio = (200 × $30) / $20,000 = 0.30 or 30%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
16) The weight of Ball Corporation in your portfolio is:
A) 50%
B) 40%
C) 20%
D) 30%
E) 10%
Answer: C
Explanation: C) Value of portfolio = 200 × $50 + 200 × $30 + 100 × $40 = $20,000
xi = value of security / value of portfolio = (100 × $40) / $20,000 = 0.20 or 20%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
17) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs
has a return of -10%. The return on your portfolio over the year is:
A) 0%
B) 7.5%
C) 3.5%
D) 5.0%
E) 2.5%
Answer: C
Explanation: C)
Stock
Weight
Return
W×R
ABT
0.5
-0.1
-0.05
LOW
0.3
0.2
0.06
BLL
0.2
0.125
0.025
Rp =
0.035
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
18) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs
has a return of -10%. The value of your portfolio over the year is:
A) $21,000
B) $20,000
C) $20,700
D) $21,500
E) $22,000
Answer: C
Explanation: C)
Stock
Weight
Return
W×R
ABT
0.5
-0.1
-0.05
LOW
0.3
0.2
0.06
BLL
0.2
0.125
0.025
Rp =
0.035
Value of portfolio = 20,000(1 + 0.035) = 20,700
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
19) What role does the correlation of two assets play in computation of the expected return of the two
asset portfolio?
Answer: The correlation of two assets does not play any role in computation of the expected return of
the two asset portfolio.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
20) What role does the standard deviations of two assets play in computation of the expected return of
the two asset portfolio?
Answer: The standard deviation of the two assets does not play any role in computation of the
expected return of the two asset portfolio.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
21) In a two-asset portfolio, what happens to the portfolio weight of the better performing asset?
Answer: The portfolio weight of the better performing asset increases in a two-asset portfolio.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
11.2 The Volatility of a Portfolio
1) When we combine stocks in a portfolio, the amount of risk that is eliminated depends on the degree
to which the stocks face common risks and move together.
Answer: TRUE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
2) If two stocks are perfectly negatively correlated, a portfolio with equal weighting in each stock will
always have a volatility (standard deviation) of 0.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
3) Correlation is the degree to which the returns of two stocks share common risks.
Answer: TRUE
Diff: 1 Type: TF
Skill: Definition
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
4) When we form an equally weighted portfolio of stocks and keep increasing the number of stocks in
the portfolio, the volatility of the portfolio also increases.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
5) When the returns of two stocks are negatively correlated, but not perfectly negatively correlated, then
A) they always move oppositely.
B) they tend to move oppositely.
C) they have no tendency.
D) they tend to move together.
E) they always move together.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
6) When the returns of two stocks are perfectly positively correlated, then
A) they always move oppositely.
B) they tend to move oppositely.
C) they have no tendency.
D) they tend to move together.
E) they always move together.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
7) Your portfolio has 25% of its value invested in Bombardier and the remainder invested in Lululemon.
Bombardier stock has a volatility of 30%, while Lululemon stock has a volatility of 18%. If the
correlation between Bombardier and Lululemon is 0.2, what is the standard deviation of your portfolio?
A) 16.7%
B) 24%
C) 2.8%
D) 21%
E) 46.1%
Answer: A
Explanation: A) Use the formula for variance of a portfolio - Eq. 4 of Chapter 11 of text.
Take the square root of variance to get standard deviation.
Var = (0.25)^2 × (0.30)^2 + (0.75)^2 × (0.18)^2 + 2 × 0.25 × 0.75 × 0.3 × 0.18 × 0.2 = 0.0279;
standard deviation = 0.0279^(1/2) = 0.167 or 16.7%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
8) Your portfolio has 50% of its value invested in Bombardier and the remainder invested in Lululemon.
Bombardier stock has a volatility of 25%, while Lululemon stock has a volatility of 10%. If the
correlation between Bombardier and Lululemon is -0.1, what is the standard deviation of your
portfolio?
A) 16.7%
B) 17.5%
C) 13%
D) 17.4%
E) 1.7%
Answer: C
Explanation: C) Use the formula for variance of a portfolio - Eq. 4 of Chapter 11 of text.
Take the square root of variance to get standard deviation.
Var = (0.5)^2 × (0.25)^2 + (0.5)^2 × (0.1)^2 + 2 × 0.5 × 0.5 × 0.25 × 0.1 × (-0.1) = 0.016875;
standard deviation = 0.016875^(1/2) = 0.13 or 13%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
9) Your portfolio has 20% of its value invested in Bombardier and the remainder invested in Lululemon.
Bombardier stock has a volatility of 15%, while Lululemon stock has a volatility of 12%. If the
correlation between Bombardier and Lululemon is 0, what is the standard deviation of your portfolio?
A) 12.6%
B) 10%
C) 1%
D) 12.7%
E) 12%
Answer: B
Explanation: B) Use the formula for variance of a portfolio - Eq. 4 of Chapter 11 of text.
Take the square root of variance to get standard deviation.
Var = (0.2)^2 × (0.15)^2 + (0.8)^2 × (0.12)^2 + 2 × 0.2 × 0.8 × 0.15 × 0.12 × 0 =0.01;
standard deviation = 0.01^(1/2) = 0.1 or 10%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
10) The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I
hold both stocks in my portfolio, the overall volatility of the portfolio is:
A) 30%
B) 26%
C) 28%
D) 20%
E) More information needed.
Answer: E
Diff: 2 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
11) The volatility of Home Depot Share prices is 30% and that of General Motors shares is 30%. When I
hold both stocks in my portfolio and the stocks returns have zero correlation, the overall volatility of
returns of the portfolio is
A) unchanged at 30%.
B) less than 30%.
C) more than 30%.
D) zero.
E) Cannot say for sure
Answer: B
Diff: 3 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
12) The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I
hold both stocks in my portfolio and the stocks' returns have a correlation of 1, the overall volatility of
returns of the portfolio is
A) more than 30%.
B) less than 30%.
C) unchanged at 30%.
D) zero.
E) Cannot say for sure
Answer: C
Diff: 3 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
13) The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I
hold both stocks in my portfolio with an equal amount in each, and the stocks' returns have a
correlation of minus 1, the overall volatility of returns of the portfolio is
A) more than 30%.
B) unchanged at 30%.
C) between 0 and 30%.
D) zero.
E) Cannot say for sure
Answer: D
Diff: 3 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
14) Diversification reduces the risk of a portfolio because ________ and some of the risks are averaged
out of the portfolio.
A) stocks do not move identically
B) stocks have common risks
C) stocks are unpredictable
D) stocks are always affected by the market
E) some stocks have lower returns than others
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
15) Stocks tend to move together if they are affected by
A) company-specific events.
B) common economic events.
C) events unrelated to the economy.
D) idiosyncratic shocks.
E) unforeseen events.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
16) We can reduce volatility by investing in less than perfectly correlated assets through diversification
because the expected return of a portfolio is the weighted average of the expected returns of its stocks,
but the volatility of a portfolio
A) is higher than the weighted average volatility.
B) is independent of weights in the stocks.
C) is less than the weighted average volatility.
D) depends on the expected return.
E) is the same as the weighted average volatility.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
17) As we add more uncorrelated stocks to a portfolio where the stocks are held in equal weights, the
benefit of diversification is most dramatic
A) after 20 stocks have been added.
B) when there are more than 500 stocks.
C) when there are more than 1000 stocks.
D) at the outset.
E) when there are more than 100 stocks.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
Use the table for the question(s) below.
Consider the following returns:
Year-End
2000
2001
2002
2003
2004
2005
Lowes
Realized
Return
20.1%
72.7%
-25.7%
56.9%
6.7%
17.9%
Home
Depot
Realized
Return
-14.6%
4.3%
-58.1%
71.1%
17.3%
0.9%
IBM
Realized
Return
0.2%
-3.2%
-27.0%
27.9%
-5.1%
-11.3%
18) The covariance between Lowes' and Home Depot's returns is closest to:
A) 0.10
B) 0.29
C) 0.12
D) 0.69
E) 0.41
Answer: A
Explanation: A)
Year-End
2000
2001
2002
2003
2004
2005
average =
Lowes
Realized
Return
20.1%
72.7%
-25.7%
56.9%
6.7%
17.9%
24.8%
Home
Depot
Realized
Return
-14.6%
4.3%
-58.1%
71.1%
17.3%
0.9%
3.5%
Lowes
Deviation
(RL - RL)
-4.7%
47.9%
-50.5%
32.1%
-18.1%
-6.9%
Home
Depot
Deviation
(RH - RH)
×
(RH - RH)
-18.1%
0.8%
-61.6%
67.6%
13.8%
-2.6%
0.00843889
0.00391456
0.31079056
0.21727489
-0.02496211
0.00177389
(RL - RL)
Variance
=
0.125447467 0.177795367
Stdev = 0.354185639 0.421657879
Covariance = 0.103446133
Correlation = 0.692664763
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
19) The volatility on Lowes' returns is closest to:
A) 35%
B) 10%
C) 13%
D) 42%
E) 22%
Answer: A
Explanation: A)
Year-End
2000
2001
2002
2003
2004
2005
Lowes
Realized
Return
20.1%
72.7%
-25.7%
56.9%
6.7%
17.9%
Home
Depot
Realized
Return
-14.6%
4.3%
-58.1%
71.1%
17.3%
0.9%
average =
24.8%
3.5%
Variance =
Stdev =
Lowes
Deviation
(RL - RL)
(RL - RL)
Home Depot
Deviation
(RH - RH)
×
(RH - RH)
-4.7%
47.9%
-50.5%
32.1%
-18.1%
-6.9%
-18.1%
0.8%
-61.6%
67.6%
13.8%
-2.6%
0.00843889
0.00391456
0.31079056
0.21727489
-0.02496211
0.00177389
0.125447467
0.354185639
0.177795367
0.421657879
Covariance = 0.103446133
Correlation = 0.692664763
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
20) The volatility on Home Depot's returns is closest to:
A) 35%
B) 31%
C) 42%
D) 18%
E) 22%
Answer: C
Explanation: C)
Year-End
2000
2001
2002
2003
2004
2005
average =
Lowes
Realized
Return
20.1%
72.7%
-25.7%
56.9%
6.7%
17.9%
24.8%
Home
Depot
Realized
Return
-14.6%
4.3%
-58.1%
71.1%
17.3%
0.9%
3.5%
Variance =
Stdev =
Lowes
Deviation
(RL - RL)
(RL - RL)
Home Depot
Deviation
(RH - RH)
×
(RH - RH)
-4.7%
47.9%
-50.5%
32.1%
-18.1%
-6.9%
-18.1%
0.8%
-61.6%
67.6%
13.8%
-2.6%
0.00843889
0.00391456
0.31079056
0.21727489
-0.02496211
0.00177389
0.125447467
0.354185639
0.177795367
0.421657879
Covariance = 0.103446133
Correlation = 0.692664763
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
Use the table for the question(s) below.
Consider the following expected returns, volatilities, and correlations:
Stock
Duke
Energy
Microsoft
Wal-Mart
Expected
Return
Standard
Deviation
Correlation
with Duke
Energy
14%
44%
23%
6%
24%
14%
1.0
-1.0
0.0
Correlation
Correlation
with Microsoft with Wal-Mart
-1.0
1.0
0.7
0.0
0.7
1.0
21) The volatility of a portfolio that is equally invested in Duke Energy and Microsoft is closest to:
A) 8%
B) 9%
C) 11%
D) 6%
E) 7%
Answer: B
Explanation: B) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2
= 0.52(0.06)2 + 0.52(0.24)2 + 2(0.5)(0.5)(-1)(0.06)(0.24)
= 0.0081
stdev =
= 0.09
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
22) The expected return of a portfolio that consists of a long position of $10,000 in Wal-Mart and a short
position of $2000 in Microsoft is closest to:
A) 21%
B) 12%
C) 27%
D) 18%
E) 24%
Answer: D
Explanation: D) (10,000 / 8000)(0.23) + (-2000 / 8000)(0.44)
= (1.25)(0.23) + (-0.25)(0.44) = 0.1775
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
�����������latility of a portfolio that is consists of a long position of $10,000 in Wal-Mart and a short
23) The volatility of a portfolio that is consists of a long position of $10,000 in Wal-Mart and a short
position of $2000 in Microsoft is closest to:
A) 9%
B) 14%
C) 11%
D) 12%
E) 10%
Answer: B
Explanation: B) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2
= 1.252(0.14)2 + (- 0.25)2(0.24)2 + 2(1.25)(-0.25)(0.7)(0.14)(0.24)
= 0.019525
stdev =
= 0.139732
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
24) The expected return of a portfolio that is equally invested in Duke Energy and Microsoft is closest
to:
A) 15%
B) 14%
C) 29%
D) 44%
E) 22%
Answer: C
Explanation: C) E[Rp] = x1E[R1] + x2E[R2] = .5 × 0.14 + .5 × 0.44 = 0.29 = 29%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
25) The volatility of a portfolio that is equally invested in Wal-Mart and Duke Energy is closest to:
A) 5.0%
B) 0.6%
C) 7.6%
D) 22.4%
E) 10.1%
Answer: C
Explanation: C) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2
= 0.52(0.14)2 + 0.52(0.06)2 + 2(0.5)(0.5)(0)(0.14)(0.06)
= 0.0058
stdev =
= 0.076
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
26) The expected return of a portfolio that is equally invested in Wal-Mart and Duke Energy is closest
26) The expected return of a portfolio that is equally invested in Wal-Mart and Duke Energy is closest
to:
A) 10.0%
B) 17.8%
C) 26.3%
D) 29.0%
E) 18.5%
Answer: E
Explanation: E) E[Rp] = x1E[R1] + x2E[R2] = .5 × 0.23 + .5 × 0.14 = 0.185 = 18.5%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
27) The volatility of a portfolio that is equally invested in Wal-Mart and Microsoft is closest to:
A) 7.2%
B) 7.6%
C) 15.4%
D) 17.6%
E) 19.0%
Answer: D
Explanation: D) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2
= 0.52(0.14)2 + 0.52(0.24)2 + 2(0.5)(0.5)(0.7)(0.14)(0.24)
= 0.03106
stdev =
= 0.176238
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
28) Which of the following combinations of stocks would give you the biggest reduction in risk?
A) Duke Energy and Wal-Mart
B) Wal-Mart and Microsoft
C) Microsoft and Duke Energy
D) Duke Energy by itself
E) Wal-Mart by itself
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
29) What diversification, if any, is achieved if two stocks in a portfolio are perfectly positively
correlated?
Answer: No diversification benefit is achieved if two stocks are perfectly positively correlated. The
portfolio risk becomes the weighted sum of the two individual stock standard deviations.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
��0) What is the lowest risk possible by selecting two stocks that are perfectly negatively correlated?
30) What is the lowest risk possible by selecting two stocks that are perfectly negatively correlated?
Answer: By selecting the weights carefully, one can create a risk-free portfolio using two stocks that are
perfectly negatively correlated.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 11.1 Calculate the expected return and volatility (standard deviation) of a portfolio
11.3 Measuring Systematic Risk
1) If you build a large enough portfolio, you can diversify away all the risks of a portfolio.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
2) Stocks that have a higher volatility will always have a higher beta.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
3) A stock market comprises 5000 shares of stock A and 2000 shares of stock B. Assume the share prices
for stocks A and B are $20 and $35, respectively. What is the capitalization of the market portfolio?
A) $170,000
B) $150,000
C) $165,000
D) $185,000
E) $100,000
Answer: A
Explanation: A) Multiply the number of shares of each stock by its price and add the values.
Thus, 5000 × 20 + 2000 × 35 = $170,000.
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
4) A stock market comprises 5000 shares of stock A and 2000 shares of stock B. Assume the share prices
for stocks A and B are $20 and $35, respectively. What proportion of the market portfolio is comprised
of stock A?
A) 58.8%
B) 41.2%
C) $100,000
D) $70,000
E) 100%
Answer: A
Explanation: A) Multiply the number of shares of each stock by its price and add the values.
Thus, 5000 × 20 + 2000 × 35 = $170,000.
Stock A is worth 5000 × 20 = $100,000; 100,000/170,000 = 58.8%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
5) A stock market comprises 5000 shares of stock A and 2000 shares of stock B. Assume the share prices
for stocks A and B are $20 and $35, respectively. If you have $15,000 to invest and you want to hold the
market portfolio, how much of your money will you invest in Stock A?
A) $10,000
B) $8,823.53
C) $6,176.47
D) $5,000
E) $4,403.42
Answer: B
Explanation: B) Multiply the number of shares of each stock by its price and add the values.
Thus, 5000 × 20 + 2000 × 35 = $170,000.
Stock A is worth 5000 × 20 = $100,000; 100,000/170,000 = 58.8%
58.8% × 15,000 = $8,823.53
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
6) A stock market comprises 2000 shares of stock A and 2000 shares of stock B. The share prices for
stocks A and B are $20 and $10, respectively. What is the capitalization of the market portfolio?
A) $55,000
B) $60,000
C) $70,000
D) $65,000
E) $50,000
Answer: B
Explanation: B) Multiply the number of shares of each stock by its price and add the values.
Thus, 2000 × 20 + 2000 × 10 = $60,000.
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
7) A stock market comprises 2000 shares of stock A and 2000 shares of stock B. The share prices for
stocks A and B are $20 and $10, respectively. What proportion of the market portfolio is comprised of
each stock?
A) Stock A is 66.7% and Stock B is 33.3%
B) Stock A is 33.3% and Stock B is 66.7%
C) Stock A is $40,000 and Stock B is $20,000
D) Stock A is 200% and Stock B is 100%
E) Stock A is 50% and Stock B is 50%
Answer: A
Explanation: A) Multiply the number of shares of each stock by its price and add the values.
Thus, 2000 × 20 + 2000 × 10 = $60,000.
Stock A is 40,000/60,000 = 66.7% and Stock B is $20,000/$60,000 = 33.3%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
8) A stock market comprises 1000 shares of stock A and 3000 shares of stock B. The share prices for
stocks A and B are $25 and $30, respectively. What is the capitalization of the market portfolio?
A) $115,000
B) $100,000
C) $98,000
D) $125,000
E) $90,000
Answer: A
Explanation: A) Multiply the number of shares of each stock by its price and add the values.
Thus, 1000 × 25 + 3000 × 30 = $115,000.
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
9) Air Canada stock has a standard deviation of 18%, while the market index standard deviation is 8%.
If the correlation between Air Canada and the market index is 0.45, what is the beta of Air Canada
stock?
A) 1.01
B) 0.03
C) 0.2
D) 2.25
E) 2.5
Answer: A
Explanation: A) Beta = (0.18 × 0.45)/0.08 = 1.01
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
10) Air Canada stock has a standard deviation of 25%, while the market index standard deviation is
12%. If the correlation between Air Canada and the market index is 0.33, what is the beta of Air Canada
stock?
A) 2.08
B) 0.16
C) 0.69
D) 2.75
E) 1.32
Answer: C
Explanation: C) Beta = (0.25 × 0.33)/0.12 = 0.69
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
11) Air Canada stock has a standard deviation of 10%, while the market index standard deviation is 7%.
If the correlation between Air Canada and the market index is 0.85, what is the beta of Air Canada
stock?
A) 0.60
B) 1.21
C) 1.43
D) 0.85
E) 1.0
Answer: B
Explanation: B) Beta = (0.1 × 0.85)/0.07 =1.21
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
12) You expect General Motors (GM) to have a beta of 1.3 over the next year and the beta of Exxon
Mobil (XOM) to be 0.9 over the next year. Also, you expect the volatility of General Motors to be 40%
and that of Exxon Mobil to be 30% over the next year. Which stock has more systematic risk? Which
stock has more total risk?
A) XOM, GM
B) XOM, XOM
C) GM, XOM
D) GM, GM
E) They both have the same risks.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.3 Measure systematic risk
13) You expect General Motors (GM) to have a beta of 1 over the next year and the beta of Exxon Mobil
(XOM) to be 1.2 over the next year. Also, you expect the volatility of General Motors to be 30% and that
of Exxon Mobil to be 40% over the next year. Which stock has more systematic risk? Which stock has
more total risk?
A) GM, GM
B) GM, XOM
C) XOM, XOM
D) XOM, GM
E) They both have the same risks.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.3 Measure systematic risk
14) You expect General Motors (GM) to have a beta of 1.5 over the next year and the beta of Exxon
Mobil (XOM) to be 1.9 over the next year. Also, you expect the volatility of General Motors to be 50%
and that of Exxon Mobil to be 35% over the next year. Which stock has more systematic risk? Which
stock has more total risk?
A) XOM, GM
B) GM, XOM
C) GM, GM
D) XOM, XOM
E) They both have the same risks.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.3 Measure systematic risk
15) The amount of a stock's risk that is diversified away
A) is independent of the portfolio that you add it to.
B) depends on market risk premium.
C) depends on the risk-free rate of interest.
D) depends on the portfolio that you add it to.
E) depends on its market capitalization.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
16) If you build a large enough portfolio, you can diversify away all ________ risk, but you will be left
with ________ risk.
A) diversifiable, unsystematic
B) unsystematic, systematic
C) systematic, undiversifiable
D) diversifiable, diversifiable
E) common, unsystematic
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
17) The market portfolio is the portfolio of all risky investments held
A) in descending weights.
B) in ascending weights.
C) in proportion to their value.
D) based on previous year performance.
E) in equal weights.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
18) The S&P 500 index traditionally is a ________ portfolio of the 500 largest U.S. stocks.
A) value weighted
B) equally weighted
C) chain weighted
D) price weighted
E) reputation weighted
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
19) For each 1% change in the market portfolio's excess return, the investment's excess return is
expected to change by ________ percent due to risks that it has in common with the market.
A) beta
B) alpha
C) zero
D) more than 1
E) less than 1
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
20) The beta of the market portfolio is:
A) 0
B) -1
C) 2
D) 1
E) 10
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.3 Measure systematic risk
21) Companies that sell household products and food have very little relation to the state of the
economy because such basic needs do not go away. These stocks tend to have ________ betas.
A) high
B) low
C) negative
D) zero
E) very high
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
22) A linear regression to estimate the relation between Research in Motion's stock returns and the
market's return gives the best-fitting line that represents the relation between the stock and the market.
The slope of this line is our estimate of
A) alpha.
B) beta.
C) risk-free rate.
D) volatility.
E) standard deviation.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
23) A linear regression was done to estimate the relation between Sprint's stock returns and the market's
return. The intercept of the line was found to be 0.23 and the slope was 1.47. Which of the following
statements is true regarding Sprint's stock?
A) Sprint's beta is 0.23.
B) Sprint's beta is 1.47.
C) The risk-free rate is 1.47%.
D) The standard deviation of Sprint's excess returns is 23%.
E) Sprint's beta is between 0.23 and 1.47.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
24) You observe that AT&T stock and the S&P 500 have the following weekly returns:
Week
1
2
3
4
AT&T return
0.005
0.010
-0.003
-0.005
S&P 500 return
0.001
0.005
-0.005
-0.001
If this pattern of stock returns is typical of AT&T stock, and you calculated a beta against the S&P 500,
which of the following is true?
A) AT&T's beta is negative.
B) AT&T's beta is zero.
C) AT&T's beta is positive.
D) AT&T's beta is highly negative.
E) Beta cannot be calculated from this data.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
25) You observe the following scatterplot of Ford's weekly returns against the S&P 500. Which of the
following statements is true about Ford's beta against the S&P 500?
A) Ford's beta appears to be positive.
B) Ford's beta appears to be negative.
C) Ford's beta appears to be zero- there is no apparent relation between its return and the S&P return.
D) Ford's beta appears to be highly negative.
E) Beta has nothing to do with the relationship seen in this scatterplot.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
26) Since total risk is greater than systematic risk, should standard deviation be always greater than
beta?
Answer: Standard deviation and beta are measured in different units and hence are not directly
comparable. For example, standard deviation is measured in percentage, while beta is a unitless ratio.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
27) Is it possible for a stock to have high total risk but low systematic risk?
Answer: Yes, it is possible for a stock to have a high total risk and yet a low systematic risk. A firm's
stock may have a significant amount of volatility, but it may also have low correlation with the general
market. Low market correlation would imply a low beta, thus a low level of systematic risk.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
28) How does the S&P/TSX Composite index rank in terms of number and market capitalization of
Canadian public firms?
Answer: The S&P/TSX Composite index is a relatively small fraction of the total of over 5000 Canadian
public firms. However, it is about 95% of the total market capitalization of public firms.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 11.2 Understand the relationship between systematic risk and the market portfolio
11.4 Putting It All Together: The Capital Asset Pricing Model
1) The market or equity risk premium can be estimated by computing the historical average excess
return of the market portfolio.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
2) The security market line is a graph of the expected return of a stock as a function of systematic risk
(beta).
Answer: TRUE
Diff: 1 Type: TF
Skill: Definition
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
3) The Capital Asset Pricing Model (CAPM) says that the excess return on a stock is equal to its beta
times the market risk premium.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
4) WestJet stock has a beta of 1.5. If the risk-free rate is 2.4%, and the expected market return is 10%,
what is the expected return of WestJet stock, according to the CAPM?
A) 13.8%
B) 17.4%
C) 21.0%
D) 11.4%
E) 15.0%
Answer: A
Explanation: A) Expected return = 2.4 + 1.5(10 - 2.4) = 13.8%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
5) CIBC stock has a beta of 1.2. If the risk-free rate is 1.8%, and the market risk premium is 6.5%, what is
the expected return of CIBC stock, according to the CAPM?
A) 7.44%
B) 8.3%
C) 9.6%
D) 7.8%
E) 10%
Answer: C
Explanation: C) Expected return = 1.8 + 1.2(6.5) = 9.6%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
6) Blackberry stock has a beta of 1.7. If the risk-free rate is 2.1%, and the market risk premium is 7%,
what is the expected return of Blackberry stock, according to the CAPM?
A) 9.8%
B) 10.4%
C) 11.9%
D) 14%
E) 10%
Answer: D
Explanation: D) Expected return = 2.1 + 1.7(7) = 14%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
7) Barrick Gold Corp stock has a beta of 2.1. If the risk-free rate is 2.6%, and expected market return is
9%, what is the expected return of Barrick Gold Corp stock, according to the CAPM?
A) 10.8%
B) 10.4%
C) 21.5%
D) 13.4%
E) 16%
Answer: E
Explanation: E) Expected return = 2.6 + 2.1(9 - 2.6) = 16%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
8) Your portfolio contains $20,000 of Air Canada stock, which has a beta of 1.4, and $30,000 of WestJet
stock, which has a beta of 1.8. What is the beta of your portfolio?
A) 1.64
B) 1.60
C) 1.40
D) 1.72
E) 1.69
Answer: A
Explanation: A) (20,000 × 1.4)/(20,000 + 30,000) + (30,000 × 1.8)/(20,000 + 30,000) = 1.64
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
9) Your portfolio contains $12,000 of BMO stock, which has a beta of 1.1, and $18,000 of Lululemon
stock, which has a beta of 1.4. What is the beta of your portfolio?
A) 1.4
B) 1.25
C) 1.28
D) 1.12
E) 1.31
Answer: C
Explanation: C) (12,000 × 1.1)/(12,000 + 18,000) + (18,000 × 1.4)/(12,000 + 18,000) = 1.28
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
10) Your portfolio contains $33,000 of CP Rail Stock, which has a beta of 1.3, and $41,000 of Lululemon
stock, which has a beta of 1.05. What is the beta of your portfolio?
A) 1.17
B) 1.16
C) 1.18
D) 1.21
E) 1.31
Answer: B
Explanation: B) (33,000 × 1.3)/(33,000 + 41,000) + (41,000 × 1.05)/(33,000 + 41,000) = 1.16
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
11) Loblaw's stock has a beta of 0.9, while Bombardier stock has a beta of 1.35. If the risk-free rate is 2%,
and the market risk premium is 8%, what is the expected return on a portfolio with equal holdings of
Loblaw's and Bombardier?
A) 9.25%
B) 8.75%
C) 10%
D) 11%
E) 13.25%
Answer: D
Explanation: D) Portfolio beta = 0.5 × 0.9 + 0.5 × 1.35 = 1.125
Portfolio return = 0.02 + 1.125(0.08) = 11%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
12) Potash Corp stock has a beta of 1.2, while Tim Horton's stock has a beta of 1.7. If the risk-free rate is
2.2%, and the market risk premium is 7%, what is the expected return on a portfolio with 40% weight in
Potash and the remainder in Tim Horton's?
A) 9.4%
B) 12.7%
C) 10.5%
D) 11.6%
E) 13.25%
Answer: B
Explanation: B) Portfolio beta = 0.4 × 1.2 + 0.6 × 1.7 = 1.5
Portfolio return = 0.022 + 1.5(0.07) = 12.7%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
13) Potash Corp stock has a beta of 1.1, while Tim Horton's stock has a beta of 1.4. The risk-free rate is
1.9%, and the expected return on a portfolio with 30% weight in Potash and the remainder in Tim
Horton's is 9.76%. What is the market risk premium?
A) 7%
B) 7.9%
C) 6%
D) 6.9%
E) 7.2%
Answer: C
Explanation: C) Portfolio beta = 0.3 × 1.1 + 0.7 × 1.4 = 1.31
9.76 = 1.9 + 1.31(Risk Premium); Risk premium = 6%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
14) RBC stock has a beta of 0.85, while TD stock has a beta of 1.21. The risk-free rate is 1.5%, and the
expected return on a portfolio with 50% weight in RBC and the remainder in TD is 9.74%. What is the
market risk premium?
A) 7%
B) 9.5%
C) 8%
D) 8.2%
E) 7.2%
Answer: C
Explanation: C) Portfolio beta = 0.5 × 0.85 + 0.5 × 1.21 = 1.03
9.74 = 1.5 + 1.03(Risk Premium); Risk premium = 8%
Diff: 2 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
15) The expected return is usually ________ the baseline risk-free rate of return that we demand to
compensate for inflation and time value of money.
A) lower than
B) higher than
C) similar to
D) much lower than
E) independent of
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
16) Historically, the average excess return of the S&P/TSX Composite Index over the return of
Government of Canada bonds has been ________ and is a proxy for the market risk premium.
A) between 10% and 12%
B) between 14% and 16%
C) between 5% and 7%
D) between 11% and 13%
E) between 4% and 6%
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
17) The Capital Asset Pricing Model asserts that the ________ return is equal to the risk-free rate plus a
risk premium for systematic risk.
A) realized return
B) expected return
C) holding period return
D) ex-post return
E) average return
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
18) The systematic risk (beta) of a portfolio is ________ by holding more stocks, even if they each had
the same systematic risk.
A) unchanged
B) increased
C) decreased
D) eliminated
E) doubled
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
Use the information for the question(s) below.
Suppose you have $10,000 in cash and you decide to borrow another $10,000 at a 6% interest rate to
invest in the stock market. You invest the entire $20,000 in an exchange-traded fund (ETF) with a 12%
expected return and a 20% volatility.
19) The expected return on your of your investment is closest to:
A) 18%
B) 20%
C) 12%
D) 24%
E) 32%
Answer: A
Explanation: A) E[Rxp] = rf + x(E[Rp] - rf)
= 0.06 + 2(0.12 - 0.06) = 0.18 or 18%
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
20) The volatility of your investment is closest to:
A) 40%
B) 20%
C) 30%
D) 24%
E) 15%
Answer: A
Explanation: A) SD( Rxp) = xSD(Rp)
= 2(0.20) = 0.40
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
21) Assume that the ETF you invested in returns -10%. Then the realized return on your investment is
closest to:
A) -20%
B) -10%
C) -24%
D) -26%
E) -15%
Answer: D
Explanation: D) Value of portfolio = $20,000( 1 + -0.10) = $18,000 - $10,600 loan & interest = 7400;
So, return = (7400 - 10,000) / 10,000 = -26%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
22) While we are using historic return to estimate a stock's beta, why can't we use historic data to
forecast the expected return for the stock?
Answer: It is extremely difficult to infer the average return of individual stocks from historic data
because stock returns are very volatile. Even 100 years of data would not be enough to forecast future
return.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
23) Why should an investor invest in a negative-beta stock knowing that it will have an expected return
lower than the risk-free rate?
Answer: A savvy investor will invest in a negative-beta stock as a part of a diversified portfolio to
reduce overall portfolio beta rather than as a single investment.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 11.4 Use the Capital Asset Pricing Model (CAPM) to compute the cost of equity capital for a stock
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 12 Determining the Cost of Capital
12.1 A First Look at the Weighted Average Cost of Capital
1) Financial managers do not need to use all sources of financing in order to determine the cost of
capital.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
2) To attract capital from outside investors, a firm must offer potential investors an expected return that
is commensurate with the level of risk that they can bear.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
3) One should use accounting-based book values rather than market values of debt and equity to
determine the weights for the different sources of capital.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
4) A firm's sources of financing, which usually consists of debt and equity, represent its
A) total assets.
B) capital.
C) total liabilities.
D) current liabilities.
E) current assets.
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
5) The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its
A) asset ratio.
B) current ratio.
C) capital structure.
D) value structure.
