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Make-up Review - Spring 2008

savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/make-up_review_-_spring_2008.htm

1.

A brokerage firm that offers to buy and sell a stock at specified bid and ask prices is "making a market."

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2.

Only large commercial banks are subject to the regulation of the Federal Reserve.

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3.

Since the reserves of commercial banks earn interest, there is an incentive to hold excess reserves.

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4.

The present value of an annuity is worth more if interest rates are 5% instead of 10%.

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5.

There is no risk in a world of certainty.

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6.

The expected return on an investment includes both the expected of income plus expected price
appreciation.

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7.

The larger an investment's standard deviation, the smaller is the element of risk.

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8.

Issuing new stock or borrowing from a bank is a cash inflow.

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9.

Depreciation expense produces a cash outflow of funds, because it reduces the firm's earnings.

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10.

Pre-emptive rights mean that current stockholders have the right to maintain their proportionate ownership
before new shares may be sold to the general public.

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11.

Federal income taxes favor the retention of earnings over the distribution of earnings.

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12.

A stock dividend decreases retained earnings.

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13.

Dividends reinvested are not subject to federal income tax.

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14.

The dividend-growth model cannot be adjusted for changes in growth rates or changes in risk.

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15.

Income bonds are the safest bonds issued by a firm.

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16.

Many bonds have a call feature, which permits the firm to retire the bonds prior to maturity.

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17.

If interest rates fall, the prices of existing bonds also fall.

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18.

One of the major advantages associated with investing in mutual funds is potential diversification.

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19.

If a corporation operates at a loss, the loss is initially carried forward to offset future income.

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20.

Corporate losses can not result in tax refunds.

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21.

If a firm has no sales, it has no costs.

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22.

As a firm increases its use of debt, it becomes more financially leveraged and riskier.

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23.

The optimal capital structure is the firm's best combination of debt and equity funds.

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24.

If the marginal cost of capital rises, that suggests the cost of some component of the firm's capital structure
has risen.

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25.

An increase in the cost of an investment decreases its internal rate of return.

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Multiple Choice
Identify the choice that best completes the statement or answers the question.

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26.

The term structure of interest rates relates


a.

risk and yields

b.

yields and bond ratings

c.

term and yields

d.

stock and bond yields

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27.

Money serves as
a.

a substitute for equity

b.

a precaution against inflation

c.

a medium of exchange

d.

a risk-free liability

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28.

An asset is liquid if it is easily


a.

converted into cash

b.

marketed

c.

converted into cash without loss

d.

sold

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29.

An investment banker
1.

is usually not a banker

2.

is frequently a division of a brokerage firm

3.

serves as a middleman between financial intermediaries and firms issuing new securities

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 3

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30.

The Securities and Exchange Commission regulates


a.

trading in publicly held securities

b.

trading in privately held securities

c.

the margin requirement

d.

the amount a stock's price may change

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31.

American Depository Receipts


1.

represent American securities traded abroad

2.

represent foreign stocks traded in the United States

3.

facilitate trading in foreign stocks

4.

facilitate trading in American securities

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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32.

The efficient market hypothesis suggests


1.

American securities markets are not competitive

2.

American securities markets are very competitive

3.

investors can expect to outperform the market

4.

investors cannot expect to outperform the market

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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33.

In an efficient market, security prices


a.

adjust rapidly to new information

b.

adjust slowly to new information

c.

poorly value a firm's future prospects

d.

indicate that the firm is overvalued

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34.

Over-the-counter stock quotes are obtained through


a.

Nasdaq

b.

SEC

c.

SIPC

d.

FDIC

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35.

The Federal Reserve may contract the money supply by


1.

selling securities

2.

buying securities

3.

raising reserve requirements

4.

lowering reserve requirements

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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36.

By selling securities to the general public, the FED


a.

reduces the money supply

b.

raises commercial banks' deposits

c.

increases the money supply

d.

increases banks' excess reserves

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37.

Anticipation of inflation encourages


a.

lending

b.

borrowing

c.

retiring debt

d.

saving

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38.

Which of the following causes a currency inflow?