E) enterprise value.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
6) The firm's overall cost of capital that is a blend of the costs of the different sources of capital is known
as the firm's
A) weighted average cost of capital.
B) cost of equity infusion.
C) cost of debt.
D) cost of preferred stock.
E) cost of financing.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
7) The book value of equity of a firm is $100 million and the market value of equity is $200 million. The
face value of debt of the firm is $50 million and the market value of debt is $60 million. What is the
market value of assets of the firm?
A) $150 million
B) $160 million
C) $260 million
D) $250 million
E) $110 million
Answer: C
Explanation: C) Market value of debt plus market value of equity gives market value of assets.
$200 + $60 = $260 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
8) Apple computers has raised all its capital via equity rather than debt. Such a firm is also referred to as
a(n) ________ firm.
A) levered
B) margined
C) risk less
D) unlevered
E) risky
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
9) A levered firm is one that has ________ outstanding.
A) debt
B) equity
C) preferred stock
D) equity options
E) accounts receivable
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
10) Leverage is the amount of ________ on a firm's balance sheet.
A) equity
B) debt
C) preferred stock
D) assets
E) liabilities
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
11) For an unlevered firm, the cost of capital of the firm can be determined by using the
A) yield on the traded debt.
B) Capital Asset Pricing Model.
C) dividend yield.
D) preferred stock yield.
E) market value of equity.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
12) Asterix Corp has debt with a book value of $20 million, currently trading at 85% of book value. It
also has book value of equity of $30 million, and 2 million shares of common stock trading at $4.75 per
share. What weights should Asterix use for debt and equity in calculating its WACC?
A) 0.64, 0.36
B) 0.4, 0.6
C) 0.68, 0.32
D) 0.5, 0.5
E) 0.6, 0.4
Answer: A
Explanation: A) $20 million × 0.85 = $17 million in debt.
2 million shares × $4.75/share = $9.5 million in equity.
Total market value = 17 + 9.5 = $26.5 million
Debt weight = 17/26.5 = 0.64; Equity weight = 9.5/26.5 = 0.36
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
13) Barley Corp has debt with a book value of $19 million, currently trading at 90% of book value. It also
has book value of equity of $15 million, and 10 million shares of common stock trading at $2.45 per
share. What weights should Barley Corp use for debt and equity in calculating its WACC?
A) 0.56, 0.44
B) 0.44, 0.56
C) 0.41, 0.59
D) 0.5, 0.5
E) 0.6, 0.4
Answer: C
Explanation: C) $19 million × 0.9 = $17.1 million in debt.
10 million shares × $2.45/share = $24.5 million in equity.
Total market value = 17.1 + 24.5 = $41.6 million
Debt weight = 17.1/41.6 = 0.41; Equity weight = 24.5/41.6 = 0.59
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
14) Billy Burger Corp has a market value of debt of $245 million, and a market value of equity of $815
million. What weights should Billy Burger use for debt and equity in calculating its WACC?
A) 0.30, 0.70
B) 0.23, 0.77
C) 0.70, 0.30
D) 0.5, 0.5
E) 0.6, 0.4
Answer: B
Explanation: B) Debt weight = 245/(245 + 815) = 0.23, Equity weight = 815/(245 + 815) = 0.77
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
15) Timbuktu Corp has a market value of debt of $2.5 billion, and a market value of equity of $1.5
billion. What weights should Timbuktu use for debt and equity in calculating its WACC?
A) 0.375, 0.625
B) 0.5, 0.5
C) 0.4, 0.6
D) 0.625, 0.375
E) 0.6, 0.4
Answer: D
Explanation: D) Debt weight = 2.5/(2.5 + 1.5) = 0.625, Equity weight = 1.5/(2.5 + 1.5) = 0.375
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
16) GM has a market value of $8 billion of equity and a market value of $12 billion of debt. What are the
weights in equity and debt that are used for calculating the WACC?
A) 0.5, 0.5
B) 0.6, 0.4
C) 0.4, 0.6
D) 0.8, 0.2
E) 0.8, 1.2
Answer: C
Explanation: C) Weight in debt equals market value of debt divided by market value of debt plus
equity. Similarly, weight in equity is market value of equity divided by market value of debt plus
equity.
Equity = 8 / (8 + 12) = 0.4; Debt = 12 / (8 + 12) = 0.6
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
17) The total market value of General Motors (GM) is $10 billion. GM has a market value of $7 billion of
equity and a face value of $10 billion of debt. What are the weights in equity and debt that are used for
calculating the WACC?
A) 0.6, 0.4
B) 0.7, 0.3
C) 0.3, 0.7
D) 0.5, 0.5
E) 0.4, 0.6
Answer: B
Explanation: B) Weight in debt equals market value of debt divided by market value of debt plus
equity. Similarly, weight in equity is market value of equity divided by market value of debt plus
equity.
Equity = 7 / 10 = 0.7; Debt = (10 - 7) / 10 = 0.3
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
18) Epiphany is an all-equity firm with an estimated market value of $400,000. The firm sells $300,000 of
debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the
weight in debt after the proposed financing and repurchase of equity.
A) 0.2, 0.8
B) 0.25, 0.75
C) 0.4, 0.6
D) 0.5, 0.5
E) 0.1, 0.3
Answer: B
Explanation: B) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1- Weight in debt
Weight in debt = $300,000 / $400,000 = 0.75
Weight in equity = 1 - 0.75 = 0.25
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
19) Epiphany is an all-equity firm with an estimated market value of $300,000. The firm sells $100,000 of
debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the
weight in debt after the proposed financing and repurchase of equity.
A) 0.2, 0.8
B) 0.25, 0.75
C) 0.67, 0.33
D) 0.5, 0.5
E) 0.75, 0.25
Answer: C
Explanation: C) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $100,000 / $300,000 = 0.33
Weight in equity = 1- 0.33 = 0.67
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
20) Epiphany is an all-equity firm with an estimated market value of $500,000. The firm sells $200,000 of
debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the
weight in debt after the proposed financing and repurchase of equity.
A) 0.2, 0.8
B) 0.25, 0.75
C) 0.4, 0.6
D) 0.6, 0.4
E) 0.5, 0.5
Answer: D
Explanation: D) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $200,000 / $500,000 = 0.4
Weight in equity = 1 - 0.4 = 0.6
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
21) Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The firm has
book equity of $20 million, and 2 million shares trading at $18 per share. What weights should JUP use
in calculating its WACC?
A) 40% for debt, 60% for equity
B) 50% for debt, 50% for equity
C) 36% for debt, 64%% for equity
D) 45% for debt, 55% for equity
E) 30% for debt, 70% for equity
Answer: A
Explanation: A) Market Value Debt = $20 million × 120% = $24 million
Market Value Equity = 2 million × $18 = $36 million
Total Market Value = $60 million
Wd = $24/$60 = 40%
We = $36/$60 = 60%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
22) As a firm increases its level of debt relative to its level of equity, the firm is
A) increasing the fraction of the firm financed with equity.
B) decreasing the fraction of the firm financed with debt.
C) decreasing its leverage.
D) increasing its leverage.
E) becoming unlevered.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
23) Why do we use market values rather than book values in calculation of WACC?
Answer: We use market values rather than book values because the cost of capital is based on investors
current assessment of the value of the firm and not the assessment of accounting-based book values.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
24) Why do we use leverage if it increases the risk of a firm?
Answer: For a particular firm, the cost of debt is cheaper than the cost of equity due to lower risk of the
debt holders as well as tax deductibility of interest payment. Thus, including debt, everything else
remaining same, reduces the cost of capital for a firm.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
12.2 The Firm's Costs of Debt and Equity Capital
1) A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
2) The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
3) The ________ of a firm's debt can be used as the firm's current cost of debt.
A) current yield
B) coupon rate
C) yield to maturity
D) discount yield
E) amount
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
4) A firm incurs $50,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the
effective after-tax interest rate expense for the firm?
A) $27,000
B) $29,000
C) $32,000
D) $35,000
E) $39,000
Answer: D
Explanation: D) Effective after-tax interest expense = Interest expense × (1 - Tax Rate)
Effective after-tax interest expense = $50,000 × (1 - 0.3) = $35,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
5) A firm incurs $40,000 in interest expenses each year. If the tax rate of the firm is 40%, what is the
effective after-tax interest rate expense for the firm?
A) $22,000
B) $24,000
C) $27,000
D) $29,000
E) $33,000
Answer: B
Explanation: B) Effective after-tax interest expense = Interest expense × (1 - Tax Rate)
Effective after-tax interest expense = $40,000 × (1 - 0.4) = $24,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
6) A firm incurs $70,000 in interest expenses each year. If the tax rate of the firm is 20%, what is the
effective after-tax interest rate expense for the firm?
A) $37,000
B) $49,000
C) $56,000
D) $65,000
E) $72,000
Answer: C
Explanation: C) Effective after-tax interest expense = Interest expense × (1 - Tax Rate)
Effective after-tax interest expense = $70,000 × (1 - 0.2) = $56,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
7) The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that
interest expense can be
A) deducted.
B) margined.
C) refinanced.
D) salvaged.
E) ignored.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
8) Outstanding debt of Home Depot trades with a yield to maturity of 7%. The tax rate of Home Depot
is 30%. What is the effective cost of debt of Home Depot?
A) 5.2%
B) 7%
C) 6.3%
D) 4.9%
E) 2.1%
Answer: D
Explanation: D) Multiply the yield to maturity by 1 minus the tax rate.
0.07 × (1 - 0.3) = 0.049 = 4.9%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
9) Starling Capital has outstanding corporate debt paying a 10% coupon, with a current yield to
maturity of 8%. If Starling's tax rate is 35%, what is the firm's effective cost of debt?
A) 5.2%
B) 6.5%
C) 10%
D) 8%
E) 5.85%
Answer: A
Explanation: A) Multiply the yield to maturity by 1 minus the tax rate.
0.08 × (1 - 0.35) = 0.052 or 5.2%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
10) Portentious Door Company has outstanding corporate debt paying a 5% semiannual coupon, with a
current yield to maturity of 6%. If the firm's tax rate is 15%, what is its effective cost of debt?
A) 5%
B) 4.25%
C) 5.1%
D) 6%
E) 5.5%
Answer: C
Explanation: C) Multiply the yield to maturity by 1 minus the tax rate.
0.06 × (1 - 0.15) = 0.051 or 5.1%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
11) Preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $30. What is
the cost of preferred stock capital for Ford?
A) 13.3%
B) 14.5%
C) 15.5%
D) 16.2%
E) 16.5%
Answer: A
Explanation: A) Divide the dividend by the preferred stock price.
4 / 30 = 13.3%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
12) Manitou Inc has preferred stock paying an annual dividend of $2.25, and common stock paying an
annual dividend of $0.85. If the current preferred stock price is $18.75, what is Manitou's cost of
preferred stock capital?
A) 11%
B) 12%
C) 4.5%
D) 10%
E) 13%
Answer: B
Explanation: B) Divide the preferred dividend by the preferred stock price.
2.25 / 18.75 =12%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
13) IBM expects to pay a dividend of $4 next year and expects these dividends to grow at 7% a year. The
price of IBM is $90 per share. What is IBM's cost of equity capital?
A) 9.65%
B) 10.23%
C) 10.89%
D) 11.44%
E) 12.36%
Answer: D
Explanation: D) Cost of equity is the next period dividend divided by the price plus the growth rate in
dividends.
Ke = D1/P0 + g = 4 / 90 + 0.07 = 0.1144 = 11.44%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
14) Garwood Garages will pay a dividend of $2.55 next year, and expects its dividends to grow at 3%
per year. The current price of Garwood stock is $18.25 per share. What is Garwood's cost of equity?
A) 17%
B) 14%
C) 15%
D) 13%
E) 20%
Answer: A
Explanation: A) Cost of equity is the next period dividend divided by the price plus the growth rate in
dividends.
Ke = D1/P0 + g = 2.55 / 18.25 + 0.03 = 17%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
15) Xcom Industries will pay a dividend of $0.44 next year, and expects its dividends to grow at 8% per
year. The current price of Xom stock is $6.45 per share. What is Xom's cost of equity?
A) 17%
B) 14.8%
C) 6.8%
D) 7.4%
E) 15.4%
Answer: B
Explanation: B) Cost of equity is the next period dividend divided by the price plus the growth rate in
dividends.
Ke = D1/P0 + g = 0.44/6.45 + 0.08 = 14.8%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
16) Your estimate of the market risk premium is 6%. The risk-free rate of return is 5% and General
Motors has a beta of 1.2. What is General Motors' cost of equity capital?
A) 12.2%
B) 11.8%
C) 12.9%
D) 11.4%
E) 10.8%
Answer: A
Explanation: A) Apply the CAPM equation.
0.05 + 1.2 × 0.06 = 0.122 = 12.2%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
17) Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General
Motors has a beta of 1.5. What is General Motors' cost of equity capital?
A) 13.5%
B) 14.5%
C) 13.9%
D) 14.8%
E) 15.1%
Answer: B
Explanation: B) Apply the CAPM equation.
0.04 + 1.5 × 0.07 = 0.145 = 14.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
18) Your estimate of the market risk premium is 6%. The risk-free rate of return is 4.5% and General
Motors has a beta of 1.6. What is General Motors' cost of equity capital?
A) 14.1%
B) 13.5%
C) 13.9%
D) 14.4%
E) 14.8%
Answer: A
Explanation: A) Apply the CAPM equation.
0.045 + 1.6 × 0.06 = 0.141 = 14.1%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
19) A firm has outstanding debt with a coupon rate of 7%, seven years maturity, and a price of $1000
per $1000 face value. What is the after-tax cost of debt if the marginal tax rate of the firm is 30%?
A) 4.9%
B) 5.2%
C) 5.5%
D) 5.9%
E) 6.3%
Answer: A
Explanation: A) YTM = coupon rate in this case. Therefore, after-tax cost = coupon rate × (1 - tax rate).
Therefore after-tax cost = 0.07 × (1 - 0.3) = 4.9%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
20) A firm has outstanding debt paying annual coupons, with a coupon rate of 10%, and 8 years to
maturity. The firm's bonds are currently trading at a price of $875.50 per $1000 face value. What is the
firm's cost of debt if it has a tax rate of 25%?
A) 7.5%
B) 10%
C) 9.4%
D) 12.6%
E) 11.2%
Answer: C
Explanation: C) First calculate yield to maturity. FV = 1000; PV = -875.50; PMT = 100; N = 8.
YTM = 12.55%
Cost of debt = 0.1255 × (1 - 0.25) = 9.4%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
21) A firm has outstanding debt paying annual coupons, with a coupon rate of 5%, and 10 years to
maturity. The firm's bonds are currently trading at a price of $950 per $1000 face value. What is the
firm's cost of debt if it has a tax rate of 15%?
A) 5.7%
B) 5%
C) 4.8%
D) 4.25%
E) 5.4%
Answer: C
Explanation: C) First calculate yield to maturity. FV = 1000; PV = -950; PMT = 50; N = 10.
YTM = 5.7%
Cost of debt = 0.057 × (1 - 0.15) = 4.8%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
22) A firm has $1 million market value and it sells preferred stock with a par value of $100. If the
coupon rate on the preferred stock is 7% and the preferred stock trades at $95, what is the cost of
preferred stock financing?
A) 6.75%
B) 7.15%
C) 7.21%
D) 7.37%
E) 8.12%
Answer: D
Explanation: D) Cost of preferred stock financing = Dividend rate × Par value / Price
Cost of preferred stock financing = 7 × 100 / 95 = 7.37%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
23) A firm has $2 million market value and it sells preferred stock with a par value of $100. If the
coupon rate on the preferred stock is 8% and the preferred stock trades at $90, what is the cost of
preferred stock financing?
A) 8.75%
B) 8.89%
C) 9.21%
D) 9.35%
E) 10.16%
Answer: B
Explanation: B) Cost of preferred stock financing = Dividend rate × Par value / Price
Cost of preferred stock financing = 8 × 100 / 90 = 8.89%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
24) A firm has $3 million market value and it sells preferred stock with a par value of $100. If the
coupon rate on the preferred stock is 9% and the preferred stock trades at $95, what is the cost of
preferred stock financing?
A) 8.75%
B) 9.47%
C) 10.21%
D) 10.41%
E) 10.44%
Answer: B
Explanation: B) Cost of preferred stock financing = Dividend rate × Par value / Price
Cost of preferred stock financing = 9 × 100 / 95 = 9.47%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
25) An all-equity firm produced a dividend flow of $30,000 last year. The market value of the firm is
$875,000 and the dividend is expected to increase at 3% each year. What is the cost of equity capital for
this firm?
A) 6.53%
B) 6.91%
C) 7.45%
D) 7.89%
E) 8.17%
Answer: A
Explanation: A) Cost of capital = Dividend flow × (1 + growth rate) / Market value of firm + growth rate
Cost of capital = $30,000 × (1 + 0.03) / $875,000 + 0.03 = 6.53%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
26) An all-equity firm produced a dividend flow of $20,000 last year. The market value of the firm is
$650,000 and the dividend is expected to increase at 4% each year. What is the cost of equity capital for
this firm?
A) 5.5%
B) 6.2%
C) 7.2%
D) 7.8%
E) 8.1%
Answer: C
Explanation: C) Cost of capital = Dividend flow × (1 + growth rate) / Market value of firm + growth rate
Cost of capital = $20,000 × (1 + 0.04) / $650,000 + 0.04 = 7.2 %
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
27) An all-equity firm produced a dividend flow of $40,000 last year. The market value of the firm is
$800,000 and the dividend is expected to increase at 5% each year. What is the cost of equity capital for
this firm?
A) 9.18%
B) 9.75%
C) 10.25%
D) 11.89%
E) 12.05%
Answer: C
Explanation: C) Cost of capital = Dividend flow × (1 + growth rate) / Market value of firm + growth rate
Cost of capital = $40,000 × (1 + 0.05) / $800,000 + 0.05 = 10.25%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
28) The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of
$95. Assume the debt has a face value of $100. What is the pretax cost of debt if the tax rate is 30%.
A) 4.9%
B) 6.5%
C) 7.0%
D) 7.37%
E) 8.15%
Answer: D
Explanation: D) Current yield = coupon / price;
0.07 = coupon / 95; hence, coupon = 0.07 × 95 = 6.65;
yield to maturity = pretax cost of debt;
using a financial calculator, -95 PV, 100 FV, 6.65 PMT, 10 N, CPT I = 7.37%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
29) The outstanding debt of Berstin Corp. has five years to maturity, a current yield of 6%, and a price of
$95. Assume the debt has a face value of $100. What is the pretax cost of debt if the tax rate is 30%?
A) 4.2%
B) 4.8%
C) 6.9%
D) 7.3%
E) 7.7%
Answer: C
Explanation: C) Current yield = coupon / price;
0.06 = coupon / 95; hence, coupon = 0.06 × 95 = 5.7.
yield to maturity = pretax cost of debt;
using financial calculator, -95 PV, 100 FV, 5.7 PMT, 5 N, CPT I = 6.9%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
30) The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 8%, and a price
of $95. Assume the debt has a face value of $100. What is the pretax cost of debt if the tax rate is 30%?
A) 5.6%
B) 6.5%
C) 8.5%
D) 7.2%
E) 7.9%
Answer: C
Explanation: C) Current yield = coupon/price;
0.08 = coupon / 95; hence, coupon = 0.08 × 95 = 7.6;
yield to maturity = pretax cost of debt;
using financial calculator, -95 PV, 100 FV, 7.6 PMT, 8 N, CPT I = 8.5%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
31) A firm has a pre-tax cost of debt of 8.5%. If the firm has a marginal tax rate of 40%, what is its
effective cost of debt?
A) 5.1%
B) 3.4%
C) 8.5%
D) 8.1%
E) 7.2%
Answer: A
Explanation: A) 8.5% × (1 - .40) = 5.1%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
32) The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal
tax rate.
A) is always greater than
B) is always equal to
C) is always less than
D) may be greater than or less than
E) is never less than
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
33) Is it incorrect to use the coupon rate of debt toward cost of debt?
Answer: Yes, it is inaccurate to use the coupon rate of debt as a company's cost of capital is forward
looking while the coupon rate is a historic rate prevalent at the time of issuance of the debt.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
34) What is the difference between the effective cost of debt and the cost of debt?
Answer: The cost of debt is the before-tax cost of debt while the effective cost of debt is the after-tax
cost of debt, which is lower for a profitable tax-paying firm.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
35) Should a firm with high retained earnings have a lower cost of equity?
Answer: Cost of equity is the return that equity holders expect from the firm and is not directly related
to the firm's retained earnings.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
36) Between the two models Constant Dividend Growth Model (CDGM) and Capital Asset Pricing
Model (CAPM), which is a better method for computation of the cost of equity?
Answer: The Capital Asset Pricing Model (CAPM) is more popular for estimating the cost of equity
because of the difficulties in estimating the dividend growth rate required for the Constant Dividend
Growth Model (CDGM).
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
37) Which of the three costs—debt, preferred stock, and common equity—is most difficult to estimate?
Answer: The cost of common equity is most difficult to estimate as it has the highest uncertainty about
its cash flows. The cash flows for debt and preferred stock are quite predictable, and hence their costs
are easier to calculate.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.2 Measure the costs of debt, preferred stock, and common stock
12.3 A Second Look at the Weighted Average Cost of Capital
1) The WACC does not depend on the risk of a company's line of business.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
2) Lululemon Athletica has a current share price of $52.50, and a market capitalization of $7 billion. The
company is expected to pay a dividend of $0.20 per share, with a dividend growth rate of 3% per year.
The firm has $4 billion of debt with a yield to maturity of 7%. If the firm's tax rate is 25%, what is
Lululemon's WACC?
A) 4.07%
B) 4.33%
C) 3.82%
D) 4.71%
E) 3.94%
Answer: A
Explanation: A) Cost of equity using dividend growth model = 0.2/52.50 + 0.03 = 3.4%
cost of debt = 0.07 × (1 - 0.25) = 5.25%
WACC = (7 × 3.4%)/11 + (4 × 5.25%)/11 = 4.07%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
3) Lululemon Athletica has a current share price of $50, and a market capitalization of $7 billion. The
firm's beta is 0.27, the risk-free rate is 2.4%, and the market risk premium is 6%. The firm has $4 billion
of debt with a yield to maturity of 8%. If the firm's tax rate is 35%, what is Lululemon's WACC?
A) 7.24%
B) 4.45%
C) 4.61%
D) 4.71%
E) 6.01%
Answer: B
Explanation: B) Cost of equity using CAPM = 2.4 + 0.27(6) = 4.02%
cost of debt = 0.08 × (1 - 0.35) = 5.2%
WACC = (7 × 4.02%)/11 + (4 × 5.2%)/11 = 4.45%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
4) Power Financial Corp has a current share price of $34, and a market capitalization of $24 billion. The
company is expected to pay a dividend of $0.37 per share, with a dividend growth rate of 4% per year.
The firm has $18 billion of debt with a yield to maturity of 6%. If the firm's tax rate is 30%, what is
Power Financial's WACC?
A) 5.00%
B) 4.65%
C) 4.71%
D) 5.49%
E) 5.55%
Answer: C
Explanation: C) Cost of equity using dividend growth model = 0.37/34 + 0.04 = 5.1%
cost of debt = 0.06 × (1 - 0.3) = 4.2%
WACC = (24 × 5.1%)/42 + (18 × 4.2%)/42 = 4.71%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
5) Power Financial Corp has a current share price of $30, and a market capitalization of $20 billion. The
firm's beta is 0.93, the risk-free rate is 3.2%, and the market risk premium is 7%. The firm has $12 billion
of debt with a yield to maturity of 5%. If the firm's tax rate is 20%, what is Power Financial's WACC?
A) 5.43%
B) 5.71%
C) 7.94%
D) 6.55%
E) 7.57%
Answer: E
Explanation: E) Cost of equity using CAPM = 3.2 + 0.93(7) = 9.71%
cost of debt = 0.05 × (1 - 0.20) = 4.0%
WACC = (20 × 9.71%)/32 + (12 × 4%)/32 = 7.57%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
6) Bombardier Inc has common stock trading at a price of $15, and a market capitalization of $8 billion.
The firm also has preferred stock worth a total of $2 billion, currently trading at $23 per share and
paying a dividend of $2.75 per share. The firm's beta is 0.93, the risk-free rate is 3.2%, and the market
risk premium is 7%. The firm has $12 billion of debt with a yield to maturity of 5%. If the firm's tax rate
is 20%, what is Bombardier's WACC?
A) 4.12%
B) 6.8%
C) 8.56%
D) 7.3%
E) 7.57%
Answer: B
Explanation: B) Cost of equity = 0.032 + 0.93 × 0.07 = 9.71%;
cost of debt = 0.05 × (1 - 0.2) = 4%;
cost of preferred stock = 2.75/23 = 11.96%
WACC = 8 × 0.0971 / 22 + 2 × 0.1196 /22 + 12 × 0.04 / 22 = 6.8%
Diff: 3 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
7) Bell Media has common stock trading at a price of $74, and a market capitalization of $23 billion. The
firm also has preferred stock worth a total of $6 billion, currently trading at $54 per share and paying a
dividend of $4.50 per share. The firm's beta is 1.2, the risk-free rate is 2.4%, and the market risk
premium is 6%. The firm has $28 billion of debt with a yield to maturity of 4%. If the firm's tax rate is
30%, what is Bell's WACC?
A) 6.41%
B) 7.19%
C) 6.61%
D) 7.31%
E) 7.71%
Answer: C
Explanation: C) Cost of equity = 0.024 + 1.2 × 0.07 = 10.8%
cost of debt = 0.04 × (1 - 0.3) = 2.8%;
cost of preferred stock = 4.50 / 54 = 8.33%
WACC = 23 × .108 / 57 + 6 × .0833 /57 + 28 × .028 / 57 = 6.61%
Diff: 3 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
8) A firm has $30 million of common stock, $20 million of preferred stock, and $40 million of debt. The
cost of equity is 8.5%, the cost of preferred stock is 9.5%, and the pretax cost of debt is 7%. If the firm's
tax rate is 30%, what is the firm's WACC?
A) 8.33%
B) 6.44%
C) 7.12%
D) 8.06%
E) 7.75%
Answer: C
Explanation: C) WACC = 30 × 0.085 / 90 + 20 × 0.095 / 90 + 40 × 0.07 × (1 - 0.3) / 90 = 7.12%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
9) A firm has $50 million of common stock, $10 million of preferred stock, and $15 million of debt. The
cost of equity is 9%, the cost of preferred stock is 7%, and the pretax cost of debt is 4%. If the firm's tax
rate is 25%, what is the firm's WACC?
A) 6.67%
B) 6.33%
C) 7.73%
D) 5.16%
E) 7.53%
Answer: E
Explanation: E) WACC = 50 × 0.09 / 75 + 10 × 0.07 / 75 + 15 × 0.04 × (1 - 0.25) / 75 = 7.53%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
10) A firm has $8 billion of common stock and $14 billion of debt. The cost of equity is 7.5%, and the
pretax cost of debt is 3.8%. If the firm's tax rate is 30%, what is the firm's WACC?
A) 4.84%
B) 3.6%
C) 5.15%
D) 4.42%
E) 5.65%
Answer: D
Explanation: D) WACC = 8 × 0.075 / 22 + 14 × 0.038 × (1 - 0.03) / 22 = 4.42%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
11) A firm has $56 million of common stock and $32 million of debt. The cost of equity is 11.4%, and the
pretax cost of debt is 5.7%. If the firm's tax rate is 20%, what is the firm's WACC?
A) 8.91%
B) 9.33%
C) 8.55%
D) 7.98%
E) 10.13%
Answer: A
Explanation: A) WACC = 56 × .114 / 88 + 32 × 0.057 × (1 - 0.2) / 88 = 8.91%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
12) Shaw Communications is currently financed with 30% equity, 10% preferred stock, and 60% debt. It
has a cost of equity capital of 11%, a cost of preferred stock of 7.5%, and its pretax cost of debt is 6%. If
the firm has a tax rate of 30%, what is Shaw's WACC?
A) 7.57%
B) 8.17%
C) 5.82%
D) 6.57%
E) 7.65%
Answer: D
Explanation: D) WACC = 0.3 × 11% + 0.1 × 7.5% + 0.6 × 6% × (1 - 0.3) = 6.57%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
13) Rogers Communications is currently financed with 60% equity, 20% preferred stock, and 20% debt.
It has a cost of equity capital of 8.5%, a cost of preferred stock of 6%, and its pretax cost of debt is 7%. If
the firm has a tax rate of 25%, what is Rogers's WACC?
A) 7.04%
B) 6.58%
C) 7.17%
D) 7.7%
E) 7.35%
Answer: E
Explanation: E) WACC = 0.6 × 8.5% + 0.2 × 6% + 0.2 × 7% × (1 - 0.25) = 7.35%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.1 Understand the drivers of the firm's overall cost of capital
14) When calculating the WACC, it is standard practice to subtract ________ to compute the net debt
outstanding.
A) equity
B) dividends
C) cash and risk-free securities
D) coupons
E) risk-free interest rate
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
15) Many financial managers use market risk premiums that are closer to 5%, which is lower than
historical averages, because investors require a ________ risk premium for holding risky securities than
in the past.
A) lower
B) higher
C) similar
D) specific
E) consistent
Answer: A
Diff: 3 Type: MC
Skill: Conceptual
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
16) Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its
current capital structure has a 20% weight in equity, 10% in preferred stock, and 70% in debt. The cost
of equity capital is 14%, the cost of preferred stock is 10%, and the pretax cost of debt is 9%. What is the
weighted average cost of capital for Ford if its marginal tax rate is 30%?
A) 7.87%
B) 8.21%
C) 8.89%
D) 9.21%
E) 10.14%
Answer: B
Explanation: B) WACC = weight in equity × cost of equity + weight in debt × cost of debt × (1 - tax rate)
+ weight in preferred stock × cost of preferred stock
WACC = 0.2 × 0.14 + 0.7 × 0.09 × (1 - 0.3) + 0.1 × 0.1 = 8.21%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
17) Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its
current capital structure has a 30% weight in equity, 10% in preferred stock, and 60% in debt. The cost
of equity capital is 17%, the cost of preferred stock is 11%, and the pretax cost of debt is 8%. What is the
weighted average cost of capital for Ford if its marginal tax rate is 30%?
A) 9.56%
B) 9.96%
C) 10.25%
D) 10.73%
E) 11.54%
Answer: A
Explanation: A) WACC = weight in equity × cost of equity + weight in debt × cost of debt × (1-tax
rate)+weight in preferred stock × cost of preferred stock
WACC = 0.3 × 0.17 + 0.6 × 0.08 × (1 - 0.3) + 0.1 × 0.11 = 9.56%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
18) Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its
current capital structure has a 10% weight in equity, 20% in preferred stock, and 70% in debt. The cost
of equity capital is 15%, the cost of preferred stock is 10%, and the pretax cost of debt is 8%. What is the
weighted average cost of capital for Ford if its marginal tax rate is 30%?
A) 7.01%
B) 7.42%
C) 7.98%
D) 8.01%
E) 8.73%
Answer: B
Explanation: B) WACC = weight in equity × cost of equity + weight in debt × cost of debt × (1 - tax rate)
+ weight in preferred stock × cost of preferred stock
WACC = 0.1 × 0.15 + 0.7 × 0.08 × (1 - 0.3) + 0.2 × 0.1 = 7.42%
Diff: 1 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
19) Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The bonds have
a yield to maturity of 6%. The firm has book equity of $20 million, and 2 million shares trading at $18
per share. The firm's cost of equity is 12%. What is JUP's WACC if the firm's marginal tax rate is 35%?
A) 9.60%
B) 8.76%
C) 9.00%
D) 6.24%
E) 7.34%
Answer: B
Explanation: B) Market Value Debt = $20 million × 120% = $24 million
Market Value Equity = 2 million × $18 = $36 million
Total Market Value = $60 million
Wd = $24/$60 = 40%
We = $36/$60 = 60%
WACC = [40% × (1 - .35) × 6%] + (60% × 12%) = 8.76%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
20) Holding everything else constant, an increase in cash ________ the firm's net debt.
A) will decrease
B) will have no impact on
C) will increase
D) may increase or decrease
E) will not change
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
21) What types of adjustment to debt are prevalent in practice?
Answer: Most practitioners would use net debt, which is total debt outstanding minus cash and other
risk-free securities.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.3 Compute a firm's overall, or weighted average, cost of capital
12.4 Using the WACC to Value a Project
1) WestJet Airlines is considering purchasing 20 new planes that will save the company $25 million per
year in fuel and maintenance costs for the next 10 years. If the cost of the new planes is $200 million
dollars and WestJet's WACC is 8.5%, what is the NPV of the project?
A) -$200,000
B) $50 million
C) $30.4 million
D) $0
E) $4.4 million
Answer: A
Explanation: A) CF0 = -200,000,000; CF1 = $15,000,000; F1 = 10; I = 8.5; Compute NPV = -$200,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.4 Apply the weighted average cost of capital to value projects
2) Lululemon Athletica is considering introducing a new line of yoga wear that is expected to increase
the company's sales by $10 million in the first year, and growing by 3% every year thereafter. If the cost
of introducing the new product line is $40 million today, and Lululemon's WACC is 9.4%, what is the
NPV of the project?
A) $196.25 million
B) $66.38 million
C) $116.25 million
D) $468.75 million
E) $319.15 million
Answer: C
Explanation: C) NPV = -40 million + 10/(.094 - .03) = $116.25 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.4 Apply the weighted average cost of capital to value projects
3) When we use the WACC to assess a project, we assume that the ________ ratio does not change.
A) reward to systematic risk
B) risk to reward
C) debt to equity
D) volatility to systematic risk
E) current
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.4 Apply the weighted average cost of capital to value projects
4) When we compute the cost of equity capital for a project we assume that the ________ of the project is
equivalent to the average risk of the firm's investments.
A) diversifiable risk
B) market risk
C) non-systematic risk
D) volatility
E) standard deviation
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.4 Apply the weighted average cost of capital to value projects
5) SAP Inc. received a $1 million grant under its Small Business Innovation program. SAP invested the
grant money and developed a system to remove metal contaminants from storm water in shipyards.
The firm estimates that each shipyard spends $500,000 a year on storm water clean-up efforts. If SAP is
able to sign up and retain four shipyards from the first year onwards, what is the present value (PV) of
the project (net of investment) if the cost of capital for SAP is 18% per year? Assume a cost of operations
and other costs for SAP equal 50% of revenue.
A) $4.56 million
B) $4.98 million
C) $5.32 million
D) $5.87 million
E) $6.12 million
Answer: A
Explanation: A) Net Present Value = - Investment + Present Value of (Revenues × (1 - proportion of
costs))
Net Present Value = - 1 + (2 × (1 - 0.5)) / 0.18 = $4.56 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 12.4 Apply the weighted average cost of capital to value projects
6) SAP Inc. received a $2 million grant under its Small Business Innovation program. SAP invested the
grant money and developed a system to remove metal contaminants from storm water in shipyards.
The firm estimates that each shipyard spends $600,000 a year on storm water clean-up efforts. If SAP is
able to sign up and retain four shipyards from the first year onwards, what is the present value (PV) of
the project (net of investment) if the cost of capital for SAP is 15% per year? Assume a cost of operations
and other costs for SAP equal 40% of revenue.
A) $6.3 million
B) $6.7 million
C) $7.6 million
D) $7.9 million
E) $8.3 million
Answer: C
Explanation: C) Net Present Value = - Investment + Present Value of (Revenues × (1 - proportion of
costs))
Net Present Value = -2 + (2.4 × (1 - 0.4)) / 0.15 = $7.6 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 12.4 Apply the weighted average cost of capital to value projects
7) SAP Inc. received a $1.5 million grant under its Small Business Innovation program. SAP invested the
grant money and developed a system to remove metal contaminants from storm water in shipyards.
The firm estimates that each shipyard spends $400,000 a year on storm water clean-up efforts. If SAP is
able to sign up and retain four shipyards in the first year onwards, what is the present value (PV) of the
project (net of investment) if the cost of capital for SAP is 16% per year? Assume a cost of operations
and other costs for SAP equal 60% of revenue.
A) $1.9 million
B) $2..1 million
C) $2.3 million
D) $2..5 million
E) $3.1 million
Answer: D
Explanation: D) Net Present Value = - Investment + Present Value of (Revenues × (1 - proportion of
costs))
Net Present Value = -1.5 + (1.6 × (1 - 0.6)) / 0.16 = $2.5 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 12.4 Apply the weighted average cost of capital to value projects
8) A firm is considering investing in a new project with an upfront cost of $400 million. The project will
generate an incremental free cash flow of $50 million in the first year and this cash flow is expected to
grow at an annual rate of 4% forever. If the firm's WACC is 13%, what is the value of this project?
A) $155.6 million
B) $555.6 million
C) $577.8 million
D) $177.8 million
E) $181.4 million
Answer: A
Explanation: A) VL = FCF0 + FCF1/(rWACC - g) = -$400 + $50/(.13 - .04) = $155.6 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 12.4 Apply the weighted average cost of capital to value projects
9) What is the assumption about risk when using WACC to evaluate a project?
Answer: Using WACC in evaluating a firm's project implies that the risk of the project is comparable to
the average risk of the firm's other investments.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.4 Apply the weighted average cost of capital to value projects
10) What is the assumption about leverage when using WACC to evaluate a project?
Answer: The implied assumption in using WACC to evaluate a firm's project is that the firm is
continuously maintaining a constant ratio of market value of debt to market value of equity—a
relationship referred to as the debt-equity ratio.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 12.4 Apply the weighted average cost of capital to value projects
12.5 Project-Based Costs of Capital
1) Firms that have many divisions with different lines of business do not use a company-wide WACC to
evaluate projects.
Answer: TRUE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
2) When a firm is evaluating the purchase of a business that is unrelated to its current business, it is
appropriate to use the current WACC of the firm that is purchasing the business.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
3) Divisional costs of capital are more appropriate when evaluating a project for a line of business when
the types of business in a firm are
A) mature businesses.
B) similar.
C) new businesses.
D) different.
E) profitable.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
4) Anheuser Busch, a manufacturer of beverages, is planning to purchase Six Flags theme parks.
Anheuser Busch should use the ________ to evaluate the business of Six Flags.
A) WACC of Anheuser Busch
B) WACC of Six Flags
C) average market return
D) cost of debt
E) cost of equity
Answer: B
Diff: 3 Type: MC
Skill: Conceptual
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
5) Different divisions with differing lines of business use different costs of capital because their cost of
________ could be different.
A) debt
B) equity
C) capital
D) assets
E) common stock capital
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
6) Different divisions with differing lines of business use different costs of capital because their cost of
equity is different and also because the ________ could be different.
A) optimal volatility
B) optimal current ratio
C) optimal asset mix
D) optimal debt-equity ratio
E) cost of debt
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
7) Verano Inc. has two business divisions—a software product line and a waste water clean-up product
line. The software business has a cost of equity capital of 10% and the waste water clean-up business has
a cost of equity capital of 7%. Verano has 50% of its revenue from software and the rest from the waste
water business. Verano is considering a purchase of another company in the waste water business using
equity financing. What is the appropriate cost of capital to evaluate the business?
A) 10%
B) 7%
C) 8.5%
D) 9%
E) 6.5%
Answer: B
Explanation: B) Cost of capital = Cost of capital for the related division
Cost of capital = 7%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
8) Verano Inc. has two business divisions—a software product line and a waste water clean-up product
line. The software business has a cost of equity capital of 11% and the waste water clean-up business has
a cost of equity capital of 6%. Verano has 50% of its revenue from software and the rest from the waste
water business. Verano is considering a purchase of another company in the waste water business using
equity financing. What is the appropriate cost of capital to evaluate the business?
A) 11%
B) 8.5%
C) 6%
D) 9.3%
E) 7.6%
Answer: C
Explanation: C) Cost of capital = Cost of capital for the related division
Cost of capital = 6%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
9) Verano Inc. has two business divisions—a software product line and a waste water clean-up product
line. The software business has a cost of equity capital of 12% and the waste water clean-up business has
a cost of equity capital of 8%. Verano has 50% of its revenue from software and the rest from the waste
water business. Verano is considering a purchase of another company in the waste water business using
equity financing. What is the appropriate cost of capital to evaluate the business?
A) 12%
B) 8%
C) 10%
D) 11%
E) 6%
Answer: B
Explanation: B) Cost of capital = Cost of capital for the related division
Cost of capital = 8%
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.5 Adjust the cost of capital for the risk associated with the project
12.6 When Raising External Capital Is Costly
1) The costs of external financing must be deducted from the net present value (NPV) of a project to
evaluate if it is worth undertaking.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.6 Account for the direct costs of raising external capital
2) Internal financing is more costly than external financing because of issuance costs.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 12.6 Account for the direct costs of raising external capital
3) New Flyer Industries has decided to expand its production of hybrid transit buses. The firm expects
incremental cash flows of $40 million per year for the next 10 years. The upfront cost of the expansion is
$150 million, and there are additional issuance costs for external financing of $15 million. If the New
Flyer's WACC is 7.5%, what is the NPV of the project?
A) $235 million
B) $125 million
C) $110 million
D) $95 million
E) $219 million
Answer: C
Explanation: C) CF0 = -165,000,000; CF1 = 40,000,000; F1 = 10; I = 7.5; Compute NPV = $110 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.6 Account for the direct costs of raising external capital
4) New Flyer Industries has decided to expand its production of hybrid transit buses. The firm expects
incremental cash flows of $20 million in the first year, growing by 2% every year thereafter. The upfront
cost of the expansion is $95 million, and there are additional issuance costs for external financing of $12
million. If the New Flyer's WACC is 6.2%, what is the NPV of the project?
A) $228 million
B) $357 million
C) $381 million
D) $216 million
E) $369 million
Answer: E
Explanation: E) NPV = -107 + 20/(0.062 - 0.02) = $369 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 12.6 Account for the direct costs of raising external capital
5) A firm is considering acquiring a competitor. The firm plans on offering $200 million for the
competitor. The firm will need to issue new debt and equity to finance the acquisition. You estimate the
issuance costs to be $10 million. The acquisition will generate an incremental free cash flow of $25
million in the first year and this cash flow is expected to grow at an annual rate of 3% forever. If the
firm's WACC is 13%, what is the value of this project?
A) $40 million
B) $50 million
C) $60 million
D) $70 million
E) $80 million
Answer: A
Explanation: A) NPV = FCF0 + FCF1/(rWACC - g)
FCF0 = -$200 - $10 = -$210
NPV = -$210 + $25/(.13 - .03) = $40 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 12.6 Account for the direct costs of raising external capital
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 13 Risk and the Pricing of Options
13.1 Option Basics
1) Hedging is accomplished by holding contracts or securities whose payoffs are positively correlated
with some risk exposure that already exists.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
2) American options allow their holders to exercise the option only on the expiration date.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
3) Options are also called derivative assets because they derive their value solely from the price of
another asset.
Answer: TRUE
Diff: 1 Type: TF
Skill: Definition
Objective: 13.1 Understand basic option terminology
4) Standard stock options are traded and bought and sold through dealers only and cannot be bought
via an exchange.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
5) An options contract gives the owner the ________ but not the ________ to buy or sell an asset at a
fixed price at some future date.
A) obligation, right
B) right, option
C) right, obligation
D) option, right
E) obligation, option
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
6) A call option gives the owner the right to ________ an asset at a fixed price at some future date.
A) sell
B) buy
C) hold
D) exchange
E) provide
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
7) A put option gives the owner the right to ________ an asset at a fixed price at some future date.
A) sell
B) buy
C) hold
D) obtain
E) purchase
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
8) When a company writes a call option on new stock in the company, it is called a
A) convertible bond.
B) put option.
C) stock option.
D) warrant.
E) stock.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
9) The price at which the holder of an option buys or sells a share of stock when the option is exercised
is called the ________ price.
A) strike
B) American
C) dilutive
D) closing
E) spot
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
10) ________ options allow the holder to exercise the option on any date up to and including the
expiration date.
A) Canadian
B) American
C) European
D) French
E) Chinese
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
11) ________ options allow the holder to exercise the option only on the expiration date.
A) Canadian
B) American
C) European
D) Brazilian
E) Chinese
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
12) The ________ side of an options contract has the option to exercise, while the ________ side has an
obligation to fulfill the contract.
A) long, long
B) short, long
C) long, short
D) short, short
E) short, other
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
13) The ________ is the total number of contracts of a particular option that have been written and not
yet closed.
A) market interest
B) open interest
C) turnover
D) local turnover
E) volume
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
14) When the exercise price of an option is equal to the current price of the stock, the option is said to be
A) at-the-money.
B) in-the-money.
C) out-of-the-money.
D) trading at par.
E) trading below par.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
15) When the exercise price of a call option is higher than the current price of the stock, the option is
said to be
A) at-the-money.
B) in-the-money.
C) out-of-the-money.
D) trading at par.
E) trading below par.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
16) When the exercise price of a call option is lower than the current price of the stock, the option is said
to be
A) at-the-money.
B) in-the-money.
C) out-of-the-money.
D) trading at par.
E) trading below par.
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
17) Using an option to reduce the risk of a portfolio is called ________, while using options to bet on the
direction of the market or an asset is called ________.
A) hedging, speculation
B) hedging, verification
C) verification, hedging
D) speculation, hedging
E) verification, speculation
Answer: A
Diff: 2 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
18) The writer of a call option has
A) the obligation to sell a security for a given price.
B) the obligation to buy a security for a given price.
C) the right to sell a security for a given price.
D) the right to buy a security for a given price.
E) the long position in the contract.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
19) The holder of a put option has
A) the obligation to sell a security for a given price.
B) the right to buy a security for a given price.
C) the right to sell a security for a given price.
D) the obligation to buy a security for a given price.
E) the short position in the contract.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
20) Using options to reduce risk is called
A) speculation.
B) a naked position.
C) hedging.
D) a covered position.
E) risk-taking.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
21) Using options to place a bet on the direction in which you believe the market is likely to move is
called
A) speculation.
B) hedging.
C) a covered position.
D) a naked position.
E) diversification.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 13.1 Understand basic option terminology
Use the table for the question(s) below.
Consider the following information on options from the CBOE for Merck:
22) Assume you want to buy one options contract with an exercise price closest to being at-the-money
and that expires January 2009. The current price that you would have to pay for such a contract is:
A) $680
B) $380
C) $650
D) $420
E) $450
Answer: A
Explanation: A) One contract is for 100 shares. The option closest to being at-the-money has an exercise
price of $40.00 and currently has an ask price of $6.80. Since you are buying the option, you will have to
pay the ask price. So $6.80 × 100 shares per contract = $680.
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
23) The open interest for a January 2009 put option that is closest to being at-the-money is:
A) 7174
B) 982
C) 319
D) 8422
E) 5513
Answer: A
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
wer: Aligning the interests of shareholders and managers incre
24) How many of the January 2009 put options are in-the-money?
A) 1
B) 3
C) 2
D) 4
E) 0
Answer: C
Explanation: C) For a put option to be in-the-money, its current stock price must be less than the
exercise price. The current stock price for Merck is $41.95, so only the put options with strike prices of
$45.00 and $50.00 are in-the-money. So there are two put options in-the-money.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
25) How many of the January 2009 call options are in-the-money?
A) 2
B) 4
C) 1
D) 3
E) 0
Answer: B
Explanation: B) For a call option to be in-the-money, its current stock price must be greater than the
exercise price. The current stock price for Merck is $41.95, so the call options with strike prices of $25.00,
$30.00, $35.00, and $40.00 are in-the-money. So there are four call options in-the-money.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
26) How many of the January 2009 put options are out-of-the-money?
A) 0
B) 1
C) 2
D) 3
E) 4
Answer: E
Explanation: E) For a put option to be out-of-the-money, its current stock price must be greater than the
exercise price. The current stock price for Merck is $41.95, so the put options with strike prices of $25.00,
$30.00, $35.00, and $40.00 are out-of-the-money. So there are four put options out-of-the-money.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
27) How many of the January 2009 call options are out-of-the-money?
A) 0
B) 1
C) 2
D) 3
E) 4
Answer: C
Explanation: C) For a call option to be out-of-the-money, its current stock price must be less than the
exercise price. The current stock price for Merck is $41.95, so the call options with strike prices of $45.00
and $50.00 are out-of-the-money. So there are two call options out-of-the-money.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
Use the table for the questions below
Consider the following information on options from the CBOE for Rackspace.
Calls
RAX 10 Dec 29
RAX 10 Dec 30
RAX 10 Dec 31
RAX 10 Dec 32
RAX 11 Jan 29
RAX 11 Jan 30
RAX 11 Jan 31
RAX 11 Jan 32
Last Sale
Net
Bid
Ask
Vol
Open Int
1.25
0
1.5
1.7
0
1436
1.05
0.27
0.95
1.1
5
2245
0.6
0.15
0.55
0.7
13
485
0.45
0
0.3
0.4
0
74
1.7
0
2.25
2.5
0
872
1.87
0.02
1.75
2
30
523
1.41
0.06
1.3
1.5
3
85
1.2
0
0.95
1.1
0
117
Puts
RAX 10 Dec 29
RAX 10 Dec 30
RAX 10 Dec 31
RAX 10 Dec 32
RAX 11 Jan 29
RAX 11 Jan 30
RAX 11 Jan 31
RAX 11 Jan 32
Last Sale
Net
Bid
Ask
Vol
Open Int
0.6
-0.2
0.5
0.7
1
750
1.19
0
0.95
1.1
0
521
2.05
0
1.55
1.7
0
31
0
0
2.15
2.5
0
0
1.85
0
1.45
1.7
0
1205
0
0
1.95
2.2
0
150
0
0
2.55
2.7
0
100
0
0
3.1
3.4
0
0
28) Assume you want to buy five call option contracts with an exercise price closest to being at-themoney and that expires December 2010. The current price that you would have to pay for such a
contract is:
A) $550
B) $110
C) $475
D) $300
E) $525
Answer: A
Explanation: A) One contract is for 100 shares. The option closest to being at-the-money has an exercise
price of $30.00 and currently has an ask price of $1.10 Since you are buying the option, you will have to
pay the ask price. So 5 × $1.10 × 100 shares per contract = $550.
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
rs9) Assume you want to buy 10 put option contracts with an exercise price closest to being at-the-
29) Assume you want to buy 10 put option contracts with an exercise price closest to being at-themoney and that expires January 2011. The current price that you would have to pay for such a contract
is:
A) $1750
B) $2000
C) $1950
D) $2200
E) $2550
Answer: D
Explanation: D) One contract is for 100 shares. The option closest to being at-the-money has an exercise
price of $30.00 and currently has an ask price of $2.20 Since you are buying the option, you will have to
pay the ask price. So 10 × $2.20 × 100 shares per contract = $2200.
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
30) Assume you want to sell 20 call option contracts with an exercise price closest to being at-the-money
and that expires January 2011. The current price that you would receive for such a contract is:
A) $4500
B) $2600
C) $3900
D) $4000
E) $3500
Answer: E
Explanation: E) One contract is for 100 shares. The option closest to being at-the-money has an exercise
price of $30.00 and currently has a bid price of $1.75 Since you are selling the option, you will receive
the bid price. So 20 × $1.75 × 100 shares per contract = $3500.
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
31) Assume you want to sell 20 put option contracts with an exercise price closest to being at-the-money
and that expires January 2011. The current price that you would receive for such a contract is:
A) $1750
B) $2000
C) $3500
D) $3900
E) $4400
Answer: D
Explanation: D) One contract is for 100 shares. The option closest to being at-the-money has an exercise
price of $30.00 and currently has a bid price of $1.95. Since you are selling the option, you will receive
the bid price. So 20 × $1.95 × 100 shares per contract = $3900.
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
32) How many of the December 2010 put options are in-the-money?
A) 1
B) 2
C) 3
D) 4
E) 5
Answer: B
Explanation: B) For a put option to be in-the-money, its current stock price must be less than the
exercise price. The current stock price for Rackspace is $30.09, so the put options with strike prices of
$31 and $32 are in-the-money. There are two put options in-the-money.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
33) The open interest for a January 2011 call option that is closest to being at-the-money is:
A) 1436
B) 2245
C) 872
D) 523
E) 117
Answer: D
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.1 Understand basic option terminology
34) What are American options?
Answer: American options, the most common kind, allow their holders to exercise the option on any
date up to and including a final date called expiration date.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
35) What are European options?
Answer: European options, allow their holders to exercise the option only on the final date called
expiration date.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
36) What is a call option?
Answer: A call option gives the owner the right to buy the underlying asset at a set price on or before
the final date, also called expiry date.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
37) What is a put option?
Answer: A put option gives the owner the right to sell the underlying asset at a set price on or before
the final date, also called expiry date.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
38) When is an option at-the-money?
Answer: An option is at-the-money when the exercise price of the option is equal to the current price of
the stock.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
39) When is an option in-the-money?
Answer: An option is in-the-money when it has a positive payoff if exercised right away.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
40) When is an option out-the-money?
Answer: An option is out-the-money when it has a negative payoff if exercised right away.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
13.2 Option Payoffs and Profits at Expiration
1) Although the payouts on a long position in an options contract are never negative, the profit from
purchasing and holding it could be negative.
Answer: TRUE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
2) When a stock price appreciates by a certain percentage, a call option on the same stock appreciates by
a lower percentage amount.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
3) A call option on a stock has an exercise price of $22.25. If the stock price at expiration is $25, what is
the option payoff for a long call position?
A) $2.75
B) $0
C) -$2.75
D) $25
E) $22.25
Answer: A
Explanation: A) 25 - 22.25 = $2.75
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
4) A call option on a stock has an exercise price of $14. If the stock price at expiration is $13.50, what is
the option payoff for a long call position?
A) $0.50
B) $0
C) -$0.50
D) $13.50
E) $14
Answer: B
Explanation: B) Stock price < Exercise price, option is not exercised.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
5) A call option on a stock has an exercise price of $34.50. If the stock price at expiration is $37.50, what
is the option payoff for a short call position?
A) $34.50
B) $0
C) $3
D) -$3
E) -$34.50
Answer: D
Explanation: D) Option payoff = 37.50 - 34.50 = $3. Short position value = -$3.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
6) A call option on a stock has an exercise price of $12.15. If the stock price at expiration is $11, what is
the option payoff for a short call position?
A) $-11
B) $11
C) $1.15
D) -$1.15
E) $0
Answer: E
Explanation: E) Stock price < Exercise price, option is not exercised.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
7) A put option on a stock has an exercise price of $31. If the stock price at expiration is $29.45, what is
the option payoff for a long put position?
A) $29.45
B) $0
C) $1.55
D) -$1.55
E) -$29.45
Answer: C
Explanation: C) Option payoff = 31 - 29.45 = $1.55
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
8) A put option on a stock has an exercise price of $74. If the stock price at expiration is $79, what is the
option payoff for a long put position?
A) $0
B) $5
C) -$5
D) $79
E) -$79
Answer: A
Explanation: A) Stock price > Exercise price, option is not exercised.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
9) A put option on a stock has an exercise price of $42. If the stock price at expiration is $35, what is the
option payoff for a short put position?
A) $0
B) $7
C) -$7
D) $35
E) -$35
Answer: C
Explanation: C) Option payoff = 42 - 35 = $7. Short position value = -$7.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
10) A put option on a stock has an exercise price of $31. If the stock price at expiration is $33.40, what is
the option payoff for a short put position?
A) $33.40
B) -$2.40
C) $2.40
D) $0
E) -$33.40
Answer: D
Explanation: D) Stock price > Exercise price, option is not exercised.
Diff: 1 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
11) Suppose you purchase a call option for $5 and a strike price of $20. On the expiration day, the price
of the stock is $30. What is the return on the call option if you hold your position until maturity?
A) 25%
B) 50%
C) 75%
D) 100%
E) 0%
Answer: D
Explanation: D) The option price is the greater of zero and the difference between the stock price and
the strike price.
Return = (Option payoff - cost)/cost
Return = (10 - 5) / 5 = 100%
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
12) Suppose you purchase a call option for $4 and a strike price of $30. On the expiration day, the price
of the stock is $40. What is the return on the call option if you hold your position until maturity?
A) 125%
B) 130%
C) 150%
D) 170%
E) 250%
Answer: C
Explanation: C) The option price is the greater of zero and the difference between the stock price and
the strike price.
Return = (Option payoff - cost) / cost
Return = (10 - 4) / 4 = 150%
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
13) Suppose you purchase a call option for $5 and a strike price of $40. On the expiration day, the price
of the stock is $55. What is the return on the call option if you hold your position until maturity?
A) 125%
B) 200%
C) 275%
D) 300%
E) -100%
Answer: B
Explanation: B) The option price is the greater of zero and the difference between the stock price and
the strike price.
Return = (Option payoff - cost) / cost
Return = (15 - 5) / 5 = 200%
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
14) An investor purchases a call option and its underlying stock on the same day. If the stock
appreciates by 25%, the call option will appreciate by:
A) more than 25%
B) less than 25%
C) exactly 25%
D) 0%
E) less than 0%
Answer: A
Diff: 3 Type: MC
Skill: Conceptual
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
15) The payoff to the holder of a call option is given by:
A) C = max(S - K, 0)
B) C = min(K, 0)
C) C = max(K - S, 0)
D) C = min(K - S, 0)
E) C = min(S - K, 0)
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
16) The payoff to the holder of a put option is given by:
A) P = max(K - S, 0)
B) P= max(S - K, 0)
C) P = min(S - K, 0)
D) P = max(K, 0)
E) P = max(S - K, 0)
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
Use the figure for the question(s) below.
17) This graph depicts the payoffs of a
A) short position in a put option at expiration.
B) short position in a call option at expiration.
C) long position in a put option at expiration.
D) long position in a call option at expiration.
E) long position in a call option before expiration.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
e agency costs and the ways to control the
Use the figure for the question(s) below.
18) This graph depicts the payoffs of a
A) a long position in a put option at expiration.
B) short position in a call option at expiration.
C) a short position in a put option at expiration.
D) a long position in a call option at expiration.
E) a long position in a call option before expiration.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
19) You pay $3.25 for a call option on Luther Industries that expires in three months with a strike price
of $40.00. Three months later, at expiration, Luther Industries is trading at $41.00 per share. Your profit
per share on this transaction is closest to:
A) -$1.00
B) $1.00
C) -$2.25
D) $2.25
E) $0
Answer: C
Explanation: C) At expiration you will choose to exercise the option since the option is in-the-money.
Your payoff will be $41 - $40 = $1 for exercising the option; however, to calculate the profit we need to
subtract the option premium. So, profit = $1.00 - $3.25 = -$2.25.
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
) You have shorted a call option on WSJ stock with a strike price of $50. The option will expire in
20) You have shorted a call option on WSJ stock with a strike price of $50. The option will expire in
exactly six months. If the stock is trading at $60 in three months, what will you owe for each share in the
contract?
A) $0
B) $60
C) $50
D) $10
E) $40
Answer: D
Explanation: D) $60 - $50 = $10
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
21) You have shorted a call option on WSJ stock with a strike price of $50. The option will expire in
exactly six months. If the stock is trading at $45 in three months, what will you owe for each share in the
contract?
A) $0
B) $50
C) $60
D) $10
E) $40
Answer: A
Explanation: A) The call is out of the money, so it will not be exercised.
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.2 Explain the difference between calls and puts; determine the payoffs and profits from holding each to
expiration
22) What is the long position of an options contract?
Answer: The option buyer or holder is said to have the long position of an options contract.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
23) What is the short position of an options contract?
Answer: The option seller or writer is said to have the short position of an options contract. In fact, it is
not an option for the short position holder, but an obligation.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.1 Understand basic option terminology
13.3 Factors Affecting Options Prices
1) A European option on a stock is more valuable than an otherwise similar American option on the
same stock.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
2) A European option with a later exercise date may trade potentially for less than an otherwise
identical option with an earlier exercise date.
Answer: TRUE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
3) In practice, option prices are not very sensitive to changes in the risk-free rate.
Answer: TRUE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
4) The value of an otherwise identical call option is ________ if the strike price the holder must pay to
buy the stock is ________.
A) higher, higher
B) lower, lower
C) higher, lower
D) unchanged, lower
E) unchanged, higher
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
5) The value of an otherwise identical call option is ________ if the stock price is ________.
A) higher, higher
B) lower, higher
C) higher, lower
D) unchanged, higher
E) unchanged, lower
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
6) The value of an otherwise identical American call option is ________ if the exercise date is ________.
A) higher, longer
B) lower, longer
C) higher, closer
D) unchanged, closer
E) unchanged, longer
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
7) The value of a call option ________ with the risk-free rate, and the value of a put option ________
with the risk-free rate.
A) increases, increases
B) decreases, decreases
C) increases, decreases
D) decreases, increases
E) increases, does not change
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
8) Which of the following will increase the value of a put option?
A) a decrease in the time to maturity
B) an increase in the stock price
C) a decrease in the stock's volatility
D) a decrease in the exercise price
E) a decrease in the risk-free rate
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
9) Which of the following will increase the value of a call option?
A) a decrease in the time to maturity
B) a decrease in the stock price
C) a decrease in the stock's volatility
D) a decrease in the exercise price
E) a decrease in the risk-free rate
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
10) What effect does volatility of the underlying asset have on the price of the option?
Answer: The higher the volatility of the underlying asset, the higher the price of the option.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 13.3 Analyze the factors that affect option prices
13.4 The Binomial Option Pricing Model
1) The binomial option pricing model calculates the option price by creating a replicating portfolio out
of a risk-free bond and the underlying stock.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 13.4 Understand and use the Binomial Option Pricing Model
2) Suppose a stock is currently trading for $35, and in one period it will either increase to $38 or
decrease to $33. If the one-period risk-free rate is 6%, what is the price of a European call option that
expires in one period and has an exercise price of $36?
A) $1.55
B) $0.80
C) $2.00
D) $1.63
E) $1.00
Answer: A
Explanation: A) Delta = (CU - CD)/(SU - SD) and B = (CD - Delta × SD)/(1 + rf)
CU = $2 if the stock goes up, and CD = 0 if the stock goes down.
Delta = ($2 - $0)/($38 - $33) = 0.4.
B = (0 - 0.4 × $33)/(1.06) = -12.45
Call price = Delta × S0 + B = 0.4 × $35 - $12.45 = $1.55
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.4 Understand and use the Binomial Option Pricing Model
3) Suppose a stock is currently trading for $35, and in one period it will either increase to $38 or
decrease to $33. If the one-period risk-free rate is 6%, what is the price of a European put option that
expires in one period and has an exercise price of $36?
A) $1.55
B) $1.50
C) $3.00
D) $0.51
E) $2.49
Answer: D
Explanation: D) Delta = (PU - PD)/(SU - SD) and B = (PD - Delta × SD)/(1 + rf)
PU = $0 if the stock goes up, and PD = $3 if the stock goes down.
Delta = ($0 - $3)/($38 - $33) = -0.6
B = (3 - (-0.6) × $33)/(1.06) = 21.51
Put price = Delta × S0 + B = -0.6 × $35 + $21.51 = $0.51
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.4 Understand and use the Binomial Option Pricing Model
4) Suppose a stock is currently trading for $12, and in one period it will either increase to $15 or
decrease to $8. If the one-period risk-free rate is 4%, what is the price of a European call option that
expires in one period and has an exercise price of $7?
A) $4.68
B) $4.50
C) $5.27
D) $5.00
E) $7.00
Answer: C
Explanation: C) Delta = (CU - CD)/(SU - SD) and B = (CD - Delta × SD)/(1 + rf)
CU = $8 if the stock goes up, and CD = $1 if the stock goes down.
Delta = ($8 - $1)/($15 - $8) = 1.
B = (1 - 1 × $8)/(1.04) = -6.73
Call price = Delta × S0 + B = 1 × 12 - 6.73 = $5.27
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.4 Understand and use the Binomial Option Pricing Model
5) Suppose a stock is currently trading for $12, and in one period it will either increase to $15 or
decrease to $8. If the one-period risk-free rate is 4%, what is the price of a European put option that
expires in one period and has an exercise price of $10?
A) $0.96
B) $1.92
C) $1.00
D) $2.00
E) $0.69
Answer: E
Explanation: E) Delta = (PU - PD)/(SU - SD) and B = (PD - Delta × SD)/(1 + rf)
PU = $0 if the stock goes up, and PD = $2 if the stock goes down.
Delta = ($0 - $2)/($15 - $8) = -0.29
B = (2 - (-0.29) × $8)/(1.04) = 4.12
Put price = Delta × S0 + B = -0.29 × $12 + $4.12 = $0.69
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.4 Understand and use the Binomial Option Pricing Model
6) Suppose a stock is currently trading for $23, and in one period it will either increase to $30 or
decrease to $20. If the one-period risk-free rate is 5%, what is the price of a European call option that
expires in one period and has an exercise price of $25?
A) $1.25
B) $1.98
C) $1.50
D) $2.21
E) $2.50
Answer: B
Explanation: B) Delta = (CU - CD)/(SU - SD) and B = (CD - Delta × SD)/(1 + rf)
CU = $5 if the stock goes up, and CD = $0 if the stock goes down.
Delta = ($5 - $0)/($30 - $20) = 0.5.
B = (0 - 0.5 × 20)/(1.05) = -9.52
Call price = Delta × S0 + B = 0.5 × 23 - 9.52 = $1.98
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.4 Understand and use the Binomial Option Pricing Model
7) Suppose a stock is currently trading for $23, and in one period it will either increase to $30 or
decrease to $20. If the one-period risk-free rate is 5%, what is the price of a European put option that
expires in one period and has an exercise price of $25?
A) $2.79
B) $2.50
C) $2.38
D) $2.21
E) $2.66
Answer: A
Explanation: A) Delta = (PU - PD)/(SU - SD) and B = (PD - Delta × SD)/(1 + rf)
PU = $0 if the stock goes up, and PD = $5 if the stock goes down.