1.

foreign travel and foreign investments

2.

domestic travel by foreigners

3.

dividend payments from foreign corporations

4.

dividend payments to foreign investors

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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39.

If a nation has a surplus in its current account,


1.

it exports fewer goods than it imports

2.

it exports more goods than it imports

3.

the value of its currency should fall

4.

the value of its currency should rise

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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40.

Which is the largest if the interest rate is 10%?


a.

present value of $100 after five years

b.

present value of $100 annuity for five years

c.

future value of $100 annuity for five years

d.

future value of $100 after five years

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41.

Which is smallest if the interest rate is 10%?


a.

present value of $100 annuity for five years

b.

future value of $100 annuity for five years

c.

present value of $100 after five years

d.

$100 received right now

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42.

An annuity due is a set of


a.

equal, annual payments made at the end of the year

b.

equal, annual payments

c.

equal, annual payments made at the beginning of the year

d.

rising annual payments

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43.

Discounting is
1.

the determination of present value

2.

the determination of future value

3.

expressing the present in the future

4.

expressing the future in the present

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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44.

The time value of money suggests


a.

that the present is less attractive than the future

b.

individuals prefer a dollar in the present to a dollar in the future

c.

the present value of an annuity is negative

d.

annuities are worth less than lump sums

ANSWER:

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45.

A beta coefficient for a risky stock is


a.

less than 1.0

b.

equal to 1.0

c.

greater than 1.0

d.

negative

ANSWER:

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46.

Which of the following will reduce the required return on an investment?


a.

an increase in beta and a reduction in the Treasury bill rate

b.

an increase in the Treasury bill rate and a decrease in beta

c.

a decrease in the Treasury bill rate and a decrease in beta

d.

an increase in the Treasury bill rate and an increase in beta

ANSWER:

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47.

Current liabilities include


a.

stock

b.

bonds

c.

accounts receivable

d.

accrued interest payable

ANSWER:

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48.

Accountants suggest that assets


a.

should be valued at market

b.

should be valued at cost

c.

should be valued at the lower of market or cost

d.

should be valued at the higher of market or cost

ANSWER:

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49.

Which of the following is a cash outflow?


a.

a new issue of bonds

b.

a decrease in accounts receivable

c.

an increase in plant

d.

an increase in accounts payable

ANSWER:

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50.

Current liabilities do not include


a.

short-term bank loans

b.

accrued interest

c.

accounts payable

d.

additional paid-in capital (capital surplus)

ANSWER:

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51.

Performance is measured by
a.

liquidity ratios

b.

leverage ratios

c.

profitability ratios

d.

turnover ratios

ANSWER:

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52.

Times-interest-earned uses
a.

gross earnings

b.

operating earnings

c.

net earnings

d.

per share earnings

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53.

The more rapidly receivables turn over


a.

the more rapidly the firm is receiving cash

b.

the larger are the firm's sales

c.

the smaller is the firm's inventory

d.

the larger are the firm's accounts payable

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54.

Which of the following is equity?


1.

investments

2.

additional paid-in capital

3.

retained earnings

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

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55.

The retention of earnings instead of paying dividends


a.

may result in greater growth and higher prices

b.

is advantageous for all stockholders

c.

is favored by stockholders in lower income tax brackets

d.

leads to lower future dividends

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56.

Dividends are paid on the


a.

declaration date

b.

ex dividend date

c.

date of record

d.

distribution date

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57.

Stock repurchases reduce


1.

total equity

2.

total assets

3.

corporate taxes

4.

total liabilities

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

3 and 4

ANSWER:

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58.

Dividends may be paid in


1.

cash

2.

stock

3.

retained earnings

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

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59.

The value of a stock should decline if


a.

the risk-free rate declines

b.

the return on the market declines

c.

the firm's beta rises

d.

the earnings multiple rises

ANSWER:

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60.

According to the dividend-growth model, the value of a common stock depends on


1.

the price of the stock

2.

investors' required rate of return

3.

the future growth in dividends

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

all three

ANSWER:

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61.