Delta = ($0 - $5)/($30 - $20) =-0.5
B = (5 - (-0.5) × $20)/(1.05) = 14.29
Put price = Delta × S0 + B = -0.5 × $23 + $14.29 = $2.79
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.4 Understand and use the Binomial Option Pricing Model
13.5 The Black-Scholes Option Pricing Formula
1) The Black-Scholes formula gives the price of an American call option.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 13.5 Be familiar with the Black-Scholes Option Pricing Formula
2) The Black-Scholes formula is notable because it does not require us to know
A) the expected return on a stock.
B) the risk-free rate.
C) the volatility of the stock.
D) the dividend rate on the stock.
E) the stock price.
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 13.5 Be familiar with the Black-Scholes Option Pricing Formula
13.6 Put-Call Parity
1) When you purchase a put option while still holding the underlying stock, it is known as a
A) protective put.
B) protective call.
C) speculative put.
D) speculative call.
E) downside put.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
2) ________ is the relationship between the value of a stock, a bond, and call and put options on the
same stock with the same exercise price.
A) Dividend exclusion
B) Limit law
C) Put-call parity
D) Put option equality
E) Option similarity
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
3) The price of a European call option on RBC stock with an exercise price of $85 and one year to expiry
is trading at $3.15. The current price of the stock is $81.25, and the risk-free rate is 2.5%. With no
arbitrage, what must be the price of a European put on RBC with an exercise price of $85?
A) $4.83
B) $3.15
C) $1.47
D) $4.71
E) $2.59
Answer: A
Explanation: A) Use the put-call parity relationship:
stock price + put price = call price + PV(strike price)
$81.25 + put price = $3.15 + $85/1.025
put price = $4.83
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
4) The price of a European call option on Lululemon stock with an exercise price of $34.50 and one year
to expiry is trading at $2.52. The current price of the stock is $34, and the risk-free rate is 4%. With no
arbitrage, what must be the price of a European put on Lululemon with an exercise price of $34.50?
A) $3.37
B) $0.71
C) $1.69
D) $2.52
E) $0.50
Answer: C
Explanation: C) Use the put-call parity relationship:
stock price + put price = call price + PV(strike price)
$34 + put price = $2.52 + $34.5/1.04
put price = $1.69
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
5) The price of a European put option on Potash Corp stock with an exercise price of $48 and one year to
expiry is trading at $4.15. The current price of the stock is $45, and the risk-free rate is 3%. With no
arbitrage, what must be the price of a European call on Potash Corp with an exercise price of $48?
A) $2.55
B) $5.75
C) $3.00
D) $2.91
E) $0.16
Answer: A
Explanation: A) Use the put-call parity relationship:
stock price + put price = call price + PV(strike price)
$45 + $4.15 = call price + $48/1.03
call price = $2.55
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
6) The price of a European put option on Air Canada stock with an exercise price of $10 and one year to
expiry is trading at $1.55. The current price of the stock is $11, and the risk-free rate is 5%. With no
arbitrage, what must be the price of a European call on Air Canada with an exercise price of $10?
A) $2.55
B) $1.07
C) $0.95
D) $1.55
E) $3.03
Answer: E
Explanation: E) Use the put-call parity relationship:
stock price + put price = call price + PV(strike price)
$11 + $1.55 = call price + $10/1.05
call price = $3.03
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
7) The price of a European put option on Bombardier stock with one year to expiry is trading at $2.25,
and the price of a European call option is trading at $1.50. If the stock is currently trading at $4.75, and
the risk-free rate is 4%, what is the exercise price of the options?
A) $3.75
B) $3.12
C) $5.72
D) $4.75
E) $3.03
Answer: C
Explanation: C) Use the put-call parity relationship:
stock price + put price = call price + PV(exercise price)
$4.75 + $2.25 = 1.50 + $X/1.04
Exercise price = $5.72
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
8) The price of a European put option on Scotiabank stock with one year to expiry is trading at $1.05,
and the price of a European call option is trading at $3.15. If the stock is currently trading at $43.25, and
the risk-free rate is 3%, what is the exercise price of the options?
A) $41.15
B) $42.38
C) $43.25
D) $46.71
E) $39.95
Answer: B
Explanation: B) Use the put-call parity relationship:
stock price + put price = call price + PV(exercise price)
$43.25 + $1.05 = $3.15 + $X/1.03
Exercise price = $42.38
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
9) The price of a European put option on Scotiabank stock with one year to expiry is trading at $2.25,
and the price of a European call option is trading at $1.60. If the exercise price of the options is $45, and
the risk-free rate is 5%, what must be the current price of Scotiabank stock?
A) $42.75
B) $45.00
C) $43.51
D) $42.21
E) $43.40
Answer: D
Explanation: D) Use the put-call parity relationship:
stock price + put price = call price + PV(exercise price)
stock price + $2.25 = $1.60 + $45/1.05
Stock price = $42.21
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
10) The price of a European put option on Power Financial Corp stock with one year to expiry is trading
at $0.55, and the price of a European call option is trading at $2.15. If the exercise price of the options is
$19, and the risk-free rate is 3.5%, what must be the current price of Power Financial stock?
A) $20.00
B) $20.60
C) $21.15
D) $16.76
E) $19.96
Answer: E
Explanation: E) Use the put-call parity relationship:
stock price + put price = call price + PV(exercise price)
stock price + $0.55 = $2.15 + $19/1.035
Stock price = $19.96
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
11) The price of a call option on Microsoft stock with a maturity of six months and a strike price of $40 is
$3.50, and the price of the stock is $38.50. The price of a put option on the same stock with the same
strike price and time to maturity is $1.25. Calculate the risk-free rate.
A) 6.36%
B) 9.33%
C) 1.99%
D) 18.52%
E) 10.34%
Answer: E
Explanation: E) Use the put-call parity relationship:
stock price + put price = call price + PV(strike price)
$38.50 + 1.25 = $3.50 + $40/(1 + r)
r = 10.34%
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
12) Consider the following equation:
C = P + S - PV(K) - PV(Div)
In this equation, what does the term S represent?
A) the payoff of a zero-coupon bond
B) the strike price of the option
C) the value of the call option
D) the stock's current price
E) the value of the put option
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
13) Consider the following equation:
C = P + S - PV(K) - PV(Div)
In this equation, what does the term C represent?
A) the value of the call option
B) the stock's current price
C) the payoff of a zero-coupon bond
D) the strike price of the option
E) the value of the put option
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
14) Consider the following equation:
C = P + S - PV(K) - PV(Div)
In this equation, what does the term K represent?
A) the value of the call option
B) the strike price of the option
C) the price of a zero-coupon bond
D) the stock's current price
E) the value of the put option
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
15) Luther Industries is currently trading for $27 per share. The stock pays no dividends. A one-year
European put option on Luther with a strike price of $30 is currently trading for $2.60. If the risk-free
interest rate is 6% per year, then the price of a one-year European call option on Luther with a strike
price of $30 will be closest to:
A) $1.30
B) $7.10
C) $2.60
D) $1.95
E) $3.00
Answer: A
Explanation: A) C = P + S - PV(K) - PV(Div)
C = $2.60 + $27 -
- $0 = $1.2981
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
er: Tunnelling is a conflict of interest that arises when a shareholder who has a controlling interest in
16) Luther Industries is currently trading for $27 per share. The stock pays a quarterly dividend of $0.50
per share, with the next dividend to be paid in exactly 3 months. A one-year European put option on
Luther with a strike price of $30 is currently trading for $4.60. If the risk-free interest rate is 6% per year,
then the price of a one-year European call option on Luther with a strike price of $30 will be closest to:
A) $3.91
B) $5.03
C) $5.29
D) $1.37
E) $1.57
Answer: D
Explanation: D) C = P + S - PV(K) - PV(Div)
First find PV(Div). Use I/Y = (1.06)1/4 - 1 = 1.4674%
Using financial calculator with N = 4, PMT = 0.5 calculate PV = 1.93
C = $4.60 + $27 -
- $1.93 = $1.37
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
17) ABX corporation is currently trading for $45 per share. The stock will pay a one-time dividend of
$2.25 in exactly 3 months. A one-year European call option on ABX with a strike price of $50 is currently
trading for $2.40. If the risk-free interest rate is 9% per year, then the price of a one-year European put
option on ABX with a strike price of $50 will be closest to:
A) $3.73
B) $5.47
C) $0.88
D) $5.52
E) $1.07
Answer: B
Explanation: B) P = C - S + PV(K) + PV(Div)
First find PV(Div). Use I/Y = (1.09)1/4 - 1 = 2.1778%
PV(Div) =
P = $2.40 - $45 +
= $2.20
+ $2.20 = $5.47
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
18) A one-year European call option on ABX corporation with a strike price of $50 is currently trading
18) A one-year European call option on ABX corporation with a strike price of $50 is currently trading
for $4.30, and a one-year European put option on ABX with the same strike price is currently trading for
$1.47. If the stock pays no dividends and the risk free rate is 4% per year, what is the current price of
ABX stock?
A) $39.79
B) $41.57
C) $45.25
D) $50.91
E) $53.85
Answer: D
Explanation: D) Use the put-call parity relationship:
stock price + put price = call price + PV(strike price)
stock price = 4.30 +
- 1.47 = $50.91
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
19) A one-year European call option on ABX corporation with a strike price of $50 is currently trading
for $1.45, and a one-year European put option on ABX with the same strike price is currently trading for
$6.22. If the stock pays a one-time dividend of $1.50 in exactly 6 months, and the risk-free rate is 8% per
year, what is the current price of ABX stock?
A) $42.97
B) $43.03
C) $49.63
D) $52.53
E) $55.41
Answer: A
Explanation: A) S = C - P + PV(K) + PV(Div)
First find PV(Div). Use I/Y = (1.08)1/2 - 1 = 3.923%
PV(Div) =
S = $1.45 - $6.22 +
= $1.44
+ $1.44 = $42.97
Diff: 3 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
20) ABX corporation stock is currently trading for $37.60. A one-year European call option on ABX is
20) ABX corporation stock is currently trading for $37.60. A one-year European call option on ABX is
currently trading for $7.23, and a one-year European put option on ABX with the same strike price is
currently trading for $0.76. If the stock pays no dividends, and the risk-free rate is 3% per year, what is
the strike price of the options?
A) $30.50
B) $46.96
C) $45.39
D) $31.13
E) $32.06
Answer: E
Explanation: E) Use the put-call parity relationship:
stock price + put price = call price + PV(strike price)
= 37.60 + 0.76 - 7.23; K = $32.06
Diff: 2 Type: MC
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
21) A protective put written on a portfolio (rather than a single stock) is known as
A) portfolio insurance.
B) put-call parity.
C) a warrant.
D) Black-Scholes.
E) diversification.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
22) According to put-call parity, which of the following would cause the value of a call option to
decrease?
A) a decrease in the present value of future dividends
B) a decrease in the present value of the strike price
C) an increase in the stock price
D) a decrease in the price of the put
E) an increase in the price of the put
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
@�@�@�@�@�@�@�@�@�@�@�@�@�@�@�@�@ trading for $47 per share. The stock pays no dividends. A
23) Rose Industries is currently trading for $47 per share. The stock pays no dividends. A one-year
European call option on Luther with a strike price of $45 is currently trading for $7.45. If the risk-free
interest rate is 6% per year, then calculate the price of a one-year European put option on Luther with a
strike price of $45.
Answer: C = P + S - PV(K) - PV(Div)
$7.45 = P + $47 -
- $0
P = $7.45 - $47 +
= $2.90
Diff: 2 Type: ES
Skill: Analytical
Objective: 13.6 Describe the relation that must hold between the prices of similar calls and puts on the same stock
13.7 Options and Corporate Finance
1) A share of stock can be thought of as a put option on the firm's assets with a strike price equal to the
face value of debt.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 13.7 Demonstrate how options are applied in corporate finance
2) A share of stock is a ________ option on the value of assets of the firm with a strike price equal to
________.
A) put option, face value of debt
B) call option, market value of equity
C) call option, face value of debt
D) put option, market value of equity
E) put option, market value of debt
Answer: C
Diff: 3 Type: MC
Skill: Conceptual
Objective: 13.7 Demonstrate how options are applied in corporate finance
3) Debt holders can be thought as owning the firm but having ________ a call option on the assets of the
firm with a strike price equal to ________.
A) sold, face value of debt
B) bought, face value of debt
C) sold, value of equity
D) bought, value of equity
E) bought, market value of debt
Answer: A
Diff: 3 Type: MC
Skill: Conceptual
Objective: 13.7 Demonstrate how options are applied in corporate finance
managers and shareholders, but instead between ________ and ity of a firm's assets because they benefit
4) Equity holders have an incentive to ________ the volatility of a firm's assets because they benefit from
such an increase at a cost to ________.
A) decrease, debt holders
B) decrease, suppliers
C) increase, directors
D) increase, debt holders
E) increase, suppliers
Answer: D
Diff: 3 Type: MC
Skill: Conceptual
Objective: 13.7 Demonstrate how options are applied in corporate finance
5) A(n) ________ in the volatility of assets of the firm benefits ________ at a cost to debt holders.
A) decrease, equity holders
B) increase, equity holders
C) decrease, directors
D) increase, directors
E) decrease, suppliers
Answer: B
Diff: 3 Type: MC
Skill: Conceptual
Objective: 13.7 Demonstrate how options are applied in corporate finance
6) How is equity like a call option on the firm's assets?
Answer: If a firm's asset value does not exceed the face value of debt outstanding, the firm must declare
bankruptcy and the equity holders receive nothing. If asset value exceeds the value of debt, the equity
holders get the difference. The payoff is the same as a call option.
Diff: 3 Type: SA
Skill: Conceptual
Objective: 13.7 Demonstrate how options are applied in corporate finance
7) How does option pricing theory help explain why equity holders have an incentive to take on
negative-NPV, high-volatility investments?
Answer: Since equity is like a call option on the firm's assets, when the firm is close to bankruptcy, the
equity is at-the-money. In this case, the loss in equity value that results from taking on a negative-NPV
investment might be outweighed by the gain in equity value from the increase in volatility.
Diff: 3 Type: SA
Skill: Conceptual
Objective: 13.7 Demonstrate how options are applied in corporate finance
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 14 Raising Equity Capital
14.1 Equity Financing for Private Companies
1) When a company founder sells stock to outside investors in order to raise capital, the share of the
company owned by the founder and the founder's control over the company will be reduced.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
2) Equity investors in a private company usually plan to realize a return on their investment by selling
their stock when that company is acquired by another firm or sold to the public in a public offering.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
3) Nature's Bounty, an organic seed company, is seeking to grow from a small company selling seeds in
local markets into a company that sells seeds across several states. The funding for this expansion comes
from a wealthy individual who uses his considerable inherited wealth to fund a variety of eco-friendly
businesses. Which of the following best describes this individual's relationship with Nature's Bounty?
A) an angel investor
B) a venture capitalist
C) an institutional investor
D) a corporate investor
E) a sovereign wealth fund
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
4) Why do most people launching a start-up company acquire their funds through the venture capital
industry rather than through angel investors?
A) Most entrepreneurs are not willing to relinquish the control of their business demanded by angel
investors.
B) Most entrepreneurs do not want the fees associated with investment by an angel investor.
C) Most entrepreneurs do not need the expertise brought to a young firm by an angel investor.
D) Most entrepreneurs do not have any relationships with individuals with substantial capital to invest.
E) Most entrepreneurs do not want to work with angel investors.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
5) Which of the following is a reason why an investor would choose to invest in new and growing firms
as a limited partner in a venture capital firm rather than making those investments directly by
themselves?
A) Venture capital firms use their control of the companies they invest in to protect those investments.
B) The investments of venture capital firm are less diversified than the investments of a single
individual.
C) A venture capital firm generally has a narrow range of expertise among its general partners.
D) The investor will have a direct say in how the companies that the venture capital firm funds will be
run.
E) The venture capital firm guarantees a higher return.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
6) Which of the following best describes a limited partnership that specializes in raising money to invest
in the private equity of young firms?
A) venture capital firms
B) institutional investors
C) corporate investors
D) a sovereign wealth fund
E) family investors
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
7) A large publishing firm specializing in college textbooks wishes to expand into online delivery of its
materials. In order to facilitate this, it invests in a number of small start-up companies that deliver
college courses online and uses these companies to start diversifying the delivery of its content. Which
of the following best describes the role of the publishing firm as described above?
A) a venture capitalist
B) an institutional investor
C) a corporate investor
D) a family investor
E) a sovereign wealth fund
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
8) The Ontario Teachers' Pension Plan is a pension fund for public school teachers in the province of
Ontario. It has a large and diverse portfolio of investments, both in Canada and internationally, and had
net assets in December 2012 of $108.5 billion. Which of the following best describes the Ontario
Teachers' Pension Plan?
A) an angel investor
B) a venture capitalist
C) an institutional investor
D) a family investor
E) a sovereign wealth fund
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
9) A firm's founder sells equity to outside investors for the first time in the form of preferred stock. In
what way is this preferred stock most likely to differ from the preferred stock issued by an established
public firm?
A) It will have a larger dividend.
B) It will most likely not pay cash dividends.
C) It will give the holder seniority in any liquidation of the company.
D) It cannot be converted into common stock.
E) It will not have special voting rights.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
10) Melissa founded her company using $100,000 of her own money, issuing herself 50,000 shares of
stock. An angel investor bought an additional 30,000 shares for $75,000. She now sells another 30,000
shares to a venture capitalist for $450,000. What is the post-money valuation for the company?
A) $1.65 million
B) $625,000
C) $1 million
D) $450,000
E) $850,000
Answer: A
Explanation: A) 30,000 shares at $450,000 leads to a valuation of $15 per share;
total shares = 50,000 + 30,000 + 30,000 = 110,000;
company valuation = 110,000 × $15 per share = $1.65 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
11) Melissa founded her company using $100,000 of her own money, issuing herself 50,000 shares of
stock. An angel investor bought an additional 30,000 shares for $75,000. She now sells another 30,000
shares to a venture capitalist for $450,000. What percentage of the firm does Melissa now own?
A) 100%
B) 45%
C) 16%
D) 50%
E) 33%
Answer: B
Explanation: B) Total shares = 50,000 + 30,000 + 30,000 = 110,000
Melissa's ownership = 50,000/110,000 = 45%
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
12) Melanie founded her company using $250,000 of her own money, issuing herself 100,000 shares of
stock. An angel investor bought an additional 50,000 shares for $350,000. She now sells another 75,000
shares to a venture capitalist for $600,000. What is the post-money valuation for the company?
A) $600,000
B) $1.2 million
C) $950,000
D) $1.8 million
E) $1 million
Answer: D
Explanation: D) 75,000 shares at $600,000 leads to a valuation of $8 per share;
total shares = 100,000 + 50,000 + 75,000 = 225,000
company valuation = 225,000 × $8 per share = $1.8 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
13) Melanie founded her company using $250,000 of her own money, issuing herself 100,000 shares of
stock. An angel investor bought an additional 50,000 shares for $350,000. She now sells another 190,000
shares to a venture capitalist for $750,000. What percentage of the firm does Melanie now own?
A) 33%
B) 19%
C) 29%
D) 50%
E) 38%
Answer: C
Explanation: C) Total shares = 100,000 + 50,000 + 190,000 = 340,000
Melanie's ownership = 100,000/340,000 = 29%
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
Use the table for the question(s) below.
Jeremy founded a company. He issues 200,000 shares of series A stock for his own $100,000 investment.
He then goes through three further rounds of investment, as shown below:
Round
Series B
Series C
Series D
Price
$1.00
$1.50
$2.25
Number of
Shares
500,000
300,000
400,000
14) What is the post-money valuation for the series D funding round?
A) $1.4 million
B) $1.95 million
C) $2.025 million
D) $2.85 million
E) $3.15 million
Answer: E
Explanation: E) Total shares = 500,000 + 300,000 + 400,000 + 200,000 = 1.4 million;
company valuation = $2.25 × 1.4 million = $3.15 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
15) Which of the following is closest to the percentage of the company owned by the series D investors?
A) 25%
B) 29%
C) 33%
D) 40%
E) 46%
Answer: B
Explanation: B) Total shares = 500,000 + 300,000 + 400,000 + 200,000 = 1.4 million;
Series D ownership = 0.4 / 1.4 = 29%
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
Use the table for the question(s) below.
The founder of a company issues 100,000 shares of series A stock for his own $250,000 investment. He
then goes through three further rounds of investment, as shown below:
Round
Series B
Series C
Series D
Price
$2.50
$2.75
$2.80
Number of
Shares
200,000
300,000
200,000
16) What is the post-money valuation for the series D funding round?
A) $1.89 million
B) $1.96 million
C) $2.14 million
D) $2.24 million
E) $2.43 million
Answer: D
Explanation: D) Total shares = 100,000 + 200,000 + 300,000 + 200,000 = 0.8 million;
$2.80 × 0.8 = $2.24 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
17) Which of the following is closest to the percentage of the company owned by the founder of the
company?
A) 11.2%
B) 12.5%
C) 25.0%
D) 37.5%
E) 42%
Answer: B
Explanation: B) Total shares = 100,000 + 200,000 + 300,000 + 200,000 = 0.8 million;
percentage owned by founder = 0.1/0.8 = 0.125
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
18) Which of the following statements regarding angel investors is most accurate?
A) They are typically arranged as limited partnerships.
B) For many start-ups, the first round of outside private equity financing is often obtained from them.
C) Because their capital investment is often small relative to the amount of capital already in place at the
firm, they typically receive a small equity share in the business in return for their funds.
D) These investors are typically not acquaintances or friends of the entrepreneur.
E) They have little influence on the business decisions of the firm.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
19) Which of the following statements regarding venture capitalists is most accurate?
A) They do not provide capital for young companies.
B) The firms do not offer limited partners a number of advantages over investing directly in start-ups
themselves as angel investors.
C) They use their control to protect their investments, so they may therefore perform a key nurturing
and monitoring role for the firm.
D) They might invest for strategic objectives in addition to the desire for investment returns.
E) They are typically friends or acquaintances of the entrepreneur.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
20) Which of the following statements regarding private equity investors is most accurate?
A) A venture capital firm specializes in raising money to invest in the equity of public firms.
B) Venture capitalists typically control about three-quarters of the seats on a start-up's board of
directors, and often represent the single largest voting block on the board.
C) The initial capital that is required to start a business is usually provided by the entrepreneur herself
and venture capital investors.
D) A limited partnership that buys equity in small private firms is called an angel investor.
E) Institutional investors are typically the limited partners in a venture capital firm.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
21) Which of the following statements regarding stock issues is most accurate?
A) The preferred stock issued by young companies typically pays regular cash dividends.
B) The preferred stock issued by young companies usually gives the owner an option to convert it to
common stock on some future date, so it is often called callable preferred stock.
C) If the company runs into financial difficulties, the preferred stockholders have a senior claim on the
assets of the firm relative to any common stockholders.
D) Preferred stock issued by mature companies such as banks usually has no dividend.
E) When a company founder decides to sell equity to outside investors for the first time, it is common
practice for private companies to issue common stock to raise capital.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
Use the information for the question(s) below.
You founded your own firm three years ago. You initially contributed $200,000 of your own money and
in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares
of stock to angel investors. You are now considering raising capital from a venture capital firm. This
venture capital firm would invest $5 million and would receive 2 million newly issued shares in return.
22) The post-money valuation of your firm is closest to:
A) $12.5 million
B) $5.2 million
C) $10.0 million
D) $5.0 million
E) $5.3 million
Answer: A
Explanation: A) Total shares outstanding = 2M (yours) + 1M (angel's) + 2M (venture) = 5 million shares
The venture capitalist would be paying
= $2.50 per share
Therefore, post-money valuation = $2.50 × 5 million shares = $12.5 million.
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
ve in C company?at this is the venture capitalist's first investment in your firm, what percentage of the
23) Assuming that this is the venture capitalist's first investment in your firm, what percentage of the
firm will the venture capitalist own?
A) 50%
B) 40%
C) 25%
D) 33%
E) 60%
Answer: B
Explanation: B) Total shares outstanding = 2M (yours) + 1M (angel's) + 2M (venture) = 5 million shares
The venture capitalist ownership percentage =
= 40%
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
24) After the venture capitalist's investment, what percentage of the firm will you own?
A) 50%
B) 40%
C) 33%
D) 25%
E) 16%
Answer: B
Explanation: B) Total shares outstanding = 2M (yours) + 1M (angel's) + 2M (venture) = 5 million shares
Your ownership percentage =
= 40%
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
25) After the venture capitalist's investment, the post-money valuation of your shares are closest to:
A) $5.0 million
B) $12.5 million
C) $4.0 million
D) $2.5 million
E) $200,000
Answer: A
Explanation: A) Total shares outstanding = 2M (yours) + 1M (angel's) + 2M (venture) = 5 million shares
The venture capitalist would be paying
= $2.50 per share
Therefore, your post-money valuation = $2.50 × 2 million shares = $5 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
26) After the venture capitalist's investment, the post-money valuation of the angel investor's shares are
26) After the venture capitalist's investment, the post-money valuation of the angel investor's shares are
closest to:
A) $12.5 million
B) $4.0 million
C) $5.0 million
D) $2.5 million
E) $1.0 million
Answer: D
Explanation: D) Total shares outstanding = 2M (yours) + 1M (angel's) + 2M (venture) = 5 million shares
The venture capitalist would be paying
= $2.50 per share
Therefore, your post-money valuation = $2.50 × 1 million shares = $2.5 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
27) Suppose you had sold the 1 million shares to the angel investor for $500,000. What would have been
the post-money valuation of your shares immediately following the angel investor's investment?
A) $500,000
B) $700,000
C) $1.0 million
D) $2.0 million
E) $2.5 million
Answer: C
Explanation: C) The angel investor paid
= $0.50 per share
Therefore, your post-money valuation = $0.50 × 2 million shares = $1.0 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
28) Suppose you had sold the 1 million shares to the angel investor for $500,000. What would have been
your percentage ownership in the company immediately following the angel investor's investment?
A) 28.6%
B) 33.3%
C) 50%
D) 66.7%
E) 100%
Answer: D
Explanation: D) Total shares outstanding = 2 million + 1 million = 3 million. Your share is 2 million/3
million = 66.7%
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
agency conflicts and how they are dealt with around the worldy a private company and a mature
29) What is the difference between preferred stocks issued by a private company and a mature
company?
Answer: Preferred stock issued by a private company generally does not carry a dividend but is often
convertible to common equity if the firm is successful. Alternately, if the firm does not do well, the
preferred stock has a higher claim on the assets of the firm. Preferred stock issued by a mature company
generally carries a preferred dividend, seniority in liquidation, and special voting rights.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
30) What advantages do venture capital firms offer limited partners compared to investing directly in
start-ups themselves as angel investors?
Answer: Because venture capital firms invest in many start-ups, limited partners are more diversified
than if they invested on their own. They also benefit from the expertise of the general partners.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.1 Contrast the different ways to raise equity capital for a private company
14.2 Taking Your Firm Public: The Initial Public Offering
1) The main advantages for a firm in going public are greater liquidity, better access to capital, and
greater ability of investors to monitor the management of the firm.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
2) In a best-efforts IPO, the underwriter guarantees that all stock will be sold.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
3) The firm commitment process is the most common practice for IPOs.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
4) Which of the following is a reason why an IPO is attractive to the managers of a private company?
A) It gives their private equity investors the opportunity to diversify.
B) They will be able to reduce their financial disclosure costs.
C) It reduces the complexity of requirements regulating the company's management.
D) It limits the amount of capital that can be raised through the public markets in subsequent offerings.
E) The managers benefit significantly from underpricing.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
5) Which of the following best describes those shares sold when a company goes public which raise new
capital?
A) primary offering
B) secondary offering
C) tertiary offering
D) preliminary offering
E) exit strategy
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
6) At what stage of the IPO process do senior management and the lead underwriters travel to promote
the company and explain their rationale for the offer price to the underwriters' largest customers?
A) when filing the preliminary prospectus
B) when filing the final prospectus
C) when managing risk
D) when matching buyers to sellers of the stock
E) when valuating the firm
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
7) Which of the following best describes a firm commitment IPO?
A) The underwriter purchases the entire issue at a small discount and then resells it at the offer price.
B) The underwriter sells new issues directly to the public in an online auction.
C) The underwriter tries to sell the stock for the best possible price but does not guarantee that the stock
will be sold.
D) The underwriter solicits bids from investors and chooses the highest price at which there is sufficient
demand to sell the entire issue.
E) The underwriter sets a deliberately low price to ensure the entire issue is sold.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
8) Which of the following best describes an auction IPO?
A) The underwriter purchases the entire issue at a small discount and then resells it at the offer price.
B) The underwriter sells new issues directly to the public through an online bidding process.
C) The underwriter tries to sell the stock for the best possible price but does not guarantee that the stock
will be sold.
D) The underwriter solicits bids from investors and chooses the highest price at which there is sufficient
demand to sell the entire issue.
E) The underwriter sets a deliberately low price to ensure the entire issue is sold.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
9) An IPO in which the underwriter purchases the entire issue at a discount and then resells it at the
offer price is
A) a primary offering.
B) a secondary offering.
C) an auction IPO.
D) a best-efforts IPO.
E) a firm commitment IPO.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
10) A situation in which the underwriter does not guarantee the stock will be sold, but instead tries to
sell the stock for the best possible price is
A) a primary offering.
B) a secondary offering.
C) an auction IPO.
D) a best-efforts IPO.
E) a firm commitment IPO.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
11) A restriction that prevents existing shareholders from selling their shares for some period after an
IPO is called
A) a greenshoe provision.
B) book building.
C) a secondary offering.
D) a lockup.
E) a red herring.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
12)
Price ($)
5.00
5.25
5.50
5.75
6.00
6.25
6.50
Number of Shares
Bid
600,000
700,000
850,000
800,000
650,000
400,000
150,000
Felicity Industries is selling 2 million shares of stock in an auction IPO. At the end of the bidding period
they have received the bids shown above. Which of the following is closest to the price at which the
shares will be offered?
A) $5.00
B) $5.25
C) $5.75
D) $6.00
E) $6.25
Answer: C
Explanation: C) Cumulative shares = 150,000 + 400,000 + 650,000 + 800,000 = 2 million; hence, $5.75
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
13)
Price ($)
6.00
6.25
6.50
6.75
7.00
7.25
7.50
Number of Shares
Bid
100,000
200,000
450,000
200,000
350,000
200,000
250,000
Harrison Products is selling 1 million shares of stock in an auction IPO. At the end of the bidding period
they have received the bids shown above. Which of the following is closest to the price at which the
shares will be offered?
A) $6.25
B) $6.60
C) $6.75
D) $7.00
E) $7.25
Answer: C
Explanation: C) Cumulative shares = 250,000 + 200,000 + 350,000 + 200,000 = 1 million; hence, $6.75
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
14)
Price ($)
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
Number of Shares
Bid
100,000
100,000
150,000
100,000
40,000
80,000
150,000
65,000
Bejeweled, a chain of crafting shops, is selling 500,000 shares of stock in an auction IPO. At the end of
the bidding period they have received the bids shown above. Which of the following is closest to the
price at which the shares will be offered?
A) $3.50
B) $3.75
C) $4.25
D) $4.50
E) $4.75
Answer: A
Explanation: A) Cumulative shares = 65,000 + 150,000 + 80,000 + 40,000 + 100,000 + 150,000 > 500,000;
hence, $ 3.50
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
Use the table for the question(s) below.
David founds a company and goes through the investment rounds shown below:
Round
Series A
Series B
Series C
Series D
Source
Self
Angel
Venture Capital
Venture Capital
Price
$0.50
$1.00
$1.50
$2.25
Number of
Shares
400,000
500,000
300,000
400,000
He decides to take the company public through an IPO, issuing 2 million new shares. Assuming that he
successfully completes the IPO, the net income for the next year is estimated to be $8 million. His
banker informs him that the price of shares should be set using average price-earnings ratios for similar
businesses, which is 15.0.
15) What will be the IPO price per share?
A) $3.40
B) $20.25
C) $33.33
D) $33.75
E) $60.00
Answer: C
Explanation: C) Cumulative shares = 400,000 + 500,000 + 300,000 + 400,000 + 2 million = 3.6 million;
EPS = $8 / 3.6 ; price = 15 × 8 / 3.6 = $33.33
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
16) What share of the company will David own after the IPO?
A) 11%
B) 14%
C) 16%
D) 22%
E) 50%
Answer: A
Explanation: A) Cumulative shares = 400,000 + 500,000 + 300,000 + 400,000 + 2 million = 3.6 million;
David's share = 0.4/3.6 = 11%
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
17) An IPO is offered at $12.50 per share for 4 million shares. The IPO underwriters had a spread of
6.5%. What was the total fee paid to the underwriters?
A) $3.25 million
B) $4 million
C) $260,000
D) $2.25 million
E) $12.5 million
Answer: A
Explanation: A) Total paid = $12.50 × 0.065 × 4 million = $3.25 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
18) An IPO is offered at $6.75 per share for 2 million shares. The IPO underwriters had a spread of 9%.
What was the total fee paid to the underwriters?
A) $13,500,000
B) $1,215,000
C) $12,285,000
D) $12,385,000
E) $1,800,000
Answer: B
Explanation: B) Total paid = $6.75 × 0.09 × 2 million = $1,215,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
19) An IPO is offered at $17 per share for 3 million shares. The IPO underwriters had a spread of 7%.
What price did the underwriters pay per share of the IPO firm?
A) $14
B) $17
C) $15.81
D) $18.19
E) $16
Answer: C
Explanation: C) Price paid per share = $17 × (1 - 0.07) = $15.81
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
20) An IPO is offered at $9.50 per share for 7 million shares. The IPO underwriters had a spread of
7.25%. What price did the underwriters pay per share of the IPO firm?
A) $9.17
B) $8.86
C) $10.19
D) $9.50
E) $8.81
Answer: E
Explanation: E) Price paid per share = $9.5 × (1 - 0.0725) = $8.81
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
21) An IPO is offered at $14 per share for 6 million shares. The IPO underwriters had a spread of 7.5%.
What proceeds did the firm receive from the IPO?
A) $6.3 million
B) $90.3 million
C) $84 million
D) $77.7 million
E) $75 million
Answer: D
Explanation: D) Amount per share = $14 × (1 - 0.075) = $12.95
Total proceeds = $12.95 × 6 million = $77.7 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
22) An IPO is offered at $23 per share for 12 million shares. The IPO underwriters had a spread of 6%.
What proceeds did the firm receive from the IPO?
A) $259 million
B) $276 million
C) $260 million
D) $293 million
E) $270 million
Answer: A
Explanation: A) Amount per share = $23 × (1 - 0.06) = $21.62
Total proceeds = $21.62 × 12 million = $259 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
Use the table for the question(s) below.
The founders and owners of a private company have funded it through the following rounds of
investment:
Round
Series A
Series B
Series C
Source
Self
Angel
Venture Capital
Price
$1.00
$1.00
$1.25
Number of
Shares
200,000
300,000
400,000
The owners decide to take the company public through an IPO, issuing 1 million new shares. Assuming
that they successfully complete the IPO, the net income for the next year is estimated to be $5 million.
The price of shares is set using average price-earnings ratios for similar businesses of 17.0.
23) What will be closest to the IPO price per share?
A) $12
B) $21.25
C) $22
D) $36
E) $45
Answer: E
Explanation: E) Cumulative shares = 200,000 + 300,000 + 400,000 + 1 million = 1.9 million;
EPS = $5 / 1.9; price = 17 × 5 / 1.9 = $44.75, therefore $45
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
24) What portion of the company will be owned by the angel investor after the IPO?
A) 12%
B) 16%
C) 22%
D) 30%
E) 33%
Answer: B
Explanation: B) Cumulative shares = 200,000 + 300,000 + 400,000 + 1 million = 1.9 million;
angel investor = 0.3 / 1.9 = 16%
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
25) What is the major reason that underwriters tend to offer stocks in an IPO at a price that is below that
which the market will pay?
A) to gain from the rise in value of any stocks they hold after the IPO
B) to reduce their exposure to losses from unsold stock
C) to benefit from greenshoe provisions
D) to increase their spread
E) The market price is unknown until after the IPO.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
26) The founder of a company currently holds 12 million of the 15 million shares in that company. She
considers an IPO where she sells a mix of primary shares and 2 million of her own secondary shares for
$18 per share. If she wants to retain a 60% ownership of the company, how much money can she raise in
this IPO?
A) $30 million
B) $36 million
C) $42 million
D) $54 million
E) $66 million
Answer: E
Explanation: E) For 10 million shares to be 60%, total shares = 16.6666 million;
thus, owner gets 2 million + 16.666 million - 15 million = 3.6666 million;
3.6666 million × $18 = $66 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
27) Which of the following statements regarding selling shares to the public is most accurate?
A) The process of selling stock to the public for the first time is called a seasoned equity offering (SEO).
B) Public companies typically have access to much larger amounts of capital through the public
markets.
C) By going public, companies prevent their private equity investors from diversifying.
D) An IPO is typically the last time a company needs to raise capital from the public markets.
E) Going public gives current shareholders less liquidity for their shares.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
28) Which of the following statements regarding IPOs is most accurate?
A) In an auction IPO, the underwriter purchases the entire issue at a small discount and then resells it at
the offer price.
B) The shares that are sold in the IPO may either be new shares that raise new capital, known as a
secondary offering, or existing shares that are sold by current shareholders (as part of their exit
strategy), known as a primary offering.
C) Many IPOs, especially the larger offerings, are managed by a group of underwriters, called a
syndicate.
D) At an IPO, a firm returns to the public market to offer more shares.
E) Auction IPOs are the most common type of IPO.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
29) Which of the following statements regarding best efforts IPOs is most accurate?
A) For smaller IPOs, the underwriter rarely uses a best-efforts IPO.
B) The underwriter guarantees that the stock will be sold at the offer price.
C) Often these arrangements have an all-or-none clause: either all of the shares are sold in the IPO, or
the deal is called off.
D) If the entire issue does not sell out, the underwriter is on the hook.
E) The underwriter sells new issues directly to the public through an online bidding process.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
30) Which of the following statements regarding firm commitment IPOs is most accurate?
A) If the entire issue does not sell out, the remaining shares must be sold at a lower price and the
underwriter must take the loss.
B) The underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for
the best possible price.
C) It is the least common underwriting arrangement.
D) Rather than setting the offer price, the underwriter lets the market determine the price through bids
from potential investors.
E) Often these arrangements have an all-or-none clause: either all of the shares are sold in the IPO, or
the deal is called off.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
31) As part of the registration statement , the preliminary prospectus circulates to investors before the
stock is offered. This preliminary prospectus is also called a(n)
A) IPO filing.
B) 10-K filing.
C) blue whale.
D) red herring.
E) greenshoe provision.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 14.2 Understand the process of taking a company public
32) In an IPO, an option that allows the underwriter to issue more stock, usually amounting to 15% of
the original offer size, at the IPO offer price, is called a(n)
A) final prospectus.
B) lockup.
C) IPO overdraft.
D) red herring.
E) greenshoe provision.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
Use the information for the question(s) below.
Luther Industries is in the process of selling shares of stock in an auction IPO. At the end of the bidding
period, Luther's investment bank has received the following bids:
Price ($)
$19.50
$19.25
$19.10
$19.00
$18.75
$18.50
$18.25
$18.00
$17.75
$17.50
$17.25
$17.00
$16.90
$16.75
$16.50
$16.25
Number of
Shares Bid
50,000
25,000
25,000
100,000
125,000
75,000
150,000
240,000
80,000
125,000
150,000
100,000
60,000
80,000
75,000
200,000
33) What will the offer price of these shares be if Luther is selling 1 million shares?
A) $17.00
B) $17.50
C) $17.25
D) $16.75
E) $18.00
Answer: C
Explanation: C)
Number of Cumulative
Price ($)
Shares Bid
Demand
$19.50
50,000
50,000
$19.25
25,000
75,000
$19.10
25,000
100,000
$19.00
100,000
200,000
$18.75
125,000
325,000
$18.50
75,000
400,000
$18.25
150,000
550,000
$18.00
240,000
790,000
$17.75
80,000
870,000
$17.50
125,000
995,000
$17.25
150,000
1,145,000
$17.00
100,000
1,245,000
$16.90
60,000
1,305,000
$16.75
80,000
1,385,000
$16.50
75,000
1,460,000
$16.25
200,000
1,660,000
By looking at cumulative demand, we see that a cumulative demand of 1 million shares corresponds to
a price of $17.25.
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
34) The proceeds from the IPO be if Luther is selling 1.25 million shares is closest to:
A) $20.6 million
B) $21.6 million
C) $21.1 million
D) $20.9 million
E) $21.5 million
Answer: C
Explanation: C)
Number of Cumulative
Price ($)
Shares Bid
Demand
$19.50
50,000
50,000
$19.25
25,000
75,000
$19.10
25,000
100,000
$19.00
100,000
200,000
$18.75
125,000
325,000
$18.50
75,000
400,000
$18.25
150,000
550,000
$18.00
240,000
790,000
$17.75
80,000
870,000
$17.50
125,000
995,000
$17.25
150,000
1,145,000
$17.00
100,000
1,245,000
$16.90
60,000
1,305,000
$16.75
80,000
1,385,000
$16.50
75,000
1,460,000
$16.25
200,000
1,660,000
By looking at cumulative demand, we see that a cumulative demand of 1.25 million shares corresponds
to a price of $16.90.
So, proceeds = $16.90 × 1,250,000 = $21,125,000
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.2 Understand the process of taking a company public
35) What are some of the advantages of going public?
Answer: Going public provides liquidity and better access to capital. It also gives an opportunity to the
private investors to diversify their portfolio.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
36) What are some of the disadvantages of going public?
Answer: When investors sell their stake and diversify their holdings, they lose their ability to monitor
the company's management, which represents a loss of control.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
37) What are some of the highlights of Google's IPO process?
Answer: The Google IPO process did not follow traditional IPO process. Rather than rely on their
underwriters, Google used an auction IPO mechanism for distributing their shares.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.2 Understand the process of taking a company public
14.3 IPO Puzzles
1) Stock issued in an IPO usually trades significantly higher at the end of the first day of trading than
the original IPO price.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
2) Newly listed firms tend to perform relatively poorly in the three to five years after their IPOs.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
3) How does the total cost of issuing stock for the first time compare to the costs of other securities?
A) substantially larger than the costs for most other securities
B) about the same as the cost for most other securities
C) substantially less than the cost for a few other securities
D) substantially less than the costs for most other securities
E) it is different for every IPO
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
4) Which of the following is a notable puzzle in IPOs?
A) The number of IPOs is highly underestimated.
B) The number of IPOs is highly seasonal.
C) The number of IPOs is almost the same every year.
D) The number of IPOs does not follow any pattern.
E) The number of IPOs is highly cyclical.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
5) The offer price of shares in an IPO is generally less than the price those shares sell for at the end of the
first trading day. Which of the following parties suffer most from this situation?
A) the buyers of shares after the initial offering
B) the underwriters of the IPO
C) the pre-IPO shareholders of the issuing firm
D) the lead underwriter of the IPO
E) the buyers of the shares at the end of the first trading day
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
6) How does the size of an issue affect the fees charged by underwriters?
A) Although large issues generally have a smaller spread, the large number of shares released means
that the total fees are somewhat larger than for smaller issues.
B) Large issues generally have a similar spread to small issues and thus attract much greater fees.
C) Large issues have a reduced spread, which means that the total fees are generally the same as for
smaller issues.
D) Large issues have substantially larger direct costs and, thus, must charge a larger spread in order to
be profitable for the underwriter.
E) Large issues involve a flat fee rather than a spread.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
7) Which of the following statements concerning the volume and number of IPOs issued over time is
most accurate?
A) They are cyclical.
B) They tend to rise over time.
C) They tend to fall over time.
D) They remain approximately the same over time.
E) They do not follow any pattern.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
8) Underpricing of an IPO would most likely be greatest in which of the following markets?
A) Australia
B) China
C) Japan
D) United States
E) Canada
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
9) What are the four IPO puzzles?
Answer:
1. On average, IPOs appear to be underpriced.
2. The number of IPOs is highly cyclical.
3. The transactions costs of the IPO are very high, and it is unclear why firms willingly incur such high
costs.
4. The long-run performance of a newly public company is poor.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
10) Who benefits from IPO underpricing?
Answer: Underwriters benefit from IPO underpricing since this reduces their risk. In addition,
investors who are able to buy stock from underwriters at the IPO price also gain from underpricing.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
11) What is the general long-run performance of an IPO?
Answer: The long-run performance, such as three to five years, for an IPO is poor. That is, on average, a
three- to five-year buy-and-hold strategy appears a bad investment.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.3 Gain insight into puzzles associated with initial public offerings
14.4 Raising Additional Capital: The Seasoned Equity Offering
1) A cash offer differs from a rights offer in that in the latter shares are offered to both existing
shareholders and investors at large.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
2) The announcement of an SEO usually raises a stock's price.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
3) Managers will try to protect their existing shareholders by selling new shares at a price that correctly
values or overvalues their firm, leading investors to reason that the announcement of an SEO indicates
that a company is over-valued.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
4) Moon Company plans to issue 10 million shares in a seasoned equity offering. The owner, Ken Moon,
plans to sell 4 million shares as part of the offering. Which of the following is true regarding the
seasoned equity issue?
A) It is a primary offering.
B) It is a secondary offering.
C) It is cash offer.
D) It is a rights offer.
E) Some shares are primary shares and some shares are secondary shares.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
5) What is a seasoned equity offering?
A) the sale of shares by the owners of a company
B) the raising of capital through retained earnings
C) the issuing of shares to the public in a proven private company
D) the issuing of shares by a company at a time after its IPO
E) the sale of shares to a private equity firm
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
6) An equity issue that raises new funds for a publicly traded company is called
A) an initial public offering.
B) an underpriced offering.
C) a secondary offering.
D) a firm commitment offering.
E) a seasoned equity offering.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
7) What are the advantages of a rights offer over a cash offer when issuing new shares?
A) It enables a firm to attract new investors from outside its current owners.
B) It enables a firm to issue equity without imposing a loss on current shareholders.
C) It enables a firm to access new sources of capital to fund its growth.
D) It enables a firm to attract new investors by offering them a windfall from the difference between the
price of the issued stock and the price of stock after the offering.
E) It enables a firm to issue equity at a price above the market price of its stock.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
8) Tangible Technologies has a market capitalization of $150 million and 8 million shares outstanding.
In order to finance its growth, the firm's management plans to raise further capital through a rights
issue. All shareholders will be issued one right per share. For every 4 rights held by a stockholder, they
can purchase one share at a price of $15 per share. How much money will this raise, if all shareholders
exercise their rights?
A) $30 million
B) $150 million
C) $120 million
D) $15 million
E) $37.5 million
Answer: A
Explanation: A) $15 × 8 / 4 = $30 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
9) Hargrave Kitchen & Bath has 6 million shares outstanding at a price of $33.25 per share. The
company has decided to raise capital through a rights issue. All shareholders will be issued one right
per share. For every five rights held by the stockholder, they can buy one share at a price of $33.25. How
much money will this raise, if all shareholders exercise their rights?
A) $30 million
B) $33.25 million
C) $234.4 million
D) $39.9 million
E) $199.5 million
Answer: D
Explanation: D) $33.25 × 6 / 5 = $39.9 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
10) Big Box retailing has a market capitalization of $500 million and 20 million shares outstanding. In
order to finance its growth, the management of Big Box plans to raise further capital through a rights
issue. All shareholders will be issued ten rights to purchase a new share at a price of $1.50. What will
the price of a share be after the SEO, if all shareholders exercise their rights?
A) $1.50
B) $2.32
C) $2.41
D) $2.50
E) $3.64
Answer: E
Explanation: E) Total capital raised = 1.5 × 20 × 10 = $300 million;
total market cap = $500 + $300 = $800 million;
total shareholders = 20 + 20 × 10 = 220 million; price per share = 800 / 220 = $3.64
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
11) Chambers Industries has a market capitalization of $800 million and 250 million shares outstanding.
The management of this firm plans to raise further capital through a rights issue. Which of the following
rights schemes will raise the most money, if all shareholders exercise their rights?
A) two rights to purchase one share at $1.60 per share
B) three rights to purchase two shares at $1.80 per share
C) four rights to purchase three shares at $2.00 per share
D) five rights to purchase two shares at $1.50 per share
E) ten rights to purchase two shares at $1.00 per share
Answer: C
Explanation: C) 4 × 3 × $2 = $24
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
12) Which of the following is an advantage of a cash offer over a rights offer?
A) The underwriter can credibly attest to the issue's quality.
B) The overall costs are lower.
C) There is no loss imposed on the current holders of stock.
D) There are lower underwriting fees.
E) More capital is raised.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
13) Waterloo Waste Management sells 5 million shares of stock in an SEO, with 3 million being primary
shares issued by the company and 2 million being secondary shares sold by investors in the company.
At the time of the sale, the firm's stock was selling at $12.50 per share. If the underwriter charges 7% of
the gross proceeds as a fee, how much money was raised in the sale?
A) $34.88 million
B) $58.13 million
C) $23.25 million
D) $37.5 million
E) $25 million
Answer: A
Explanation: A) $12.50 × 0.93 × 3 = $34.88 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
14) Ontario Operating Systems sells 20 million shares of stock in an SEO, with 15 million being primary
shares issued by the company and 5 million being secondary shares sold by investors in the company.
At the time of the sale, the firm's stock was selling at $34 per share. If the underwriter charges 6% of the
gross proceeds as a fee, how much money was raised in the sale?
A) $639.5 million
B) $479.4 million
C) $160 million
D) $170 million
E) $510 million
Answer: B
Explanation: B) $34 × 0.94 × 15 = $479.4 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
15) Manitoba Marketing sells 8 million shares of stock in an SEO, with 5 million being primary shares
issued by the company and 3 million being secondary shares sold by investors in the company. At the
time of the sale, the firm's stock was selling at $16 per share. If the underwriter charges 5% of the gross
proceeds as a fee, how much money was raised in the sale?
A) $32 million
B) $48 million
C) $76 million
D) $30.4 million
E) $45.6 million
Answer: E
Explanation: E) $16 × 0.95 × 3 = $45.6 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
16) Saskatoon Smelting sells 25 million shares of stock in an SEO, with 20 million being primary shares
issued by the company and 5 million being secondary shares sold by investors in the company. At the
time of the sale, the firm's stock was selling at $4.75 per share. If the underwriter charges 7% of the gross
proceeds as a fee, how much money was raised in the sale?
A) $23.75 million
B) $110.44 million
C) $88.35 million
D) $22.08 million
E) $118.75 million
Answer: C
Explanation: C) $4.75 × 0.93 × 20 = $88.35 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
17) Regina Respiratory Devices stock trades at $21 per share and there are 14 million shares
outstanding. The management would like to raise $80 million in an SEO. If the underwriter charges 5%
of gross proceeds, how many shares must it sell?
A) 3.6 million
B) 3.8 million
C) 4 million
D) 4.5 million
E) 3.4 million
Answer: C
Explanation: C) 21 × 0.95 = $19.95; number of shares sold = 80 / 19.95 = 4 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
18) Niagara Novelty Stores stock trades at $46 per share and there are 34 million shares outstanding.
The management would like to raise $150 million in an SEO and current investors would like to sell $30
million of their own stock. If the underwriter charges 6% of gross proceeds, how many shares must it
sell in the total (primary and secondary) offering?
A) 3.69 million
B) 3.26 million
C) 3.47 million
D) 4.16 million
E) 3.91 million
Answer: D
Explanation: D) 46 × 0.94 = $43.24; number of shares sold = 180 / 43.24 =4.16 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
19) Canadian Copper stock trades at $22.50 per share and there are 82 million shares outstanding. The
management would like to raise $300 million in an SEO and current investors would like to sell $40
million of their own stock. If the underwriter charges 5% of gross proceeds, how many shares must it
sell in the total (primary and secondary) offering?
A) 15.9 million
B) 14 million
C) 15.1 million
D) 14.4 million
E) 14.7 million
Answer: A
Explanation: A) 22.50 × 0.95 = $21.375; number of shares sold =340 / 21.375 = 15.9 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
20) Nunavut Mining Company stock trades at $3.25 per share and there are 46 million shares
outstanding. The management would like to raise $50 million in an SEO. If the underwriter charges 6%
of gross proceeds, how many shares must it sell?
A) 15.4 million
B) 16.4 million
C) 14.5 million
D) 16.3 million
E) 14.7 million
Answer: B
Explanation: B) 3.25 × 0.94 = $3.055; number of shares sold =50 / 3.055 =16.4 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
21) Yukon Gold Inc. stock trades at $37 per share and there are 18 million shares outstanding. The
management would like to raise $40 million in an SEO. If the underwriter charges 5% of gross proceeds,
and all the shares are primary shares sold to new investors, what percentage of the company will be
owned by the new investors?
A) 5.4%
B) 5.7%
C) 6%
D) 6.5%
E) 6.8%
Answer: C
Explanation: C) 37 × 0.95 = $35.15; number of shares sold =40 / 35.15 =1.14 million;
percentage of company owned by new shareholders = 1.14/ (18 + 1.14) = 6%
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
22) Northern Lights Corp. stock trades at $55 per share and there are 72 million shares outstanding. The
management would like to raise $190 million in an SEO. If the underwriter charges 7% of gross
proceeds, and all the shares are primary shares sold to new investors, what percentage of the company
will be owned by the new investors?
A) 5.4%
B) 5.7%
C) 4.3%
D) 4.6%
E) 4.9%
Answer: E
Explanation: E) 55 × 0.93 = $51.15; number of shares sold =190 / 51.15 =3.7 million;
percentage of company owned by new shareholders = 3.7/ (72 + 3.7) = 4.9%
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
23) Which of the following statements regarding SEOs is most accurate?
A) Secondary shares are new shares issued by the company.
B) Today, investors become informed about the impending sale of stock by the news media, via a road
show, or through the book-building process, so tombstones are purely ceremonial.
C) In a cash offer, the firm offers the new shares to existing shareholders.
D) In a rights offer, the firm sells rights to new shareholders.
E) Rights offers expose existing shareholders to underpricing.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
24) Which of the following statements regarding SEOs is most accurate?
A) SEO rights offers have higher costs than cash offers.
B) The decision to raise financing externally usually implies that a firm has run out of investment
opportunities.
C) Although not as costly as IPOs, seasoned offerings are still expensive.
D) Researchers have found that, on average, the market greets the news of an SEO with a price increase.
E) SEOs, unlike IPOs, do not have underwriting fees.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
25) Luther Industries currently has 100 million shares of stock outstanding at a price of $25 per share.
The company would like to raise money and has announced a rights issue. Every existing shareholder
will be sent one right per share of stock that he or she owns. The company plans to require twenty
rights to purchase one share at a price of $20 per share. The amount of money that Luther will raise
through its rights offering is closest to?
A) $500 million
B) $125 million
C) $100 million
D) $400 million
E) $200 million
Answer: C
Explanation: C) The number of new shares issues =
= 5 million shares
Amount raised = 5 million new shares × $20 price per new share = $100 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 14.4 Explain how to raise additional equity capital once the company is public
26) How many types of seasoned equity offerings are there?
Answer: There are two kinds of seasoned equity offerings: a cash offer and a rights offer. In cash offer,
the firm offers the new shares to investors at large, while in a rights offer, the firm offers new shares
only to existing shareholders.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 14.4 Explain how to raise additional equity capital once the company is public
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 15 Debt Financing
15.1 Corporate Debt
1) The chief advantage of debt financing over financing through raising equity capital is that the former
does not dilute the current owner's share of the business.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
2) A bond that makes payments in a certain currency contains the risk of holding that currency and so is
priced according to the yields of similar bonds in that currency.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
3) Private debt cannot be in the form of bonds.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
4) The public debt market is substantially larger than the private debt market.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
5) By definition, a corporate bond is any form of debt security.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
6) A bond issue that does not trade on the public market but instead is sold to a small group of investors
is called a(n)
A) private placement.
B) syndicated bond.
C) revolving line of credit.
D) syndicated bank loan.
E) Eurobond.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
7) Which of the following is usually a form of public debt?
A) a private placement
B) a bank loan
C) a bond issue
D) a revolving line of credit
E) an asset-backed line of credit
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
8) Which of the following is an advantage of private debt over public debt?
A) It is liquid.
B) It does not need to be registered with the securities commission.
C) It does not require interest and principal payments made upon it.
D) It dilutes the ownership of the firm.
E) It is sold to a wider group of investors.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
9) Which of the following terms best describes a loan where a larger line of credit or lower interest rate
has been obtained by providing collateral to back that loan?
A) a term loan
B) a revolving line of credit
C) an asset-backed line of credit
D) a private placement
E) a syndicated bank loan
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
10) Which of the following terms best describes a credit commitment for a specific time period which a
company can use as needed?
A) a term loan
B) a revolving line of credit
C) a syndicated bank loan
D) a private placement
E) an asset-backed line of credit
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
11) Which of the following is an advantage of a public bond issue over private placement?
A) It can be tailored to the particular situation.
B) It is less costly to issue.
C) It does not need to be registered with the securities commission.
D) It is freely tradable on the bond market.
E) It is sold to a small group of investors.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
12) In terms of public offerings of bonds, what is an indenture?
A) a list of the duties of the trust company representing the bondholders' interests
B) a memorandum that must be produced to describe the details of a bond offering
C) a formal contract that specifies the firm's obligations to the bondholders
D) a schedule of the fees charged by the underwriting company
E) a registration filing with the securities commission
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
13) The face value of bonds are denominated most commonly in which of the following standard
increments?
A) $10
B) $100
C) $1000
D) $10,000
E) $100,000
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
14) In terms of public offerings of bonds, what is a prospectus?
A) a list of the duties of the trust company representing the bondholders' interests
B) a memorandum that must be produced to describe the details of a bond offering
C) a formal contract that specifies the firm's obligations to the bondholders
D) a schedule of the fees charged by the underwriting company
E) a registration filing with the securities commission
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
15) Smithfield Enterprises issues debt with a maturity of 7 years. In the case of bankruptcy, holders of
this debt may only claim those assets of the firm that are not already pledged as collateral on other debt.
Which of the following best describes this type of corporate debt?
A) a note
B) a mortgage bond
C) an asset-backed bond
D) unsecured debt
E) a debenture
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
16) Gepps Cross Industries issues debt with a maturity of 25 years. In the case of bankruptcy, holders of
this debt may only claim those assets of the firm that are not already pledged as collateral on other debt.
Which of the following best describes this type of corporate debt?
A) a note
B) a debenture
C) an asset-backed bond
D) unsecured debt
E) a mortgage bond
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
17) Athelstone Realty issues debt with a maturity of 20 years. In the case of bankruptcy, holders of this
debt may claim the property held by Athelstone Realty. Which of the following best describes this type
of corporate debt?
A) a note
B) a debenture
C) a mortgage bond
D) an asset-backed bond
E) unsecured debt
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
18) Clearview Corporation, a company that deals mainly with the financing and distribution of music,
issues debt with a maturity of 15 years. In the case of bankruptcy, holders of this debt will have claim to
the intellectual property of Clearview. Which of the following best describes this type of corporate debt?
A) a note
B) a debenture
C) a mortgage bond
D) an asset-backed bond
E) unsecured debt
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
19) What is a bond's seniority?
A) the bondholder's priority in claiming assets in the event of default
B) clauses restricting a company from issuing new debt
C) the yield to maturity of a bond as compared to bonds of comparable rating
D) the issue price of the bond as compared to its face value
E) the time to maturity of a bond
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
20) Different classes of securities that make up a single bond issuance are called
A) subordinated debentures.
B) unsecured debt.
C) sen ior debt.
D) secured debt.
E) tranches.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
21) BC Brewery issues $50 million in straight bonds at an original issue discount of 1% and a coupon
rate of 7.5%. The firm also pays underwriting fees of 3.5% on the face value of the bonds. What are the
net proceeds to BC Brewery from the bond issue?
A) $49.5 million
B) $50 million
C) $47.75 million
D) $48.25 million
E) $44 million
Answer: C
Explanation: C) Amount received after discount = 50 × (1 - 0.01) = $49.5 million.
Amount paid in fees = 50 × 0.035 = $1.75 million.
Net proceeds = $47.75 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.1 Identify different types of debt financing available to a firm
22) BC Brewery issues $30 million in straight bonds at an original issue discount of 2% and a coupon
rate of 6%. The firm also pays underwriting fees of 2.5% on the face value of the bonds. What are the net
proceeds to BC Brewery from the bond issue?
A) $27.45 million
B) $26.85 million
C) $29.25 million
D) $30 million
E) $28.65 million
Answer: E
Explanation: E) Amount received after discount = 30 × (1 - 0.02) = $29.4 million.
Amount paid in fees = 30 × 0.025 = $0.75 million.
Net proceeds = $28.65 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.1 Identify different types of debt financing available to a firm
23) BC Brewery issues $120 million in straight bonds at an original issue discount of 1.5% and a coupon
rate of 5%. The firm also pays underwriting fees of 3% on the face value of the bonds. What are the net
proceeds to BC Brewery from the bond issue?
A) $114.6 million
B) $118.2 million
C) $116.4 million
D) $108.6 million
E) $110.4 million
Answer: A
Explanation: A) Amount received after discount = 120 × (1 - 0.015) = $118.2 million.
Amount paid in fees = 120 × 0.03 = $3.6 million.
Net proceeds = $114.6 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.1 Identify different types of debt financing available to a firm
24) Alberta Energy issues $150 million in straight bonds at par with a coupon rate of 6%. The firm also
pays underwriting fees of 2% on the face value of the bonds. What are the net proceeds to Alberta
Energy from the bond issue?
A) $141 million
B) $147 million
C) $150 million
D) $138 million
E) $144 million
Answer: B
Explanation: B) 150 × (1 - 0.02) = $147 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.1 Identify different types of debt financing available to a firm
25) Alberta Energy issues $110 million in straight bonds at par with a coupon rate of 8%. The firm also
pays underwriting fees of 1.5% on the face value of the bonds. What are the net proceeds to Alberta
Energy from the bond issue?
A) $99.55 million
B) $110 million
C) $108.35 million
D) $101.2 million
E) $99.68 million
Answer: C
Explanation: C) 110 × (1 - 0.015) = $108.35 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.1 Identify different types of debt financing available to a firm
26) Alberta Energy issues $85 million in straight bonds at par with a coupon rate of 6.5%. The firm also
pays underwriting fees of 3.5% on the face value of the bonds. What are the net proceeds to Alberta
Energy from the bond issue?
A) $80 million
B) $79.5 million
C) $76.5 million
D) $85 million
E) $82 million
Answer: E
Explanation: E) 85 × (1 - 0.035) = $82 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.1 Identify different types of debt financing available to a firm
27) Which of the following best describes a bond that is issued by a local entity and traded in a local
market, but that may be purchased by foreigners?
A) a domestic bond
B) a foreign bond
C) a Eurobond
D) a global bond
E) a corporate bond
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
28) Which of the following best describes an international bond that is not denominated in the local
currency of the country in which it is issued?
A) a domestic bond
B) a foreign bond
C) a Eurobond
D) a global bond
E) a corporate bond
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
29) Kruller A.G. issues a bond that is offered for sale simultaneously in Europe, the United States, and
Japan. Which of the following best describes this bond?
A) a domestic bond
B) a foreign bond
C) a Eurobond
D) a global bond
E) a corporate bond
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
30) Tompkinson's PLC, a British company, issues a bond in Canadian dollars in Canada, intended for
Canadian investors. Which of the following best describes this bond?
A) a foreign bond
B) a Eurobond
C) a global bond
D) a Yankee bond
E) a Maple bond
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
31) What kind of corporate debt must be secured by real property?
A) mortgage bonds
B) notes
C) asset-backed bonds
D) debentures
E) unsecured debt
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
32) What kind of corporate debt can be secured by any specified assets?
A) mortgage bonds
B) notes
C) asset-backed bonds
D) debentures
E) revolving line of credit
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
33) What kind of corporate debt has a maturity of less than ten years?
A) asset-backed bonds
B) debentures
C) notes
D) mortgage bonds
E) unsecured debt
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
34) What kind of unsecured corporate debt has a maturity of greater than ten years?
A) mortgage bonds
B) asset-back bonds
C) term loans
D) notes
E) debentures
Answer: E
Diff: 1 Type: MC
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
35) Bonds issued by a foreign company in a local market, intended for local investors, and denominated
in the local currency are known as
A) domestic bonds.
B) Yankee bonds.
C) Eurobonds.
D) foreign bonds.
E) global bonds.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
36) Which of the following statements regarding bonds is most accurate?
A) Foreign bonds are bonds issued by a local entity and traded in a local market, but purchased by
foreigners.
B) Domestic bonds are bonds issued by a foreign company in a local market and are intended for local
investors.
C) Debentures are a type of secured corporate debt in which specific assets are pledged as collateral.
D) Eurobonds are international bonds that are denominated in the local European currency of the
country in which they are issued.
E) Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in
several different markets simultaneously.
Answer: E
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
37) Which of the following statements is most accurate?
A) In the event of default, the assets not pledged as collateral for outstanding bonds can be used to pay
off the holders of subordinated debentures before more senior debt has been paid off.
B) Even though more than one debenture might be outstanding, the bondholders all have the same
priority in claiming assets in the event of default.
C) When a firm conducts a subsequent debenture issue that has lower priority than its outstanding
debt, the new debt is known as a subordinated debenture.
D) Most debenture issues contain clauses restricting the company from issuing new debt with equal or
lower priority than existing debt.
E) Debentures are a type of secured corporate debt with maturities greater than 10 years.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.1 Identify different types of debt financing available to a firm
38) What is the difference between secured and unsecured debt?
Answer: With unsecured debt, in the event of a bankruptcy bondholders have a claim to only the assets
of the firm that are not already pledged as collateral on other debt. With secured debt, specific assets are
pledged as collateral that bondholders have a direct claim to in the event of a bankruptcy.
Diff: 1 Type: SA
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
39) Explain the difference between notes and debentures.
Answer: Notes are a type of unsecured debt, typically with maturities of less than 10 years, while
debentures are a type of unsecured debt with maturities of 10 years or longer.
Diff: 1 Type: SA
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
40) What is bond seniority?
Answer: Seniority is a bondholder's priority, in the event of a default, in claiming assets not already
securing other debt.
Diff: 1 Type: SA
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
41) What is the difference between Eurobonds and Foreign bonds?
Answer: Foreign bonds are issued by a foreign company in a local market and intended for local
investors. They are denominated in the local currency. Eurobonds international bonds that are not
denominated in the local currency of the country in which they are issued.
Diff: 1 Type: SA
Skill: Definition
Objective: 15.1 Identify different types of debt financing available to a firm
15.2 Bond Covenants
1) Covenants in a bond contract restrict the actions that management of a firm can take that would
benefit the debt holders of the firm at the expense of the equity holders of that firm.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
2) Bond covenants tend to increase a bond issuer's borrowing costs.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
3) If a bond covenant is not met, then the bond goes into technical default and the bondholder can
demand immediate repayment or force the company to renegotiate the terms of the bond.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
4) Why do the issuers of bonds seek to increase the strength and number of covenants in a bond
agreement?
A) Covenants favour the equity holders that managers work for.
B) Covenants can increase the flexibility of the company issuing the bond.
C) Covenants lower the interest rate investors will require to buy the bond.
D) Covenants force the company to renegotiate the terms of the bond if they are broken.
E) Covenants increase a firm's default risk.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
5) Which of the following will have the greatest need of strong bond covenants if it is to receive a high
bond rating?
A) a debenture
B) a mortgage bond
C) an asset-backed bond
D) a foreign bond
E) a Eurobond
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
6) A covenant that restricts a company from making loans or otherwise providing credit is best viewed
as a restriction on which of the following?
A) issuing new debt
B) dividends and share repurchases
C) mergers and acquisitions
D) asset disposition
E) investment opportunities
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
7) Which of the following is a typical bond covenant restriction on the issuance of new debt?
A) New debt must have a lower coupon payment than existing debt.
B) No new debt can be issued until existing debt has been paid.
C) New debt cannot mature before existing debt.
D) New debt must be offered at a discount.
E) New debt must be subordinate to existing debt.
Answer: E
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
8) Which of the following is a typical bond covenant restriction on dividends and share repurchases?
A) Payouts can be made only once existing debt has been paid.
B) Payouts can be made only if earnings exceed some threshold.
C) Payouts cannot exceed interest payments to existing bondholders.
D) Shares can only be repurchased by issuing new debt.
E) Payouts cannot be made until existing debt is within one year of maturity.
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
9) Which of the following is a typical bond covenant restriction on mergers and acquisitions?
A) Funding for acquisitions cannot include new debt.
B) Acquisitions can be made only once existing debt has been paid.
C) Mergers are allowed only if the combined firm's earnings exceed some threshold.
D) Mergers are allowed only if the combined firm has a minimum ratio of net tangible assets to debt.
E) Mergers are allowed only if the combined firm has a lower cost of issuing new debt.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
10) Which of the following statements regarding bond covenants is most accurate?
A) If the issuer fails to live up to any covenant, the issuer goes into bankruptcy.
B) The stronger the covenants in the bond contract, the less likely the issuer will default on the bond,
and so the higher the interest rate investors will require to buy the bond.
C) Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may
undercut its ability to repay the bonds.
D) Bond agreements seldom contain covenants that restrict the ability of management to pay dividends.
E) Equity holders try to include as few covenants as possible in a bond agreement.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
11) Why are bond covenants necessary?
Answer: Since managers work for the equity holders, and sometimes there are actions managers can
take that benefit the equity holders at the expense of debt holders. Covenants are there to protect debt
holders from these actions.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
12) How might equity holders benefit from bond covenants?
Answer: The stronger the covenants in the bond contract, the less likely the firm will be to default on
the bond, and thus the lower the interest rate will be that investors will require to buy the bond. Thus,
equity holders can benefit as the firm will reduce its cost of borrowing.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 15.2 Understand limits within bond contracts that protect the interests of bondholders
15.3 Repayment Provisions
1) The sole way that a firm can repay its bonds is by making the coupon and principal payments as
specified in the bond contract.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
2) A firm raising capital by issuing callable bonds instead of non-callable bonds will either have to pay a
higher coupon rate or accept lower proceeds.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
3) If a company issues both a straight bond and a convertible bond simultaneously, at par, then the
straight bond will have a higher interest rate.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
4) What is a call provision?
A) the periodic repurchasing of issued bonds through a sinking fund by the issuer
B) an option to the issuer to repurchase the bonds at a predetermined price
C) the option for the bondholder to convert each bond owned into a fixed number of shares of common
stock
D) a clause in a bond contract that restricts the actions of the issuer that might harm the interests of the
bondholders
E) a formal contract that specifies the firm's obligations to the bondholder
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
5) When would it make sense for a firm to call a bond issue and refinance?
A) when the market price of the bond exceeds the call price, and market interest rates are greater than
the bond's coupon rate
B) when the market price of the bond exceeds the call price, and market interest rates are less than the
bond's coupon rate
C) when the market price of the bond is less than the call price, and market interest rates are greater
than the bond's coupon rate
D) when the market price of the bond is less than the call price, and market interest rates are less than
the bond's coupon rate
E) when the market price of the bond equals the call price, and market interest rates are equal to the
bond's coupon rate
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
6) In which of the following situations would the yield to worst for a certain bond be that bond's yield
to call?
I. The bond's coupon payments are high relative to market yields.
II. The bond price is at a discount.
III. The likelihood of the bond being called is high.
A) I only
B) II only
C) III only
D) I and II
E) I and III
Answer: E
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
7) A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $104 per $100 of face value. What is the yield to call of this bond when it is
released?
A) 0.60%
B) 1.50%
C) 1.92%
D) 5.47%
E) 6.00%
Answer: C
Explanation: C) Using a financial calculator, PV = -104, FV = 100, PMT = 6, N = 1;
computing interest = 1.92%
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
8) A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $104 per $100 of face value. What is the yield to maturity of this bond when it is
released?
A) 0.60%
B) 1.92%
C) 4.00%
D) 5.47%
E) 6.00%
Answer: D
Explanation: D) Using a financial calculator, PV = -104, FV = 100, PMT = 6, N = 10 ;
computing interest = 5.47%
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
9) A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $104 per $100 of face value. What is the yield to worst of this bond when it is
released?
A) 0.60%
B) 1.92%
C) 4.00%
D) 5.47%
E) 6.00%
Answer: B
Explanation: B) Using a financial calculator, PV = -104, FV = 100, PMT = 6, N = 1;
computing interest = 1.92%
Using financial calculator, PV = -104 FV = 100 PMT = 6 N =10
computing interest = 5.47%
1.92% is worse than 5.47%; hence, 1.92% is the yield to worst.
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
10) A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a yield to maturity of 4.8%, which is below the yield to call. What is the price of this bond
per $100 of face value when it is released?
A) $101.15
B) $109.36
C) $100.00
D) $104.80
E) $95.42
Answer: B
Explanation: B) Using a financial calculator, FV = 100, PMT = 6, N = 10;
Interest = 4.8%. Compute PV = -109.36
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
11) A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a yield to call of 4.8%. What is the price of this bond per $100 of face value when it is
released?
A) $101.15
B) $109.36
C) $100.00
D) $104.80
E) $95.42
Answer: A
Explanation: A) Using a financial calculator, FV = 100, PMT = 6, N = 1;
Interest = 4.8%. Compute PV =-101.15
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
12) A company issues a callable (at par) ten-year coupon bond with annual coupon payments. The bond
can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $102.50 per $100 of face value, and has a yield to call of 4.8%. What is the bond's
coupon rate?
A) 5.12%
B) 4.8%
C) 7.10%
D) 7.42%
E) 8.54%
Answer: D
Explanation: D) Using a financial calculator, FV = 100, PV = -102.50, N = 1;
Interest = 4.8%. Compute PMT = 7.42
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
13) A company issues a callable (at par) five-year, 7% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $110 per $100 of face value. What is the yield to call of this bond when it is
released?
A) 1.40%%
B) 2.73%
C) 4.71%
D) 5.66%
E) 7.00%
Answer: B
Explanation: B) Using a financial calculator, PV = -110, FV = 100, PMT = 7, N = 1;
computing interest = 2.73%
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
14) A company issues a callable (at par) five-year, 7% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $110 per $100 of face value. What is the yield to maturity of this bond when it is
released?
A) 1.40%%
B) 2.80%
C) 4.71%
D) 5.66%
E) 7.00%
Answer: C
Explanation: C) Using a financial calculator, PV = -110, FV = 100, PMT = 7, N = 5;
computing interest = 4.71%
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
15) A company issues a callable (at par) five-year, 7% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $110 per $100 of face value. What is the yield to worst of this bond when it is
released?
A) 1.40%
B) 2.73%
C) 3.00%
D) 4.71%
E) 5.66%
Answer: B
Explanation: B) Using a financial calculator, PV = -110, FV = 100, PMT = 7, N = 1;
computing interest = 2.73%
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
16) A company issues a callable (at par) ten-year, 7% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a yield to maturity of 3.1%, which is below the yield to call. What is the price of this bond
per $100 of face value when it is released?
A) $103.78
B) $100.00
C) $107.00
D) $96.36
E) $133.10
Answer: E
Explanation: E) Using a financial calculator, FV = 100, PMT = 7, N = 10;
Interest = 3.1%. Compute PV = -133.10
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
17) A company issues a callable (at par) ten-year, 7% coupon bond with annual coupon payments. The
bond can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a yield to call of 3.1%. What is the price of this bond per $100 of face value when it is
released?
A) $103.78
B) $100.00
C) $107.00
D) $96.36
E) $133.10
Answer: A
Explanation: A) Using a financial calculator, FV = 100, PMT = 7, N = 1;
Interest = 3.1%. Compute PV =-103.78
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
18) A company issues a callable (at par) ten-year coupon bond with annual coupon payments. The bond
can be called at par in one year after release or any time after that on a coupon payment date. On
release, it has a price of $107 per $100 of face value, and has a yield to call of 3.5%. What is the bond's
coupon rate?
A) 4.34%
B) 3.5%
C) 7.00%
D) 10.75%
E) 3.27%
Answer: D
Explanation: D) Using a financial calculator, FV = 100, PV = -107, N = 1;
Interest = 3.5%. Compute PMT = 10.75
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
19) A callable bond with the call price set equal to the present value of the bond's remaining payments
is a
A) convertible bond.
B) straight bond.
C) par call.
D) Yankee call.
E) Canada call.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
20) Which of the following statements concerning the use of sinking funds to repurchase a bond issue is
most correct?
A) The firm makes a single payment into a sinking fund administered by a trustee at the beginning of
the life of the bond.
B) The firm can reduce the amount of outstanding debt without affecting the cash flows of the
remaining bonds.
C) Payments into the sinking fund are held in reserve to protect the firm from default.
D) Bonds can be issued with a sinking fund provision or a call provision, but not both.
E) Sinking fund provisions require the issuer to repay the entire principal balance on the maturity date.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
21) A firm issues $200 million in ten-year bonds with an annual coupon rate of 6%. The firm uses a
sinking fund to repurchase 8% of the bond issue on each coupon payment date. What payment must
they make on the tenth and final coupon payment date?
A) $40 million
B) $52 million
C) $56 million
D) $62 million
E) $68 million
Answer: E
Explanation: E) Final coupon payment = 0.06 × 200 = $12 million;
balance principal payment = (1 - 9 × 0.08) × 200 = $56 million;
total payment = $56 million + $12 million = $68 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
22) A firm issues $200 million in ten-year bonds with an annual coupon rate of 6%. The firm uses a
sinking fund to repurchase 8% of the bonds on each coupon payment date. What payment must they
make on the first coupon payment date?
A) $6 million
B) $12 million
C) $16 million
D) $22 million
E) $28 million
Answer: E
Explanation: E) First coupon payment = 0.06 × 200 = $12 million
First principal payment = 0.08 × 200 = $16 million
total payment = $12 million + $16 million = $28 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
23) A firm issues $200 million in ten-year bonds with an annual coupon rate of 6%. The firm makes a
final payment of $68 million on the tenth and final coupon date. If the firm uses a sinking fund to
repurchase some of the bond issue on each coupon payment date, what percentage of the issue must
they repurchase each year?
A) 10%
B) 7.2%
C) 7.33%
D) 6%
E) 8%
Answer: E
Explanation: E) Final coupon payment = 0.06 × 200 = $12 million;
Principal payment = $68 million - $12 million = $56 million;
$200 million - $56 million = $144 million;
144/9 = $16 million;
16/200 = 0.08.
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
24) A firm issues $500 million in twenty-year bonds with an annual coupon rate of 5%. The firm uses a
sinking fund to repurchase 4% of the bond issue on each coupon payment date. What payment must
they make on the twentieth and final coupon payment date?
A) $25 million
B) $120 million
C) $145 million
D) $160 million
E) $200 million
Answer: C
Explanation: C) Final coupon payment = 0.05 × 500 = $25 million;
balance principal payment = (1 - 19 × 0.04) × 500 = $120 million;
total payment = $120 million + $25 million = $145 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
25) A firm issues $500 million in twenty-year bonds with an annual coupon rate of 5%. The firm uses a
sinking fund to repurchase 4% of the bond issue on each coupon payment date. What payment must
they make on the first coupon payment date?
A) $20 million
B) $25 million
C) $35 million
D) $45 million
E) $145 million
Answer: D
Explanation: D) First coupon payment = 0.05 × 500 = $25 million
First principal payment = 0.04 × 500 = $20 million
total payment = $20 million + $25 million = $45 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
26) A firm issues $500 million in twenty-year bonds with an annual coupon rate of 5%. The firm makes
a final payment of $145 million on the tenth and final coupon date. If the firm uses a sinking fund to
repurchase some of the bond issue on each coupon payment date, what percentage of the issue must
they repurchase each year?
A) 4%
B) 3.7%
C) 3.8%
D) 3.9%
E) 4.1%
Answer: A
Explanation: A) Final coupon payment = 0.05 × 500 = $25 million;
Principal payment = $145 million - $25 million = $120 million;
$500 million - $120 million = $380 million;
380/19 = $20 million;
20/500 = 0.04
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
27) In which of the following situations does the value of a convertible bond exceed the value of straight
debt or equity by the greatest amount?
A) when the price of the stock is high
B) when the price of the stock is close to the conversion price
C) when the price of the stock is low
D) when the price of the stock much lower than the conversion price
E) when the price of the stock is much higher than the conversion price
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
28) Which of the following statements about bonds that are both convertible and callable is most
correct?
A) If these bonds are called by the issuer, the holder has no option other than to let them be called.
B) Prior to maturity, the value of such a bond will be greater than the shares of stock that bond can be
converted into.
C) The decision to be made by the bondholder when the bonds are called is the same as she would have
to make at maturity.
D) The issuer cannot force bondholders to decide whether or not to convert at a time of the issuer's
choosing.
E) Prior to the maturity date, a convertible bond is worth less than an otherwise identical straight bond.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
29) A bond has a face value of $100 and a conversion ratio of 28. What is the conversion price?
A) $0.28
B) $2.80
C) $3.57
D) $7.14
E) $28.00
Answer: C
Explanation: C) 100 / 28 = $3.57
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
30) A bond has a face value of $10,000 and a conversion ratio of 560. The stock is currently trading at
$16.30. What is the conversion price?
A) $1.56
B) $6.13
C) $16.30
D) $17.86
E) $56.00
Answer: D
Explanation: D) 10,000 / 560 = $17.86
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
31) A bond has a face value of $10,000 and a conversion ratio of 265. The stock is currently trading at
$38.80. What is the conversion price?
A) $1.56
B) $5.84
C) $25.73
D) $26.50
E) $37.74
Answer: E
Explanation: E) 10,000 / 265 = $37.74
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
32) A bond has a face value of $10,000 and a conversion price of $17.86. The stock is currently trading at
$16.30. What is the conversion ratio?
A) 330
B) 487
C) 500
D) 560
E) 614
Answer: D
Explanation: D) 10,000 / 17.86 = 560
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
33) A bond has a face value of $10,000 and a conversion price of $37.74. The stock is currently trading at
$38.80. What is the conversion ratio?
A) 231
B) 246
C) 281
D) 258
E) 265
Answer: E
Explanation: E) 10,000 / 37.74 = 265
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
34) A bond with a face value of $1000 is convertible to common stock at a conversion ratio of 60. If the
stock is currently trading at $8.20 per share, the value of the bond is probably closest in value to which
of the following?
A) less than $492
B) about $492
C) about $508
D) about $1000
E) above $1666
Answer: D
Explanation: D) Conversion value is 60 × $8.20 = $492, so bond will likely sell closer to par. If the
conversion value of a bond is less than the face value of the bond, you would choose not to convert the
bond into stock, and instead receive the face value of $1000. Thus, the bond would trade close to its par
value of $1000.
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
35) Supreme Industries issues the following announcement to holders of an issue of callable, convertible
notes:
"Prior to the close of business on May 17, 2011, holders may convert their Notes into shares of Supreme
Industries common stock at 28.45 shares of Supreme Industries common stock per $1000 principal
amount of the Notes. Cash will be paid in lieu of fractional shares. On April 16, 20011, the last reported
sale price of Supreme Industries common stock on the NYSE was $22.51 per share."
If on May 17, Supreme Industries is trading as $24.80, what is the value of common stock a holder of a
$1,000 note would receive?
A) $787.51
B) $791.21
C) $694.40
D) $871.70
E) $1,000
Answer: C
Explanation: C) No fractional shares, so use conversion ratio of 28.28 × 24.80 = 694.40.
Diff: 2 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
36) Which of the following would be most likely to have the lowest price?
A) a straight senior bond
B) a convertible senior bond
C) a callable subordinated bond
D) a straight subordinated bond
E) a callable senior bond
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
37)
Coupon:
Conversion Ratio
Call Date:
Call Price:
Maturity:
0%
207 shares per $1000 principal amount
July 1, 2008
Par
July 1, 2015
A firm issues the convertible debt shown above. The price of stock in this company on July 1, 2008 is
$4.95. If the bonds are called on this date, which of the following is the action most likely to be taken by
a holder of bond of face value of $10,000?
A) Convert the bond and accept shares with a value of $10,000.
B) Convert the bond and accept shares with a value of $10,128.00.
C) Convert the bond and accept shares with a value of $10,239.13.
D) Convert the bond and accept shares with a value of $10,246.50.
E) Accept the call price and receive $10,000.
Answer: D
Explanation: D) 2070 × $4.95 = $10,246.50
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
38)
Coupon:
Conversion Ratio:
Call Date:
Maturity:
0%
158 shares per $1000 principal amount
July 1, 2008
July 1, 2015
A firm issues the convertible debt shown above. The price of stock in this company on July 1, 2008 is
$6.58. What is the minimum call price that would make a bondholder prefer to accept the call rather
than convert?
A) par
B) par plus 0.6%
C) par plus 4%
D) par plus 6%
E) par plus 8%
Answer: C
Explanation: C) 158 × $6.58 = $1039.64
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
39)
Coupon:
Conversion Ratio:
Call Date:
Maturity:
0%
78 shares per $1000 principal amount
July 1, 2008
July 1, 2015
A firm issues the convertible debt shown above. The price of stock in this company on July 1, 2008 is
$14.40. What is the minimum call price that would make a bondholder prefer to accept the call rather
than convert?
A) par plus 6.66%
B) par plus 7.50%
C) par plus 8.46%
D) par plus 12.32%
E) par plus 15.00%
Answer: D
Explanation: D) 78 × 14.40 = $1123.20
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
40)
Coupon:
Conversion Ratio:
Call Date:
Maturity:
0%
258 shares per $10,000 principal amount
July 1, 2008
July 1, 2015
A firm issues the convertible debt shown above. The price of stock in this company on July 1, 2008 is
$36.00. What is the minimum call price that would make a bondholder prefer to accept the call rather
than convert?
A) par
B) par plus 2.6%
C) par plus 3.0%
D) par plus 3.4%
E) par plus 4.1%
Answer: B
Explanation: B) 285 × 36 = $10,260.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
41)
Coupon:
Call Date:
Call Price:
Maturity:
0%
July 1, 2008
104.32%
July 1, 2015
A firm issues the convertible debt shown above. The price of stock in this company on July 1, 2008 is
$28.20. What is the minimum conversion ratio that would make a bondholder prefer to convert rather
than accept the call price?
A) 32 shares per $1000 principal amount
B) 35 shares per $1000 principal amount
C) 37 shares per $1000 principal amount
D) 41 shares per $1000 principal amount
E) 45 shares per $1000 principal amount
Answer: C
Explanation: C) 1043.2 / 28.2 = 36.99 or 37 shares per $1000 principal
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
42) Which of the following statements regarding a call provision is most accurate?
A) The issuer can repurchase a fraction of the outstanding bonds in the market or it can make a tender
offer for the entire issue.
B) A call provision allows the issuer to repurchase the bonds at the market price.
C) The call price is generally set at or below, and expressed as a percentage of, the bond's face value.
D) A call feature forces the issuer of the bond to retire all outstanding bonds on (or after) a specific date
for the call price if the call price exceeds the market price.
E) A call feature gives the bondholder the option to convert each bond owned into a fixed number of
shares of common stock.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
43) Which of the following statements is most accurate?
A) The holder of a callable bond faces reinvestment risk precisely when it hurts: when market rates are
lower than the coupon rate she is currently receiving.
B) When yields have risen, the issuer will choose to exercise the call on the callable bond.
C) The issuer will exercise the call option only when the prevailing market rate exceeds the coupon rate
of the bond.
D) A callable bond is relatively more attractive to the bondholder than the identical non-callable bond.
E) The issuer will exercise the call option only when the call price exceeds the prevailing market price of
the bond.
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
44) Which of the following statements is most accurate?
A) Before the call date, investors anticipate the optimal strategy that the issuer will follow, and the bond
price reflects this strategy.
B) The yield to maturity of a callable bond is calculated as if the bond were called at the earliest
opportunity.
C) A callable bond will trade at a higher price (and therefore a lower yield) than an otherwise
equivalent non-callable bond.
D) A firm raising capital by issuing callable bonds instead of non-callable bonds will be able to pay a
lower coupon rate.
E) When the bond's coupon rate is below the yield for similar securities, the bond is likely to be called.
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
45) A company issues a 10-year, callable bond at par with 8% annual coupon payments. The bond can
be called at par in one year after issue or any time after that on a coupon payment date. The call price is
$105 per $100 of face value. What is the yield to call if this bond is called in one year?
A) 5%
B) 8%
C) 10%
D) 11%
E) 13%
Answer: E
Explanation: E) PV = -1000, FV = 1050, PMT = 80, N = 1;
Compute I/Y = 13%
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
46) A company issues a 20-year, callable bond at par with a 6% annual coupon. The bond can be called
at par in three years or any time after that on a coupon payment date. The call price is $110 per $100 of
face value. What is the yield to call?
A) 4%
B) 6%
C) 8%
D) 9%
E) 12%
Answer: D
Explanation: D) PV = -1000, FV = 1100, PMT = 60, N = 3;
Compute I/Y = 9%
Diff: 1 Type: MC
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
47) When a callable bond sells at a premium, the likelihood of a call is ________ and the yield to worst is
the yield to ________.
A) high, call
B) low, call
C) low, maturity
D) high, maturity
E) high, par
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
48) When a callable bond sells at a discount, the bond's coupon rate is ________ than market yields and
the yield to worst is the yield to ________.
A) higher, call
B) higher, maturity
C) lower, call
D) lower, maturity
E) higher, par
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
49) Which of the following is a type of call provision?
A) sinking fund
B) balloon payment
C) conversion feature
D) indenture
E) bond covenant
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
50) A callable bond will typically have a(n) ________ yield than an otherwise identical bond without a
call feature because ________.
A) lower, the firm loses flexibility with a callable bond
B) higher, the firm loses flexibility with a callable bond
C) lower, the option to call a bond is valuable
D) higher, the option to call a bond is valuable
E) identical, the call feature is without value
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
51) The purchase by a group of private investors of all the equity of a public corporation, primarily
through debt financing, is known as a(n)
A) IPO.
B) SEO.
C) LBO.
D) debt buyout.
E) equity buyout.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
52) What are callable bonds?
Answer: A call feature allows the issuer of the bond the right but not the obligation to retire all
outstanding bonds on or after a specific date (call date) for a specific price (call price).
Diff: 1 Type: SA
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
53) When would a firm choose to call a callable bond?
Answer: When the market price of the bond exceeds the call price, the firm will call the bond.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
54) What is a Canada call?
Answer: A Canada call is a callable bond with the call price set equal to the present value of the bond's
remaining payments, calculated with a rate adjusted for prevailing interest rates in the economy.
Diff: 1 Type: SA
Skill: Analytical
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
55) Why do corporations choose to have a Canada call provision rather than leaving the bonds as noncallable?
Answer: Management may wish to retire a bond issue for reasons other than a drop in interest rates,
such as a desire to change the firm's capital structure or if a bond covenant becomes troublesome. It
may be less costly to call the bond rather than repurchase it on the open market through a tender offer.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
56) What is a sinking fund?
Answer: A sinking fund is a method for repaying a bond in which a company makes regular payments
into a fund administered by a trustee over the life of the bond. These payments are then used to
repurchase bonds.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 15.3 Describe the various options available to firms for the early repayment of debt
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 16 Capital Structure
16.1 Capital Structure Choices
1) Financial managers prefer to choose the same debt level no matter which industry they operate in.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.1 Examine how capital structures vary across industries and companies
2) Even if two firms operate in the same industry, they may prefer different choices of debt-equity
ratios.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.1 Examine how capital structures vary across industries and companies
3) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its
A) capital structure.
B) leverage.
C) retained earnings.
D) paid-out capital.
E) debt-to-value ratio.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 16.1 Examine how capital structures vary across industries and companies
4) A firm's ________ ratio is the fraction of the firm's total value that corresponds to debt.
A) debt-to-equity
B) asset
C) debt-to-value
D) liability
E) obligations
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 16.1 Examine how capital structures vary across industries and companies
5) How do capital structure choices differ across industries?
Answer: The average debt-to-value ratios vary across industries. For example, software companies
such as OpenText are far less levered (have less debt relative to their equity) than banks such as CIBC.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.1 Examine how capital structures vary across industries and companies
6) What is the capital structure of a firm?
Answer: The relative proportion of debt and equity used by a firm is called its capital structure.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.1 Examine how capital structures vary across industries and companies
7) What considerations should managers have while deciding on their capital structure?
Answer: Managers should first take a look at the industry norm for the firm. Subsequently, they should
consider if the securities issued receive fair price in the market, have tax consequences, entail
transaction costs, or require a change to future investment opportunities.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.1 Examine how capital structures vary across industries and companies
16.2 Capital Structure in Perfect Capital Markets
1) Equity in a firm with no debt is called unlevered equity.
Answer: TRUE
Diff: 1 Type: TF
Skill: Definition
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
2) With perfect capital markets, the total value of a firm should not depend on its capital structure.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
3) With perfect capital markets, because different choices of capital structure offer a benefit to investors,
they affect the value of the firm.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
4) Equity in a firm with debt is called
A) risk-free equity.
B) risky equity.
C) shareholders' equity.
D) unlevered equity.
E) levered equity.
Answer: E
Diff: 1 Type: MC
Skill: Definition
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
5) Equity in a firm with no debt is called
A) risk-free equity.
B) risky equity.
C) shareholders' equity.
D) unlevered equity.
E) levered equity.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
6) A financial manager makes a choice of the amount and source of capital based on how the choice will
impact
A) debt-equity ratio.
B) debt value.
C) earnings per share.
D) firm value.
E) profit.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
7) Investment cash flows are independent of financing choices in a
A) market with frictions.
B) perfect capital market.
C) setting with frictions in investment returns.
D) firm with leverage.
E) firm with no leverage.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
8) A new business will generate a one-time cash flow of $20,000 after one year. The business will be
financed with 50% equity and 50% debt. If the firm's unlevered equity cost of capital is 10%, what is the
levered value of the firm with perfect capital markets?
A) $18,182
B) $20,000
C) $19,000
D) $22,000
E) $18,000
Answer: A
Explanation: A) Since the levered value of the firm equals the unlevered value of the firm, compute the
present value of the cash flow using the unlevered equity cost of capital
$20,000 / 1.10 = $18,182
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
9) A new business will generate a one-time cash flow of $25,000 after one year. The business will be
financed with 20% equity and 80% debt. If the firm's unlevered equity cost of capital is 12%, what is the
levered value of the firm with perfect capital markets?
A) $19,882
B) $22,321
C) $22,000
D) $28,000
E) $23,000
Answer: B
Explanation: B) Since the levered value of the firm equals the unlevered value of the firm, compute the
present value of the cash flow using the unlevered equity cost of capital
$25,000 / 1.12 = $22,321
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
10) A new business will generate a one-time cash flow of $22,000 after one year. The business will be
financed with 60% equity and 40% debt. If the firm's unlevered equity cost of capital is 11%, what is the
levered value of the firm with perfect capital markets?
A) $18,182
B) $20,000
C) $19,820
D) $24,200
E) $19,580
Answer: C
Explanation: C) Since the levered value of the firm equals the unlevered value of the firm, compute the
present value of the cash flow using the unlevered equity cost of capital
$22,000 / 1.11 = $19,819.82
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
11) MM Proposition I states that in a perfect capital market the total value of a firm is equal to the
market value of the ________ generated by its assets.
A) earnings after taxes
B) earnings after interest
C) cash flows after taxes
D) free cash flows
E) earnings after interest and taxes
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
12) We discount the cash flows of a levered firm with a different discount rate than the cost of equity of
the unlevered firm because
A) leverage decreases the risk of equity of the firm.
B) leverage changes the unlevered cost of equity.
C) leverage increases the risk of equity of the firm.
D) cost of debt decreases in this setting.
E) default risk increases.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
13) By adding leverage, the returns of the firm are split between debt holders and equity holders, but
equity-holder risk increases because
A) interest payments can be rolled over.
B) dividends are paid first.
C) debt and equity have equal priority.
D) interest payments have first priority.
E) interest payments are so high.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
14) A new business requires a $20,000 investment today, and will generate a one-time cash flow of
$25,000 after one year. The business will be financed with 50% equity and 50% debt. If the firm can
borrow at 7%, what is the return on levered equity?
A) 43%
B) 25%
C) 18%
D) 39%
E) 7%
Answer: A
Explanation: A) The firm will owe debt holders the amount borrowed times (1 + 0.07) after one year.
Return on levered equity = (Total cash flow - amount returned to debt holders)/ (equity investment).
Cash left for equity holders = $25,000 - $10,000 × (1.07) = $14,300
Return on levered equity = 14,300 / 10,000 - 1 = 0.43, or 43%
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
15) A new business requires a $20,000 investment today, and will generate a one-time cash flow of
$25,000 after one year. The business will be financed with 20% equity and 80% debt. If the firm can
borrow at 4%, what is the return on levered equity?
A) 25%
B) 21%
C) 109%
D) 125%
E) 33%
Answer: C
Explanation: C) The firm will owe debt holders the amount borrowed times (1 + 0.04) after one year.
Return on levered equity = (Total cash flow - amount returned to debt holders)/ (equity investment).
Cash left for equity holders = $25,000 - $16,000 × (1.04) = $8,360
Return on levered equity = 8,360 / 4,000 - 1 = 1.09, or 109%
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
16) A new business requires a $20,000 investment today, and will generate a one-time cash flow of
$25,000 after one year. The business will be financed with 60% equity and 40% debt. If the firm can
borrow at 10%, what is the return on levered equity?
A) 25%
B) 35%
C) 15%
D) 42%
E) 17%
Answer: B
Explanation: B) The firm will owe debt holders the amount borrowed times (1 + 0.10) after one year.
Return on levered equity = (Total cash flow - amount returned to debt holders)/ (equity investment).
Cash left for equity holders = $25,000 - $8,000 × (1.10) = $16,200
Return on levered equity = 16,200 / 12,000 - 1 =0.35, or 35%
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
17) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm,
it is referred to as
A) outside debt.
B) retained earnings.
C) homemade leverage.
D) payout ratio.
E) portfolio rebalancing.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
18) A firm requires an investment of $20,000 , and will be financed with 50% equity and 50% debt. If the
firm's debt cost of capital is 6%, and its return on equity is 15%, what is the firm's pre-tax WACC?
A) 10.5%
B) 15%
C) 6%
D) 9%
E) 21%
Answer: A
Explanation: A) Use Eq. 16.2 for the WACC
15 × 0.5 + 6 × 0.5 = 10.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
19) A firm requires an investment of $20,000. The firm's debt cost of capital is 6%, and its return on
equity is 15%. If the firm's pre-tax WACC is 10.5%, how much did the firm borrow?
A) $8,000
B) $10,000
C) $12,000
D) $14,000
E) $20,000
Answer: B
Explanation: B) Use Eq. 16.2 for the WACC
15 × (1-D) + 6 × (D) = 10.5%.
Solve for D = 0.5. Total borrowed = 0.5x $20,000 = $10,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
20) A firm requires an investment of $20,000. The firm's debt cost of capital is 5%, and its return on
equity is 12%. If the firm's pre-tax WACC is 7.8%, how much equity did the firm use for its investment?
A) $8,000
B) $10,000
C) $12,000
D) $14,000
E) $20,000
Answer: A
Explanation: A) Use Eq. 16.2 for the WACC
12 × (E) + 5 × (1-E) = 7.8%.
Solve for E = 0.4. Total equity = 0.4x $20,000 = $8,000
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
21) A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15%,
what is the firm's pre tax WACC?
A) 14%
B) 13%
C) 12%
D) 11%
E) 10.5%
Answer: C
Explanation: C) Use Eq. 16.2 for the WACC
15 × (2/3) + 6 × (1/3) = 12%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
22) A firm requires an investment of $40,000 and borrows $10,000 at 8%. If the return on equity is 20%,
what is the firm's pre tax WACC?
A) 14%
B) 15%
C) 16%
D) 17%
E) 18%
Answer: D
Explanation: D) Use Eq. 16.2 for the WACC
20 × (3/4) + 8 × (1/4) = 17%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
23) A firm has a market value of assets of $50,000. It borrows $10,000 at 5%. If the unlevered cost of
equity is 15%, what is the firm's cost of equity capital?
A) 15%
B) 17.5%
C) 18.5%
D) 19.2%
E) 20.6%
Answer: B
Explanation: B) Use Eq. 16.3 in the text.
15 + (1/4) × (15 - 5) = 17.5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
24) A firm has a market value of assets of $50,000. It borrows $10,000 at 7%. If the unlevered cost of
equity is 15%, what is the firm's cost of equity capital?
A) 15%
B) 16%
C) 17%
D) 18%
E) 19%
Answer: C
Explanation: C) Use Eq. 16.3 in the text.
15 + (1/4) × (15 - 7) = 17.0%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
25) A firm has a market value of assets of $50,000. It borrows $10,000 at 3%. If the unlevered cost of
equity is 15%, what is the firm's cost of equity capital?
A) 15%
B) 16%
C) 17%
D) 18%
E) 19%
Answer: D
Explanation: D) Use Eq. 16.3 in the text.
15 + (1/4) × (15 - 3) = 18.0%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
26) A new business requires a $20,000 investment today, and will generate a one-time cash flow of
$25,000 after one year. The business will be financed with 50% equity and 50% debt. If the firm can
borrow at 7%, what is the pre-tax WACC?
A) 43%
B) 25%
C) 18%
D) 39%
E) 7%
Answer: B
Explanation: B) With no taxes, the firm's pre-tax WACC is the unlevered cost of capital:
25,000/20,000 - 1 = 25%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
27) Leverage can ________ a firm's expected earnings per share, but does not necessarily increase the
share price.
A) decrease
B) dilute
C) increase
D) not change
E) decrease the variation of
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
28) In general, issuing equity may not dilute the ownership of existing shareholders if
A) the value of new shares is equal to the value of debt.
B) the new shares are sold at a fair price.
C) the firm has no debt financing.
D) the firm uses debt conservatively.
E) the original owners do not sell their shares.
Answer: B
Diff: 3 Type: MC
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
29) Which of the following is one of the characteristics of perfect capital markets?
A) All investors hold the efficient portfolio of assets.
B) There are no taxes, but there may be transaction costs associated with security trading.
C) A firm's financing decisions may change the cash flows generated by its investments.
D) Investors and firms can trade the same set of securities at competitive market prices equal to the
present value (PV) of their future cash flows.
E) No market participants engage in illegal behaviour.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
30) Under perfect capital markets, which of the following statements is regarding capital structure is
most accurate?
A) As long as the firm's choice of securities does not change the cash flows generated by its assets, the
capital structure decision will not change the total value of the firm or the amount of capital it can raise.
B) If securities are fairly priced, then buying or selling securities has a positive net present value (NPV)
and will, therefore, change the value of a firm.
C) The future repayments that the firm must make on its debt are larger than the amount of the loan it
receives up front.
D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his
or her own portfolio.
E) The firm can increase debt levels to increase firm value.
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows.
Without is an all-equity firm, with 1 million shares outstanding that trade at a price of $24 per share.
With has 2 million shares outstanding and $12 million of debt at an interest rate of 5%.
31) According to MM Proposition I, the stock price for With is closest to:
A) $8.00
B) $24.00
C) $6.00
D) $12.00
E) $18.00
Answer: C
Explanation: C) Under MM I, the total value of With and Without must be the same.
Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 million - $12 million = $12 million
Price per share =
= $6.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
32) Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at
the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying
Without stock. Using homemade leverage, how much do you need to borrow in your margin account so
that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in
With stock?
A) $10,000
B) $5250
C) $5000
D) $2500
E) $0
Answer: C
Explanation: C) Under MM I, the total value of With and Without must be the same.
Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 million - $12 million = $12 million
So, the leverage ratio of With is 50% equity to 50% debt. To duplicate this in homemade leverage we
need to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin
loan. So, $5000 is our equity, and we need to match it with $5000 in a margin loan.
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
s a controlling interestrfect capital markets conditions are met and that you can borrow and lend at the
33) Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at
the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying
Without stock. Using homemade leverage you borrow enough in your margin account so that the
payoff of your margined purchase of Without stock will be the same as a $5000 investment in With
stock. The number of shares of Without stock you purchased is closest to:
A) 1650
B) 425
C) 2000
D) 825
E) 200
Answer: B
Explanation: B) Under MM I, the total value of With and Without must be the same.
Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 million - $12 million = $12 million
So, the leverage ratio of With is 50% equity to 50% debt. To duplicate this in homemade leverage we
need to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin
loan. So, $5000 is our equity and we need to match it with $5000 in a margin loan. So, the total invested
is $10,000 / $24 per share = 417 shares.
Diff: 3 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
34) Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at
the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying With
stock. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the
payoff of your account will be the same as a $5000 investment in Without stock?
A) $5000
B) $0
C) $2500
D) $4000
E) -$5000 (borrow $5000)
Answer: C
Explanation: C) Under MM I, the total value of With and Without must be the same.
Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 million - $12 million = $12 million
So, the leverage ratio of With is 50% equity to 50% debt. To duplicate this in homemade leverage we
need to have equal proportions in our portfolio, which means we need 50% equity and 50% in the riskfree asset. So, $5000 is our total portfolio and we need $2500 in equity (With stock) and $2500 in the riskfree asset.
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
35) Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at
the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying With
stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your
account will be the same as a $5000 investment in Without stock. The number of shares of With stock
you purchased is closest to:
A) 100
B) 425
C) 1650
D) 825
E) 1000
Answer: B
Explanation: B) Under MM I, the total value of With and Without must be the same.
Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 million - $12 million = $12 million
Price per share =
= $6.00
So, the leverage ratio of With is 50% equity to 50% debt. To duplicate this in homemade leverage we
need to have equal proportions in out portfolio, which means we need 50% equity and 50% in the riskfree asset. So $5000 is our total portfolio and we need $2500 in equity (With stock) and $2500 in the riskfree asset.
= 417 shares
Diff: 3 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to
use this cash to repurchase shares from its investors and has already announced the stock repurchase
plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are
currently trading at $20 per share.
36) The market value of Luther's non-cash assets is closest to:
A) $20 billion
B) $19 billion
C) $25 billion
D) $24 billion
E) $30 billion
Answer: A
Explanation: A) 1.25 billion × $20 per share = $25 billion - $5 billion cash = $20 billion
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
37) After the repurchase, how many shares will Luther have outstanding?
A) 0.75 billion
B) 1.0 billion
C) 1.1 billion
D) 1.2 billion
E) 1.25 billion
Answer: B
Explanation: B) $5 billion / $20 Share = 0.250 billion shares repurchased
Shares outstanding = 1.25 - 0.25 = 1.0 billion
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
38) With perfect capital markets, what is the market value of Luther's equity after the share repurchase?
A) $15 billion
B) $10 billion
C) $25 billion
D) $20 billion
E) $5 billion
Answer: D
Explanation: D) 1.25 billion × $20 per share = $25 billion - $5 billion cash = $20 billion
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
39) With perfect capital markets, what is the market price per share of Luther's stock after the share
repurchase?
A) $25
B) $24
C) $15
D) $20
E) $18
Answer: D
Explanation: D) 1.25 billion × $20 per share = $25 billion - $5 billion cash = $20 billion / 1 billion shares =
$20
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
40) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given
to employees valued at $2 billion. The market value of Luther's non-cash assets is closest to:
A) $22 billion
B) $20 billion
C) $25 billion
D) $18 billion
E) $27 billion
Answer: A
Explanation: A) 1.25 billion × $20 per share = $25 billion + $2 billion options - $5 billion cash = $22
billion
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
41) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given
to employees valued at $2 billion. After the repurchase, how many shares will Luther have outstanding?
A) 1.0 billion
B) 1.2 billion
C) 0.75 billion
D) 1.1 billion
E) 1.25 billion
Answer: A
Explanation: A) $5 billion / $20 Share = 0.250 billion shares repurchased
Shares outstanding = 1.25 - 0.25 = 1.0 billion
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
Use next year's Cash Flow Forecast for Blank Company to answer the following question(s):
Demand
Weak
Expected
Strong
Cash Flow
$25,000
$35,000
$45,000
42) Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of
8%. What is the value of the company?
A) $23,148.15
B) $32,407.40
C) $41,666.67
D) $43,356.43
E) $51,621.95
Answer: B
Explanation: B) Expected cash flow is $35,000. Discounted for one period, value = 35,000/1.08 =
$32,407.40.
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
43) Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of
8%. If the company uses no leverage, what is expected return to equity holders?
A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
E) 33.3%
Answer: A
Explanation: A) Unlevered cost of equity is given at 8%.
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
44) Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of
8%. If the company borrows $10,000 at 5% to make the investment, what is expected return to equity
holders?
A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
E) 33.3%
Answer: C
Explanation: C) Expected cash flow is $35,000. Equity costs $22,407.40 initially ($35,000/1.08 - $10,000).
The firm must repay $10,500 ($10,000 × 1.05) to debt holders, so cash flow to equity is $24,500 ($35,000 10,500). Expected return to equity is $24,500/22,407.40 - 1 = 9.33%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
45) Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of
8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders
if demand is weak?
A) 8.0%
B) -37.5%
C) -58.6%
D) -35.3%
E) -12.5%
Answer: D
Explanation: D) In the weak demand scenario, cash flow is $25,000. Equity costs $22,407.40 initially
($35,000/1.08 - $10,000).
The firm must repay $10,500 ($10,000 × 1.05) to debt holders, so cash flow to equity is $14,500 ($25,000 10,500). Expected return to equity is $14,500/22,407.40 - 1 =-35.3%.
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
46) Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of
8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders
if demand is strong?
A) 8.0%
B) 54.0%
C) 28.6%
D) 38.0%
E) 42.3%
Answer: B
Explanation: B) In the strong demand scenario, cash flow is $45,000. Equity costs $22,407.40 initially
($35,000/1.08 - $10,000).
The firm must repay $10,500 ($10,000 × 1.05) to debt holders, so cash flow to equity is $34,500 ($45,000 10,500). Expected return to equity is $34,500/22,407.40 - 1 = 54.0%
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
Consider the following equation for the question(s) below:
E + D = VU
47) The E in the equation above represents
A) the value of the firm's equity.
B) the value of the firm's debt.
C) the value of the firm's unlevered equity.
D) the market value of the firm's assets.
E) the total value of the firm.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
48) The VU in the equation above represents
A) the value of the firm's equity.
B) the market value of the firm's assets.
C) the value of the firm's unlevered equity.
D) the value of the firm's debt.
E) the total value of a levered firm.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.2 Understand why investment decisions, rather than financing decisions, fundamentally determine the
value and cost of capital of the firm
16.3 Debt and Taxes
1) In general, the gain to investors from the tax deductibility of interest payments is referred to as the
interest rate tax shield.
Answer: TRUE
Diff: 1 Type: TF
Skill: Definition
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
2) Suppose a project financed via an issue of debt requires five annual interest payments of $10 million
each year. If the tax rate is 30% and the cost of debt is 6%, what is the value of the interest rate tax
shield?
A) $11.35 million
B) $12.21 million
C) $13.20 million
D) $12.64 million
E) $15 million
Answer: D
Explanation: D) Value of tax shield each year equals tax rate times the interest payment.
Compute the present value of annuity of payments calculated above.
Tax shield = 0.3 × 10 = $3 million; so PMT = 3 and N - 5
PV annuity at 6% using a financial calculator = $12.64 million.
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
3) Suppose a project financed via an issue of debt requires six annual interest payments of $20 million
each year. If the tax rate is 30% and the cost of debt is 8%, what is the value of the interest rate tax
shield?
A) $31.35 million
B) $27.74 million
C) $23.20 million
D) $32.64 million
E) $36 million
Answer: B
Explanation: B) Value of tax shield each year equals tax rate times the interest payment.
Compute the present value of annuity of payments calculated above.
Tax shield = 0.3 × 20 = $6 million; so PMT = 6, N = 6
PV annuity at 8% using a financial calculator = $27.74 million.
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
4) Suppose a project financed via an issue of debt requires six annual interest payments of $20 million
each year. If the cost of debt is 8%, and the present value of the interest rate tax shield is $27.74 million,
what is the firm's tax rate?
A) 25%
B) 30%
C) 33%
D) 35%
E) 40%
Answer: B
Explanation: B) Value of tax shield each year equals tax rate times the interest payment.
Compute the present value of annuity of payments calculated above.
N = 6; interest rate = 8%; PV = -$27.74 million. Solve for PMT using a financial calculator = $6 million.
6/20 = 0.3 or 30%
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
5) Suppose a project financed via an issue of debt requires five annual interest payments of $20 million
each year. If the tax rate is 30%, and the present value of the interest tax shield is 25.98 million, what is
the firm's cost of debt?
A) 3%
B) 4%
C) 5%
D) 6%
E) 7%
Answer: C
Explanation: C) Value of tax shield each year equals tax rate times the interest payment.
Compute the present value of annuity of payments calculated above.
Annual Tax shield = 0.3 × 20 = $6 million; so PMT = 6, N = 5
PV = -25.98 million, solve for interest rate using a financial calculator = 5%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
6) Suppose a firm has $50 million of permanent debt. If the tax rate is 25% and the cost of debt is 7%,
what is the value of the interest tax shield each year?
A) $3.5 million
B) $50 million
C) $0.875 million
D) $178.6 million
E) $12.5 million
Answer: E
Explanation: E) Use Eq 16.7
PV = .25 × 50 = $12.5 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
7) Suppose a firm has $80 million of permanent debt. If the tax rate is 35% and the cost of debt is 8%,
what is the value of the interest tax shield each year?
A) $2.2 million
B) $6.4 million
C) $28 million
D) $80 million
E) $350 million
Answer: C
Explanation: C) Use Eq 16.7
PV = .35 × 80 = $28 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
8) A firm requires an investment of $30,000 and borrows $20,000 at 7%. If the return on equity is 15%
and the tax rate is 30%, what is the firm's WACC?
A) 8.27%
B) 9.13%
C) 10.4%
D) 8.91%
E) 9.67%
Answer: A
Explanation: A) Use Eq. 16.9 for the WACC
15 × (1/3) + 7 × (2/3) - 7 × 0.3 × (2/3) = 8.27%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
9) A firm requires an investment of $20,000 and borrows $10,000. If the return on equity is 20%, the tax
rate is 30%, and the WACC is 12.8%, what is the firm's cost of debt?
A) 5.6%
B) 8%
C) 18.7%
D) 13.2%
E) 14%
Answer: B
Explanation: B) Use Eq. 16.9 for the WACC
0.20 × (1/2) + rD × ( 1 - 0.3) × (1/2) = 0.128
Solve for rD = 0.08
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
10) A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the tax rate is 30%, and the
firm's WACC is 11.4%, what is the firm's cost of equity?
A) 15%
B) 14.1%
C) 5.4%
D) 17.4%
E) 15.6%
Answer: A
Explanation: A) Use Eq. 16.9 for the WACC
rE × (2/3) + 0.06 × (1 - 0.3)× (1/3) = 0.114
Solve for rE = 15%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
11) A firm requires an investment of $30,000 and borrows $15,000 at 6%. If the cost of equity is 18%, and
the firm's WACC is 10.8%, what is the firm's tax rate?
A) 40%
B) 35%
C) 30%
D) 45%
E) 50%
Answer: A
Explanation: A) Use Eq. 16.9 for the WACC
0.18 × (0.5) + 0.06 × (1 - TC)× (0.5) = 0.108
Solve for TC = 0.4
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
12) A firm requires an investment of $100,000, financed with $60,000 of equity and the remainder with
debt. If the return on equity is 12%, the cost of debt is 4% and the tax rate is 35%, what is the firm's
WACC?
A) 6.64%
B) 7.20%
C) 7.96%
D) 8.24%
E) 8.80%
Answer: D
Explanation: D) Use Eq. 16.9 for the WACC
12 × (3/5) + 4 × (2/5) - 4 × 0.35 × (2/5) = 8.24%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
13) A firm undertakes an investment that is financed with $10,000 of equity and $30,000 of debt. If the
return on equity is 14%, the cost of debt is 7% and the tax rate is 25%, what is the firm's WACC?
A) 6.76%
B) 9.92%
C) 7.00%
D) 8.75%
E) 7.44%
Answer: E
Explanation: E) Use Eq. 16.9 for the WACC
14 × (1/4) + 7 × (3/4) - 7 × 0.25 × (3/4) = 7.44%
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
14) Consider a firm whose capital structure includes both debt and equity. If the firm must pay taxes in
a given year, which of the following has the highest value?
A) The value of the unlevered firm.
B) The value of the levered firm.
C) The value of the firm's debt.
D) The value of the firm's equity.
E) The value of the interest tax shield.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
15) An unlevered firm currently has a value of $100 million. The firm has a tax rate of 30%. The firm
wishes to replace $50 million of its equity with $50 million of permanent debt. What is the value of the
levered firm if it goes ahead with this plan?
A) $115 million
B) $100 million
C) $50 million
D) $150 million
E) $85 million
Answer: A
Explanation: A) VL = VU + TCD
VL = $100m + 0.30 × $50m = $115 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
16) A firm is currently financed with 50% equity and 50% debt. The firm generates perpetual earnings
after taxes and interest rates of $10 million per year. The firm's cost of equity is 14%, its cost of debt is
7%, and it has a tax rate of 30%. What is the value of the levered firm?
A) $10 million
B) $73 million
C) $105.8 million
D) $173.5 million
E) $100 million
Answer: C
Explanation: C) WACC = 0.5 × 0.14 + 0.5x(1 - 0.3)x0.07 = 0.0945. Firm value is the PV of perpetuity of
earnings.
V = $10 million/0.0945 = $105.82 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
17) A firm is currently financed with 40% equity and 60% debt. The firm generates perpetual earnings
after taxes and interest payments of $2 million per year. The firm's cost of equity is 12%, its cost of debt
is 5%, and it has a tax rate of 40%. What is the value of the levered firm?
A) $2 million
B) $30.3 million
C) $25.6 million
D) $46.7 million
E) $10 million
Answer: B
Explanation: B) WACC = 0.4 × 0.12+ 0.6x(1 - 0.4) × 0.05 = 0.066. Firm value is the PV of perpetuity of
earnings.
V = $2 million/0.066 = $30.3 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
18) An unlevered firm currently has a value of $40 million. The firm has a tax rate of 40%. The firm
wishes to replace $10 million of its equity with $10 million of permanent debt. What is the value of the
levered firm if it goes ahead with this plan?
A) $42 million
B) $50 million
C) $40 million
D) $44 million
E) $45 million
Answer: D
Explanation: D) VL = VU + TCD
VL = $40m + 0.40 × $10m = $44 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
19) A firm is currently financed with 40% equity and 60% debt. The firm generates perpetual earnings
before interest and taxes of $2 million per year. The firm's cost of equity is 12%, its cost of debt is 5%,
and it has a tax rate of 40%. What is the value of the levered firm?
A) $2 million
B) $30.3 million
C) $25.6 million
D) $18.2 million
E) $17.6 million
Answer: E
Explanation: E) WACC = 0.4 × 0.12 + 0.6 × (1 - 0.4) × 0.05 = 0.066. Firm value is the PV of perpetuity of
free cash flow. Annual interest payment = 0.6 × 2,000,000 × 0.05 = $60,000. Earnings after interest = 2m 60,000 = $1.94 million. Earnings after interest and taxes = 1.94 × (1 - 0.4)= $1.164 million.
V = $1.164 million/0.066 = $17.6 million
Diff: 3 Type: MC
Skill: Analytical
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
20) What are some implications of market imperfections?
Answer: Market frictions such as corporate taxes affect the firm's value to its investors and hence play a
critical role in the firm's choice of capital structure.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
21) How does the interest paid by a firm affect its value to investors?
Answer: The interest paid by a firm is tax-deductible and is referred to as interest tax shield. This is the
additional amount that a firm would have paid in taxes if it did not have any debt in its capital
structure.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
22) What effect does debt have on a firm's weighted average cost of capital?
Answer: In a world with taxes, debt produces an interest tax shield that tends to reduce a firm's
weighted average cost of capital.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.3 Describe how leverage increases the risk of the firm's equity
16.4 The Costs of Bankruptcy and Financial Distress
1) A firm that does not have trouble meeting its debt obligations is said to be in financial distress.
Answer: FALSE
Diff: 1 Type: TF
Skill: Definition
Objective: 16.4 Demonstrate how debt can affect the firm's value through taxes and bankruptcy costs
2) The direct costs of bankruptcy are estimated to be far greater, as a percent of assets, than the indirect
costs of bankruptcy.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.4 Demonstrate how debt can affect the firm's value through taxes and bankruptcy costs
3) A bankruptcy process is complex, time-consuming, and costly. The costs of bankruptcy include
A) dividend payments.
B) raw material costs.
C) costs of hiring legal experts, appraisers, and auctioneers.
D) taxes.
E) interest payments.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.4 Demonstrate how debt can affect the firm's value through taxes and bankruptcy costs
4) Aside from direct costs of bankruptcy, a firm may also incur other indirect costs such as
A) loss of customers and loss of suppliers.
B) loss of interest receipts.
C) loss of dividend receipts.
D) increase in raw material costs.
E) increase in salvage costs.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.4 Demonstrate how debt can affect the firm's value through taxes and bankruptcy costs
5) What are direct costs of financial distress?
Answer: When a corporation becomes financially distressed, outside professionals, such as legal,
appraisers, auctioneers, and others with experience in distressed assets are generally hired. These are
direct costs of financial distress.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.4 Demonstrate how debt can affect the firm's value through taxes and bankruptcy costs
6) What are indirect costs of financial distress?
Answer: Indirect costs of financial distress are difficult to measure and are often larger than the direct
costs. These costs arise from defaulting on the commitments of a firm with its various constituents.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.4 Demonstrate how debt can affect the firm's value through taxes and bankruptcy costs
7) What are the issues in determining the present value (PV) of financial distress?
Answer: Calculating the precise present value (PV) of financial distress costs is very difficult, if not
impossible. However, there are two key qualitative factors that need to be considered: (1) the
probability of financial distress and (2) the magnitude of direct and indirect costs related to financial
distress.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 16.4 Demonstrate how debt can affect the firm's value through taxes and bankruptcy costs
16.5 Optimal Capital Structure: The Tradeoff Theory
1) The presence of financial distress costs can explain why firms choose debt levels that are too low to
exploit the interest tax shield.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
2) Differences in the magnitude of financial distress costs and volatility of cash flows across industries
do not impact the choice of leverage.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
3) The tradeoff theory of optimal capital structure weighs the benefits of debt against the costs of
A) financial distress.
B) interest payments.
C) dividend reinvestment.
D) input factors.
E) equity.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
4) The tradeoff theory suggests
A) the firm should choose a debt level where the tax savings from increasing leverage are just offset by
the increased probability of incurring the costs of financial distress.
B) with higher costs of financial distress, it is optimal for the firm to choose higher leverage.
C) differences in the magnitude of financial distress costs and the volatility of cash flows cannot explain
the differences in the use of leverage across industries.
D) there is no rational explanation for why firms choose debt levels that are too low to fully exploit the
debt tax shield.
E) the firm should choose a debt level where the cost of debt is equal to the cost of equity.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
5) One of the factors that determines the present value (PV) of financial distress costs is
A) costs of unpaid interest arrears.
B) loss of dividend payments.
C) probability of financial distress.
D) employee compensation.
E) size of the interest tax shield.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
6) Firms in industries such as real estate tend to have ________ distress costs because of a large
proportion of tangible assets.
A) high
B) low
C) unexpected
D) varying
E) constant
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
7) The probability of financial distress depends on the
A) likelihood that a firm will be unable to meet its debt commitments.
B) chance that a firm's raw material costs will increase.
C) likelihood of dividend payments.
D) likelihood of asset growth.
E) likelihood of issuing new debt.
Answer: A
Diff: 2 Type: MC
Skill: Definition
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
8) As the level of debt increases, the tax benefits of debt increase until
A) interest costs exceed dividend payments.
B) the tax shield benefit exceeds distress costs.
C) raw material costs exceed dividend payments.
D) employee costs exceed interest expense.
E) the firm decides to issue more equity.
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
9) An unlevered firm currently has a value of $100 million. The firm has a tax rate of 30%. The firm
wishes to replace $50 million of its equity with $50 million of permanent debt. By increasing its
leverage, the PV of the expected costs of financial distress would rise from 0 to $10 million. What is the
value of the levered firm if it goes ahead with this plan?
A) $105 million
B) $115 million
C) $100 million
D) $125 million
E) $110 million
Answer: A
Explanation: A) VL = VU + TCD - PV(financial distress costs)
VL = $100m + 0.30 × $50m - $10m = $105 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
10) An unlevered firm currently has a value of $15 million. The firm has a tax rate of 40%. The firm
wishes to replace $5 million of its equity with $5 million of permanent debt. By increasing its leverage,
the PV of the expected costs of financial distress would rise from 0 to $1 million. What is the value of the
levered firm if it goes ahead with this plan?
A) $10 million
B) $14 million
C) $15 million
D) $16 million
E) $20 million
Answer: D
Explanation: D) VL = VU + TCD - PV(financial distress costs)
VL = $15m + 0.40 × $5m - $1m = $16 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
11) What are the issues in determining the optimal leverage for a firm?
Answer: While interest tax shield tends to increase the value of the firm to its investors, the direct and
indirect cost of financial distress tend to increase with leverage. Thus, there is an optimal leverage
where the costs and benefits are optimized.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 16.5 Show how the optimal mix of debt and equity trades off the costs (including financial distress costs)
and benefits (including the tax advantage) of debt
16.6 Additional Consequences of Leverage: Agency Costs and Information
1) The presence of leverage can influence the behaviour of the managers of a firm.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
2) Equity-debt holder conflicts are more likely to arise if the risk of financial distress is high.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
3) Agency costs arise when
A) there are high labour costs.
B) input costs are higher than interest costs.
C) interest costs exceed dividend payments.
D) conflicts of interest exist between stakeholders.
E) a firm becomes financially distressed.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
4) Managerial entrenchment means that managers ________ and run the firm for their own best
interests.
A) may face little threat of being fired
B) are overseen by equity holders
C) are overseen by debt holders
D) are well compensated
E) wish to leave the firm
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
5) When a firm's investment decisions have different consequences for the value of equity and the value
of debt, managers may take actions
A) to increase debt values.
B) to decrease costs of distress.
C) that benefit shareholders at the expense of debt holders.
D) that benefit debt holders at the expense of shareholders.
E) to reduce fixed costs.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
6) The presence of a large amount of debt can encourage shareholders to take excessive risk because
A) equity holders are risk seeking by nature.
B) the costs of failure are borne largely by debt holders.
C) debt holders are risk seeking.
D) firm value increases with risk taking.
E) this will increase profits.
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
7) Issuing debt provides incentives for managers to run the firm efficiently because
A) debt increases the funds available to managers to run the firm.
B) ownership may remain more concentrated, improving monitoring of management.
C) managers may take actions that benefit shareholders but harm creditors and lower the value of the
firm.
D) shareholders prefer to decline new projects to save cash, even if their NPVs are positive.
E) managers will be obligated to run the firm in the interests of bondholders.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
8) The under-investment problem refers to the problem that equity holders prefer not to invest in
positive-NPV projects in highly levered firms because
A) future investments are contingent on debt financing.
B) projects are contingent on equity financing.
C) gains are evenly shared between all stakeholders.
D) most of the gains from the investment accrue to debt holders.
E) these investments will decrease share prices.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
9) The use of leverage as a way to signal ________ information to investors is known as the signalling
theory of debt.
A) good
B) bad
C) random
D) new
E) old
Answer: A
Diff: 2 Type: MC
Skill: Definition
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
10) Asymmetric information implies that ________ may have better information about a firm's cash
flows than other stakeholders.
A) debt holders
B) suppliers
C) managers
D) creditors
E) shareholders
Answer: C
Diff: 2 Type: MC
Skill: Definition
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
11) Market timing means that managers may sell ________ when they believe the stock is over-valued
and rely on ________ when the stock is under-valued.
A) debt, shares
B) debt, preferred stock
C) new shares, debt
D) debt, debt
E) shares, preferred stock
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
12) The pecking order hypothesis states that managers will have a preference to fund investment by
using ________, followed by ________, and will issue ________ as a last resort.
A) debt, equity, retained earnings
B) retained earnings, equity, debt
C) retained earnings, debt, equity
D) debt, retained earnings, equity
E) equity, retained earnings, debt
Answer: C
Diff: 2 Type: MC
Skill: Definition
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
13) When a firm commits to large future debt payments to convince the stock market it has great
projects, this is an example of
A) market timing.
B) adverse selection.
C) the pecking order hypothesis.
D) the agency cost of debt.
E) the signalling theory of debt.
Answer: E
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
14) When firms generate sufficient cash to fund their investments and choose not to issue debt or equity,
instead relying on retained earnings, this is an example of
A) market timing.
B) adverse selection.
C) the pecking order hypothesis.
D) the agency cost of debt.
E) the signalling theory of debt.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
16.7 Capital Structure: Putting It All Together
1) Managers should make use of the interest tax shield if the firm has
A) consistent taxable income.
B) volatility in taxable income.
C) consistent dividend payments.
D) low tax rates.
E) many tangible assets.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
2) Managers should consider ________ for external financing when agency costs are significant.
A) long-term debt
B) retained earnings
C) internal equity
D) short-term debt
E) preferred stock
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
3) Managers should not change the capital structure unless it departs significantly from the optimal
level because such a change would
A) reduce dividends.
B) incur transactions costs.
C) increase fixed costs.
D) change incentives of stakeholders.
E) favour shareholders over debt holders.
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
4) The optimal capital structure depends on ________ such as taxes, distress costs, and agency costs.
A) capital market factors
B) market imperfections
C) firm-specific risks
D) systematic risks
E) government regulations
Answer: B
Diff: 1 Type: MC
Skill: Conceptual
Objective: 16.6 Analyze how debt can alter the incentives managers have for choosing different projects and can be
used as a signal to investors
Fundamentals of Corporate Finance, 2nd Cdn. Ed. (Berk et al.)
Chapter 17 Payout Policy
17.1 Distributions to Shareholders
1) The Record Date falls before the Ex-Dividend Date.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
2) The way a firm chooses between alternate uses of free cash flow is referred to as
A) retention ratio.
B) payout policy.
C) call policy.
D) debt policy.
E) investment policy.
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
3) The date on which the board of directors of a company authorizes the dividend is called the ________
date.
A) declaration
B) record
C) ex-dividend
D) distribution
E) payable
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
4) The firm will pay the dividend to all shareholders of record on a specific date, set by the board, called
the ________ date.
A) declaration
B) record
C) ex-dividend
D) distribution
E) payable
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
5) The date two business days prior to the date on which all shareholders of record receive a payment is
called the ________ date.
A) declaration
B) record
C) ex-dividend
D) distribution
E) payable
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
6) The date on which a firm pays out dividends is called the ________ date.
A) declaration
B) record
C) ex-dividend
D) distribution
E) dividend
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
7) A one-time payment to shareholders that is much larger than a regular dividend is often referred to
as a(n) ________ dividend.
A) taxable
B) divesting
C) special
D) ex-day
E) extra
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
8) Dividend payments that are the result of liquidation of assets are known as ________ and are taxed as
capital gains.
A) return of capital
B) rolling dividends
C) alternate payments
D) private earnings
E) special dividends
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
9) An alternate way to pay investors is when the firm uses cash to buy shares of its own outstanding
stock, also known as
A) dividend investment.
B) retained earnings.
C) initial public offering.
D) share repurchases.
E) seasoned equity offering.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
10) A firm may announce its intention to buy its own shares in the open market like any other investor,
also known as a(n)
A) open market purchase.
B) tender offer.
C) targeted repurchase.
D) greenmail.
E) Dutch auction.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
11) When a firm offers to buy its shares at a prespecified price during a short time period it is also
known as a(n)
A) open market purchase.
B) tender offer.
C) targeted repurchase.
D) greenmail.
E) Dutch auction.
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
12) When a firm purchases shares directly from a major shareholder it is also known as a(n)
A) open market purchase.
B) tender offer.
C) targeted repurchase.
D) greenmail.
E) Dutch auction.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
13) A firm may decide to eliminate the threat of a takeover by a major shareholder by purchasing shares
from him at a premium also known as a(n)
A) open market purchase.
B) tender offer.
C) targeted repurchase.
D) greenmail.
E) Dutch auction.
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
14) Another to method to repurchase shares is the ________, in which the firm lists different prices at
which it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing
to sell at each price.
A) tender offer
B) Dutch auction share repurchase
C) targeted repurchase
D) open market share repurchase
E) greenmail repurchase
Answer: B
Diff: 2 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
15) A(n) ________ may occur if a major shareholder desires to sell a large number of shares but the
market for the shares is not sufficiently liquid to sustain such a large sale without severely affecting the
price.
A) open market share repurchase
B) Dutch auction share repurchase
C) tender offer
D) targeted repurchase
E) closed offer
Answer: D
Diff: 2 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
16) A(n) ________ is the most common way that firms repurchase shares.
A) targeted repurchase
B) Dutch auction share repurchase
C) tender offer
D) open market share repurchase
E) greenmail repurchase
Answer: D
Diff: 2 Type: MC
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
17) What is a firm's payout policy?
Answer: The way a firm chooses between the alternative ways to pay cash out to shareholders.
Diff: 1 Type: SA
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
18) What is the sequence of the four important dates for a dividend payment, from initial authorization
to final payment?
Answer: The declaration date, the ex-dividend date, the record date, and the payable date.
Diff: 1 Type: SA
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
19) What is the difference between a regular dividend and a liquidating dividend?
Answer: A regular dividend comes from a firm's free cash flow, while a liquidating dividend uses cash
from the liquidation of assets of a business operation that is being terminated.
Diff: 1 Type: SA
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
20) What is the difference between an open market share repurchase and a targeted repurchase?
Answer: In an open market repurchase, a firm buys its own shares on the open market, just like any
other investor. In a targeted repurchase, a firm buys its own shares directly from a major shareholder.
Diff: 1 Type: SA
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
21) What is greenmail?
Answer: Greenmail is a targeted share repurchase in which a firm buys out a major shareholder
threatening to take over the firm and remove its management.
Diff: 1 Type: SA
Skill: Definition
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
22) What are the characteristics of special dividend?
Answer: Special dividends are occasional, one-time payments to shareholders. These are generally
larger than regular dividends.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
23) What are the different ways a firm can repurchase shares?
Answer: There are three possible ways a firm can repurchase shares. A firm can repurchase using open
market operations, make a tender offer, or make a targeted repurchase.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
17.2 Dividends Versus Share Repurchases in a Perfect Capital Market
1) With perfect capital markets, an open market repurchase increases the stock price as the number of
outstanding shares is decreased.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
2) With perfect capital markets, investors prefer share repurchases to receiving dividends.
Answer: FALSE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
3) The share price falls when a dividend is paid because the reduction in cash decreases the
A) liabilities of the firm.
B) current account of the firm.
C) market value of assets.
D) equity of the firm.
E) present value of future dividends.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
4) BC Brewery has a current share price of $37.50, and has announced a dividend payment of $1.25 per
share. Assuming perfect capital markets, what should the price of BC Brewery be once the stock begins
trading ex-dividend?
A) $37.50
B) $36.25
C) $38.75
D) $35
E) $38
Answer: B
Explanation: B) $37.50 - $1.25 = $36.25
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.1 Identify the different ways in which corporations can make distributions to shareholders
5) Suppose a firm does not pay a dividend but repurchases stock using $20 million of cash. The market
value of the firm decreases by
A) $20 million.
B) -$20 million.
C) 0.
D) $40 million.
E) -$40 million.
Answer: A
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
6) A firm has assets of $250 million, of which $25 million is cash. It has debt of $100 million. If the firm
were to repurchase $10 million of its stock, what would its new debt-to-equity ratio be?
A) 71.4%
B) 28.6%
C) 80%
D) 20%
E) 30%
Answer: A
Explanation: A) Before Repurchase, Assets = $250,Debt = $100, Equity = $150
After Repurchase, Assets = $240, Debt = $100, Equity = $140
Debt/Equity = $100/$140 = 71.4%
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
7) A firm has $300 million of assets that includes $50 million of cash and 10 million shares outstanding.
If the firm uses $30 million of its cash to repurchase shares, what is the new price per share?
A) $25
B) $27
C) $30
D) $32
E) $35
Answer: C
Explanation: C) Price per share before repurchase equals total assets divided by number of shares.
New shares = existing shares - (cash spent divided by price per share in A).
New price per share = (Total assets - cash spent) / (new number os shares outstanding in B).
Per share price (old) = $30;
new shares = 10 - 30 / 30 = 9 million;
new price per share = 270 / 9 = $30
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
8) A firm has $400 million of assets that includes $50 million of cash and 10 million shares outstanding.
If the firm uses $40 million of its cash to repurchase shares, what is the new price per share?
A) $38
B) $40
C) $42
D) $44
E) $48
Answer: B
Explanation: B) Price per share before repurchase equals total assets divided by number of shares.
New shares = existing shares - (cash spent divided by price per share in A).
New price per share = (Total assets - cash spent) / (new number os shares outstanding in B).
Per share price (old) = $40;
new shares = 10 - 40/ 40 = 9 million;
new price per share = 360 / 9 = $40
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
9) A firm has $200 million of assets that includes $50 million of cash and 8 million shares outstanding. If
the firm uses $20 million of its cash to repurchase shares, what is the new price per share?
A) $25
B) $27
C) $30
D) $32
E) $35
Answer: A
Explanation: A) Price per share before repurchase equals total assets divided by number of shares.
New shares = existing shares - (cash spent divided by price per share in A).
New price per share = (Total assets - cash spent) / (new number of shares outstanding in B).
Per share price (old) = 200/8 = 25;
new shares = 8 - 20 / 25 = 7.2 million;
new price per share = 180 / 7.2 = $25
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
10) When a firm repurchases shares, the supply of shares is ________, but at the same time, the firm's
assets ________.
A) reduced, decline
B) increased, decline
C) reduced, increase
D) increased, increase
E) reduced, are unchanged
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
11) Homemade dividend refers to the process by which an investor
A) can take on more debt.
B) chooses between equity and debt.
C) can sell shares to create a dividend policy to suit his preferences.
D) reinvests dividend payments.
E) automatically withdraws money from his investment account.
Answer: C
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
12) A firm has $300 million of assets that includes $50 million of cash and 10 million shares outstanding.
The firm uses $30 million of its cash to pay dividends. If an investor has 1000 shares, how many shares
must he sell to create a homemade dividend of $3900?
A) 33.3 shares
B) 40.2 shares
C) 50.5 shares
D) 60.3 shares
E) 65.6 shares
Answer: A
Explanation: A) Dividend payment = number of shares times dividend per share
Shares sold = (amount needed - dividend payment) / (new price per share)
Old share price = 300 / 10 = $30;
dividend payment = 30 / 10 = $3
new share price = $30 - $3 = $27
shares sold = (3900 - 3000) / 27 = 33.33 shares
Diff: 3 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
13) A firm has $400 million of assets that includes $50 million of cash and 10 million shares outstanding.
The firm uses $40 million of its cash to pay dividends. If an investor has 1000 shares, how many shares
must she sell to create a homemade dividend of $4900?
A) 25 shares
B) 30 shares
C) 35 shares
D) 40 shares
E) 45 shares
Answer: A
Explanation: A) Dividend payment = number of shares times dividend per share
Shares sold = (amount needed - dividend payment) / (new price per share)
Old share price = 400 / 10 = $40;
dividend payment = 40 / 10 = $4
new share price = $40 - $4 = $36
shares sold = (4900 - 4000) / 36 = 25 shares
Diff: 3 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
14) A firm has $500 million of assets that includes $50 million of cash and 10 million shares outstanding.
The firm uses $50 million of its cash to pay dividends. If an investor has 1000 shares, how many shares
must he sell to create a homemade dividend of $6575?
A) 25 shares
B) 30 shares
C) 35 shares
D) 40 shares
E) 45 shares
Answer: C
Explanation: C) Dividend payment = number of shares times dividend per share
Shares sold = (amount needed - dividend payment) / (new price per share)
Old share price = 500 / 10 = $50;
dividend payment = 50 / 10 = $5
new share price = $50 - $5 = $45
shares sold = (6575 - 5000) / 45 = 35 shares
Diff: 3 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
15) Modigliani and Miller Dividend Irrelevance states that in perfect capital markets, holding ________
policy fixed, the firm's choice of dividend policy is irrelevant and does not affect the initial share price.
A) debt
B) investment
C) interest rate
D) equity issuance
E) payout
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
Use the information for the question(s) below.
Omicron Technologies has $50 million in excess cash and no debt. The firm expects to generate
additional free cash flows of $40 million per year in subsequent years and will pay out these future free
cash flows as regular dividends. Omicron's unlevered cost of capital is 10% and there are 10 million
shares outstanding. Omicron's board is meeting to decide whether to pay out its $50 million in excess
cash as a special dividend or to use it to repurchase shares of the firm's stock.
16) Omicron's enterprise value is closest to:
A) $500 million
B) $900 million
C) $450 million
D) $400 million
E) $300 million
Answer: D
Explanation: D) Enterprise value = PV(Future FCF) =
= $400 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
17) Including its cash, Omicron's total market value is closest to:
A) $500 million
B) $900 million
C) $400 million
D) $450 million
E) $300 million
Answer: D
Explanation: D) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
18) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. The
amount of the special dividend is closest to:
A) $5.00
B) $9.00
C) $4.00
D) $4.50
E) $3.00
Answer: A
Explanation: A) Dividend =
= $5 per share
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
19) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. The
amount of the regular yearly dividends in the future is closest to:
A) $4.50
B) $5.00
C) $4.00
D) $9.00
E) $3.00
Answer: C
Explanation: C) Dividend =
= $4 per share
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
20) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. Omicron's
cum-dividend price is closest to:
A) $50.00
B) $40.00
C) $5.00
D) $45.00
E) $35.00
Answer: D
Explanation: D) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
Share price =
=
= $45.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
21) Assume that Omicron uses the entire $50 million in excess cash to pay a special dividend. Omicron's
ex-dividend price is closest to:
A) $40.00
B) $5.00
C) $50.00
D) $45.00
E) $35.00
Answer: A
Explanation: A) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
However, once the $50 million in cash is used to pay the dividend, the new market value becomes $450
- $50 = $400 million.
Share price =
=
= $40.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
22) Assume that Omicron uses the entire $50 million to repurchase shares. The number of shares that
Omicron will repurchase is closest to:
A) 1.0 million
B) 1.2 million
C) 1.1 million
D) 0.9 million
E) 1.5 million
Answer: C
Explanation: C) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
Share price =
Number of shares repurchased =
=
= $45.00
= 1,111,111 shares
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
onceptualme that Omicron uses the entire $50 million to repurchase shares. The number of shares that
23) Assume that Omicron uses the entire $50 million to repurchase shares. The number of shares that
Omicron will have outstanding following the repurchase is closest to:
A) 8.8 million
B) 1.2 million
C) 9.0 million
D) 8.9 million
E) 7.8 million
Answer: D
Explanation: D) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
Share price =
Number of shares repurchased =
=
= $45.00
= 1,111,111 shares
Shares outstanding = 10 million - 1,111,111 = 8,888,889 shares
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
24) Assume that Omicron uses the entire $50 million to repurchase shares. The amount of the regular
yearly dividends in the future is closest to:
A) $9.00
B) $5.00
C) $4.50
D) $4.00
E) $5.50
Answer: C
Explanation: C) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
Share price =
Number of shares repurchased =
=
= $45.00
= 1,111,111 shares
Shares outstanding = 10 million - 1,111,111 = 8,888,889 shares
Dividend =
= $4.50 per share
Diff: 3 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
25) Assume that you own 2500 shares of Omicron stock and that Omicron uses the entire $50 million to
repurchase shares. Suppose you are unhappy with Omicron's decision and would prefer that Omicron
used the excess cash to pay a special dividend. The number of shares that you would have to sell in
order to receive the same amount of cash as if Omicron paid the special dividend is closest to:
A) 275
B) 310
C) 125
D) 250
E) 175
Answer: A
Explanation: A) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
Share price =
=
= $45.00
Dividends that you wanted to receive = 2500 shares × $5 share = $12,500
Number of shares to sell =
= 277.78 shares
Diff: 3 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
@�@�@�@�@�@�@�@�@�@�@�@�@�@�@ shares of Omicron stock and that Omicron uses the entire $50
26) Assume that you own 2500 shares of Omicron stock and that Omicron uses the entire $50 million to
pay a special dividend. Suppose you are unhappy with Omicron's decision and would prefer that
Omicron used the excess cash to repurchase shares. The number of shares that you would have to buy
in order to undo the special cash dividend that Omicron paid is closest to:
A) 125
B) 275
C) 250
D) 310
E) 200
Answer: D
Explanation: D) Enterprise value - PV(Future FCF) =
= $400 million
Market value = Enterprise value + cash = $400 + $50 = $450 million
However, once the $50 million in cash is used to pay the dividend, the new market value becomes $450
- $50 = $400 million
Share price =
=
= $40.00
Dividends that you did not want to receive = 2500 shares × $5 share = $12,500
Number of shares to sell =
= 312.50 shares
Diff: 3 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
27) A firm has $75 million of assets that includes $12 million of cash and 25 million shares outstanding.
If the firm uses $12 million of cash to repurchase shares, what is the new price per share?
A) $1
B) $2
C) $3
D) $4
E) $5
Answer: C
Explanation: C) Price per share before repurchase = $75 million/$25 million = $3.00
Number of shares repurchased = $12 million/3 = 4 million shares repurchased
New shares outstanding = 25 million - 4 million = 21 million
New price per share = ($75 million - $12 million)/21 million = $3.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
is illegal in Canada and most other industrialized counrepurchases its shares?
28) What is the effect on the stock price when a firm repurchases its shares?
Answer: There is a common misconception that the share price rises when a firm repurchases its shares
due to a decrease in shares outstanding. However, the firm value also declines, as cash is used to buy
those shares. Consequently, both firm value and number of shares decline leaving share price
unchanged.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
29) What is the bird-in-the-hand fallacy in dividend theory under perfect capital markets?
Answer: According to Modigliani and Miller, under perfect capital markets shareholders can generate
an equivalent homemade dividend at any time by selling shares. Thus the dividend choice of the firm
should not matter.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 17.2 Understand why the way in which they distribute cash flow does not affect value, absent market
imperfections
17.3 The Tax Disadvantage of Dividends
1) Long-term investors can defer capital gains tax until they sell and, therefore, there is a tax advantage
for share repurchases over dividends.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
2) The optimal dividend policy when dividend tax rates exceed capital gains tax rates is to pay
dividends only.
Answer: FALSE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
3) Different investor groups have differing dividend policy preferences that create clientele effects in
which dividend policy of a firm is optimized for its investors.
Answer: TRUE
Diff: 2 Type: TF
Skill: Definition
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
4) Share repurchases have a tax advantage over dividends because
A) dividend payments are tax deductible.
B) share repurchases increase the value of debt.
C) capital gains can be deferred by long-term investors.
D) repurchases are associated with increased customer loyalty.
E) dividends are not taxed.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
5) Historical evidence shows that over the last few decades a larger proportion of firms have used
________ for payouts.
A) repurchases
B) dividends
C) stock reverse splits
D) stock splits
E) seasoned equity offerings
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
6) The fact that firms continue to issue dividends despite their tax disadvantage is often referred to as
the
A) issuance puzzle.
B) dividend puzzle.
C) payback puzzle.
D) policy puzzle.
E) capital structure puzzle.
Answer: B
Diff: 2 Type: MC
Skill: Definition
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
7) When a firm pays out a dividend, the share price ________, and when it conducts a share repurchase
at the market price, the share price ________.
A) increases, increases
B) is unchanged, decreases
C) decreases, decreases
D) decreases, is unchanged
E) decreases, increases
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
8) Corporations enjoy a tax advantage associated with dividends due to
A) personal tax exemptions.
B) the 100% exclusion allowance.
C) laddered tax rates.
D) concave tax structure.
E) tax carryforwards.
Answer: B
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
Use the information for the question(s) below.
The JRN Corporation will pay a constant dividend of $3 per share per year in perpetuity. Assume that
all investors pay a 20% tax on dividends and that there is no capital gains tax. The cost of capital for
investing in JRN stock is 12%.
9) The price of a share of JRN's stock is closest to:
A) $20.00
B) $24.00
C) $25.00
D) $18.00
E) $26.00
Answer: A
Explanation: A) Price =
=
= $20.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
10) Assume that management makes a surprise announcement that JRN will no longer pay dividends
but will use the cash to repurchase stock instead. The price of a share of JRN's stock is now closest to:
A) $20.00
B) $25.00
C) $18.00
D) $24.00
E) $16.00
Answer: B
Explanation: B) In a perfect capital market the dividend / repurchase decision does not impact firm
value. Since the tax rate for repurchases is zero, the stock price would be the same as if the firm paid out
the dividend and the dividends were not taxed, so:
Price =
=
= $25.00
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
11) The WTC Corporation will pay a constant dividend of $3.20 per share, per year, in perpetuity. If all
11) The WTC Corporation will pay a constant dividend of $3.20 per share, per year, in perpetuity. If all
investors pay a 15% tax on dividends, there is no capital gains tax, and the cost of capital for investing
in WTC stock is 9%, what is the price for a share of WTC stock?
A) $30.22
B) $26.67
C) $18.77
D) $16.45
E) $15.76
Answer: A
Explanation: A) [$3.20(1 - 0.15)/0.09 = $30.22
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
12) The largest proportion of investors in common stock are
A) mutual funds.
B) pension funds.
C) corporations.
D) individual investors.
E) hedge funds.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
13) Why do firms still pay dividends, despite their tax disadvantage?
Answer: Investors have different tax rates and thus different preferences for dividends and capital
gains. If there is no tax advantage to capital gains, some investors may prefer the regular cash flow from
dividends.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
14) Explain the different effects on a firm's share price for a dividend payment versus a share
repurchase.
Answer: With a dividend payment, the share price drops by the amount of the dividend. In a share
repurchase, the share price is unaffected as long as shares are repurchased at a fair price.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 17.3 Indicate how taxes can create an advantage for share repurchases versus dividends
17.4 Payout Versus Retention of Cash
1) In perfect capital markets, buying and selling securities is a zero-NPV transaction, so retaining cash
versus paying it out does not affect firm value.
Answer: TRUE
Diff: 1 Type: TF
Skill: Conceptual
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
2) Because the dividend tax will be paid whether the firm pays cash immediately or retains cash and
pays the interest over time, the dividend tax rate does not affect the cost of retaining cash.
Answer: TRUE
Diff: 2 Type: TF
Skill: Conceptual
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
3) Palo Alto Enterprises has $200,000 in cash. They wish to invest the money in Treasury bills at 5% and
use the returns to pay dividends to shareholders after a year. Alternately they can pay a dividend and
allow shareholders to make the investment. In perfect capital markets, which option will shareholders
prefer?
A) immediate cash dividend
B) dividend after one year
C) prefer half from each source
D) indifferent between options
E) most paid now, the balance paid in one year
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
4) Apex Analytics is an all-equity firm with 50 million shares outstanding. Apex has $30 million in cash,
and expects future free cash flows of $8 million per year. The cash can be used to expand the firm's
future operations, increasing future free cash flows to $10 million per year. If Apex's cost of capital for
the expansion is 8%, what will be the difference in the firm's share price compared to using the cash for
a share repurchase?
A) Share price is $0.10 higher with expansion.
B) Share price is $0.10 higher with repurchase.
C) Share price is the same with both options.
D) Share price is $0.50 higher with expansion.
E) Share price is $0.50 higher with repurchase.
Answer: B
Explanation: B) Market value with expansion = $10 million/8% = $125 million, or 125/50 = $2.50 per
share.
With no expansion: $8 million/8% = $100 million
Market value = $100 million + $30 million cash = $130 million, or $2.60 per share before repurchase.
Share price is unchanged after repurchase, still $2.60, and the share price is $0.10 higher with the
repurchase than with the expansion.
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
5) Collingwood Costumes is an all-equity firm with 80 million shares outstanding. Collingwood has $75
million in cash, and expects future free cash flows of $15 million per year. The cash can be used to
expand the firm's future operations, increasing future free cash flows to $16 million per year. If
Collingwood's cost of capital for the expansion is 10%, what will be the difference in the firm's share
price compared to using the cash for a share repurchase?
A) Share price is $0.12 higher with expansion.
B) Share price is $0.12 higher with repurchase.
C) Share price is the same with both options.
D) Share price is $0.81 higher with expansion.
E) Share price is $0.81 higher with repurchase.
Answer: E
Explanation: E) Market value with expansion = $16 million/10% = $160 million, or 160/80 = $2.00 per
share.
With no expansion: $15 million/10% = $150 million
Market value = $150 + $75 = $225 million, or 225/80 = $2.81 per share, and the share price is $0.81 higher
with the repurchase than with the expansion.
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
6) Malibu Mannequins is an all-equity firm with 40 million shares outstanding. Malibu has $20 million
in cash, and expects future free cash flows of $5 million per year. The cash can be used to expand the
firm's future operations, increasing future free cash flows to $8 million per year. If Malibu's cost of
capital for the expansion is 5%, what will be the difference in the firm's share price compared to using
the cash for a share repurchase?
A) Share price is $1.00 higher with expansion.
B) Share price is $1.00 higher with repurchase.
C) Share price is the same with both options.
D) Share price is $1.50 higher with expansion.
E) Share price is $1.50 higher with repurchase.
Answer: A
Explanation: A) Market value with expansion = $8 million/5% = $160 million, or 160/40 = $4.00 per
share.
With no expansion: $5 million/5% = $100 million
Market value = $100 + $20 = $120 million, or 120/40 = $3 per share, and the share price is $1.00 higher
with the expansion than with the repurchase.
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
7) Fireball Furnaces is an all-equity firm with 50 million shares outstanding. Fireball has $10 million in
cash, and expects future free cash flows of $2 million per year. The cash can be used to expand the firm's
future operations, increasing future free cash flows to $3.5 million per year. If Fireball's cost of capital
for the expansion is 7%, what will be the difference in the firm's share price compared to using the cash
for a share repurchase?
A) Share price is $0.43 higher with expansion.
B) Share price is $0.43 higher with repurchase.
C) Share price is the same with both options.
D) Share price is $0.23 higher with expansion.
E) Share price is $0.23 higher with repurchase.
Answer: D
Explanation: D) Market value with expansion = $3.5 million/7% = $50 million, or 50/50 = $1.00 per share.
With no expansion: $2 million/7% = $28.57 million
Market value = $28.57 + $10 = $38.57 million, or 38.57/50 = $0.77 per share, and the share price is $0.23
higher with the expansion than with the repurchase.
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
8) When a firm retains cash, it pays corporate tax on the interest it earns and the investor will owe
capital gains tax on the increased firm value—in essence the interest on retained cash is taxed
A) once.
B) at a rate of zero.
C) twice.
D) only at the corporate level.
E) only at the investor level.
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
9) Firms may retain large amounts of cash to cover future potential needs that allows a firm to avoid
A) transaction costs and financial distress costs.
B) tax payments.
C) clientele effects.
D) agency costs.
E) share price reductions.
Answer: A
Diff: 1 Type: MC
Skill: Conceptual
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
10) When a firm has excessive cash, managers may make use of the funds in an inefficient manner. This
is also referred to as the ________ cost of retaining cash.
A) fixed
B) agency
C) interest
D) special
E) hidden
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
11) According to the ________ theory of payout policy, managers pay out cash only when pressured to
do so by investors.
A) agency
B) supply
C) price pressure
D) managerial entrenchment
E) pecking order
Answer: D
Diff: 1 Type: MC
Skill: Definition
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
Use the information for the question(s) below.
Luther Industries has $5 million in excess cash and 1 million shares outstanding. Luther is considering
investing the cash in one-year Treasury bills that are currently paying 5% interest and then using the
cash to pay a dividend next year. Alternatively, Luther can pay the cash out as a dividend immediately
and the shareholders can invest in the Treasury bills themselves. Assume that capital markets are
perfect.
12) If Luther invests the excess cash in Treasury bills, then the dividend per share next year will be
closest to:
A) $5.00
B) $5.25
C) $4.75
D) $1.05
E) $4.50
Answer: B
Explanation: B) $5 million × (1.05) = $5.25 million / 1 million shares = $5.25
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
13) If Luther decides to pay the dividend immediately the dividend per share will be closest to:
A) $1.05
B) $5.25
C) $5.00
D) $4.75
E) $4.50
Answer: C
Explanation: C) $5 million / 1 million shares = $5.00
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
Use the information for the question(s) below.
Consider the following tax rates:
Year
1997-2000
2001-2002
2003-
Corporate
Tax Rate
35%
35%
35%
Capital
Gains
Rate
20%
20%
15%
Ordinary
Income Rate
40%
39%
35%
Dividen
d Rate
40%
39%
15%
14) In 2006, Luther Incorporated paid a special dividend of $5 per share for the 1 million shares
outstanding. If Luther has instead retained that cash permanently and invested it into Treasury bills
earning 6%, then the present value (PV) of the additional taxes paid by Luther would be closest to:
A) $.35 million
B) $2.90 million
C) $1.75 million
D) $5.85 million
E) $3.25 million
Answer: C
Explanation: C) PV =
= $5 × 1 million shares × 0.35 = $1.75 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
Use the information for the question(s) below.
Iota Industries is an all-equity firm with 50 million shares outstanding. Iota has $200 million in cash and
expects future free cash flows of $75 million per year. Management plans to use the cash to expand the
firm's operations, which in turn will increase future free cash flows by 12%. Iota's cost of capital is 10%
and assume that capital markets are perfect.
15) The value of Iota, if they use the $200 million to expand, is closest to:
A) $825 million
B) $688 million
C) $840 million
D) $950 million
E) $630 million
Answer: C
Explanation: C) value =
= $840 million
Diff: 2 Type: MC
Skill: Analytical
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
16) If there is a tax disadvantage to retaining cash, why do some firms accumulate large cash balances?
Answer: Generally, firms retain cash balances to cover potential future cash shortfalls. This strategy
allows a firm to avoid the transaction costs of raising new capital.
Diff: 2 Type: SA
Skill: Conceptual
Objective: 17.4 Explain how increased payouts can reduce principal-agent problems but potentially reduce financial
flexibility
17.5 Signalling with Payout Policy
1) According to the dividend signalling hypothesis, firms smooth their dividends in order to maintain
consistent cash flows and thus increase investor confidence in the firm.
Answer: FALSE
Diff: 1 Type: TF
Skill: Definition
Objective: 17.5 Describe alternative non-cash methods for payouts
2) The practice of maintaining relatively constant dividends is called
A) dividend calibration.
B) dividend rollover.
C) dividend smoothing.
D) dividend rollbacks.
E) dividend consistency.
Answer: C
Diff: 1 Type: MC
Skill: Definition
Objective: 17.5 Describe alternative non-cash methods for payouts
3) The idea that dividend changes reflect managers' views about a firm's future earnings prospects is
called the ________ hypothesis.
A) signalling
B) predictor
C) instrumental
D) pecking order
E) dividend growth
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 17.5 Describe alternative non-cash methods for payouts
4) Empirical evidence about the behaviour of financial managers suggests that firms ________
repurchase activity and also ________ dividend payments.
A) smooth, smooth
B) smooth, do not smooth
C) do not smooth, do not smooth
D) do not smooth, smooth
E) sometimes smooth, do not smooth
Answer: D
Diff: 3 Type: MC
Skill: Conceptual
Objective: 17.5 Describe alternative non-cash methods for payouts
17.6 Stock Dividends, Splits, and Spin-offs
1) In a stock split or stock dividend, the company issues additional shares rather than cash to its
shareholders.
Answer: TRUE
Diff: 1 Type: TF
Skill: Definition
Objective: 17.5 Describe alternative non-cash methods for payouts
2) In a stock dividend, each shareholder who owns the stock before the ex-dividend date receives
A) additional shares of the firm.
B) additional shares and stock.
C) cash only.
D) shares for partial cash payment.
E) larger dividends.
Answer: A
Diff: 1 Type: MC
Skill: Definition
Objective: 17.5 Describe alternative non-cash methods for payouts
3) The typical reason for a stock split is to
A) allow for growth in the company assets.
B) allow liabilities to grow.
C) increase earnings per share.
D) keep the share price in a range.
E) increase the share price.
Answer: D
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.5 Describe alternative non-cash methods for payouts
4) A firm can distribute shares of a subsidiary in a transaction referred to as a
A) merger.
B) spin-off.
C) acquisition.
D) cash disbursement.
E) seasoned equity offering.
Answer: B
Diff: 1 Type: MC
Skill: Definition
Objective: 17.5 Describe alternative non-cash methods for payouts
5) CCR stock is currently trading at $63 per share. If CCR issues a 25% stock dividend, what would its
new share price be?
A) $50.40
B) $78.75
C) $15.75
D) $252.00
E) $63.00
Answer: A
Explanation: A) $63/1.25 = $50.40
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.5 Describe alternative non-cash methods for payouts
6) Which of the following is an advantage of a spin-off versus selling a subsidiary and distributing the
cash?
A) A spin-off increases the transaction costs associated with selling the subsidiary.
B) Shareholders must immediately pay capital gains taxes versus ordinary income taxes on the value of
the spin-off.
C) A spin-off guarantees a lower cost of capital.
D) The spin-off is not taxed as a cash distribution.
E) A spin-off results in a higher price for the subsidiary.
Answer: D
Diff: 1 Type: MC
Skill: Conceptual
Objective: 17.5 Describe alternative non-cash methods for payouts
7) A firm issues a 50% stock dividend. This transaction is equivalent to a:
A) 3:2 stock split.
B) 1:2 stock split
C) 2:1 stock split
D) 2:3 stock split
E) 1:1 stock split
Answer: A
Explanation: A) Each shareholder receives one new share for each two shares owned. A holder of two
shares will end up holding three shares, and thus the stock split is three for two, or 3:2.
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.5 Describe alternative non-cash methods for payouts
8) A firm issues a 75% stock dividend. This transaction is equivalent to a:
A) 3:2 stock split.
B) 4:3 stock split
C) 7:4 stock split
D) 3:4 stock split
E) 1:1 stock split
Answer: C
Explanation: C) Each shareholder receives three new shares for each four shares owned. A holder of
four shares will end up holding seven shares, and thus the stock split is seven for four, or 7:4.
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.5 Describe alternative non-cash methods for payouts
9) A firm issues a 100% stock dividend. This transaction is equivalent to a:
A) 3:2 stock split.
B) 1:2 stock split
C) 100:1 stock split
D) 1:1 stock split
E) 2:1 stock split
Answer: E
Explanation: E) Each shareholder receives one new share for each share owned. A holder of one share
will end up holding two shares. Thus the stock split is two for one, or 2:1
Diff: 1 Type: MC
Skill: Analytical
Objective: 17.5 Describe alternative non-cash methods for payouts
10) Why do firms issue stock dividends or split their stock?
Answer: If the firm's share price rises significantly, it might be difficult for investors to afford shares. A
stock split can keep the firm in a more affordable price range that will be attractive to small investors.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 17.5 Describe alternative non-cash methods for payouts
11) Why might a firm choose a spinoff instead of selling a division and distributing the cash?
Answer: A spinoff avoids the transaction costs associated with selling a division, and shareholders will
not be taxed for a cash distribution, instead paying capital gains tax if they sell the spinoff shares.
Diff: 1 Type: SA
Skill: Conceptual
Objective: 17.5 Describe alternative non-cash methods for payouts
17.7 Advice for the Financial Manager
1) Repurchases and special dividends are useful for making ________ and ________ distributions to
shareholders.
A) small, frequent
B) small, infrequent
C) large, infrequent
D) large, frequent
E) medium, frequent
Answer: C
Diff: 1 Type: MC
Skill: Conceptual
Objective: 17.5 Describe alternative non-cash methods for payouts
2) Because ________ are seen as an implicit commitment, they send a ________ signal of financial
strength to shareholders.
A) dividends, strong
B) dividends, weak
C) repurchases, strong
D) repurchases, weak
E) spin-offs, strong
Answer: A
Diff: 2 Type: MC
Skill: Conceptual
Objective: 17.5 Describe alternative non-cash methods for payouts
3) Future investment plans are important determinants of payout policy because of
A) signalling to investors.
B) costs of raising new capital.
C) stock price depreciation.
D) debt holder res