If interest rates rise, a firm may retire a bond issue by


1.

calling it

2.

repurchasing it

3.

issuing new bonds and redeeming the old bonds

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 2

ANSWER:

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62.

Which of the following is not equity?


a.

paid-in capital

b.

retained earnings

c.

preferred stock

d.

debentures

ANSWER:

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63.

The net asset value


a.

is the price of an investment company's shares

b.

is reduced by the loading fee

c.

declines if the value of the fund's assets are reduced

d.

measures the quality of the fund's management

ANSWER:

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64.

Costs associated with investing in mutual funds include


1.

management fees

2.

taxes on unrealized profits

3.

brokerage commissions when the investor sells the shares

4.

load charges

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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65.

The net asset value of a mutual fund's share increases with


a.

an increase in loading fees

b.

an increase in interest rates

c.

an increase in security prices

d.

an increase in the fund's assets

ANSWER:

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66.

No load mutual funds


a.

have no selling fees

b.

pay no cash dividends

c.

have no administrative expenses

d.

have a fixed portfolio

ANSWER:

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67.

Variable costs
a.

are greater than fixed costs

b.

are greater than total costs

c.

are paid after fixed costs

d.

change with the level of output

ANSWER:

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68.

Straight-line break-even analysis implies that


1.

fixed costs eventually decline

2.

per unit variable cost may initially fall but start to increase with further increases in output

3.

per unit variable costs are constant

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 3

ANSWER:

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69.

A major weakness with the payback method is it failure to


a.

consider the cost of an investment

b.

consider an investment's cash inflows

c.

employ the firm's cost of funds (capital)

d.

rank investments

ANSWER:

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70.

The lower the debt ratio,


a.

the higher is the use of financial leverage

b.

the lower is the use of financial leverage

c.

the lower are the firm's total assets

d.

the higher are the firm's total assets

ANSWER:

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71.

Which of the following involves a fixed payment?


1.

bonds

2.

preferred stock

3.

common stock

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 1

ANSWER:

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72.

Debt financing
1.

increases stockholders' return more than an equal dollar amount of preferred stock

2.

increases stockholders' return less than an equal dollar amount of preferred stock

3.

is less risky to the investor than preferred stock

4.

is more risky to the investor than preferred stock

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

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73.

Debt financing is more risky for firms than preferred stock financing because
a.

preferred dividend payments are legal obligations

b.

interest payments are legal obligations

c.

preferred stock must be retired

d.

debt need not be refinanced

ANSWER:

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74.

The marginal cost of capital


a.

is the firm's cost of debt and equity finance

b.

is constant given an optimal capital structure

c.

declines as flotation costs alter equity financing

d.

refers to the cost of additional financing

ANSWER:

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75.

Small standard deviations for cash inflows


a.

reduces an investment's net present value

b.

increases an investment's internal rate of return

c.

increases the firm's cost of capital

d.

implies more certainty

ANSWER:

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Problem

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76.

You bought an asset for $10,000 and sold it for $20,000 after 10 years. What was the annual rate of return
on this investment?

RESPONSE:
ANSWER:

$10,000(1 + g) 10 = $20,000
(1 + g) 10 = $20,000/$10,000 = 2
The rate of return or growth rate (g) is approximately 7%.
(PV = -10000; N = 10; I = ?; PMT = 0, and FV = 20,000. I = 7.18.)

POINTS:

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REF:

77.

An investment is expected to generate $1,000,000 each year for 4 years. If the firm's cost of funds is 10%,
what is the maximum amount the firm should pay for the investment?

RESPONSE:
ANSWER:

X = $1,000,000(3.170) = $3,170,000
3.170 is the interest factor for the present value of an annuity at 10% for four years.
(PV = ?; N = 4; I = 10; PMT = 1000000, and FV = 0. PV = -3169865.)

POINTS:

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REF:

78.

You bought a Picasso for $50,000 and sold it after 5 years for $88,000. What was the annual return on the
investment?

RESPONSE:
ANSWER:

(1 + x) 5 = $88,000/$50,000 = 1.760
x = 12%
Look up 1.760 in the interest table for the future value of $1 for 5 years, and determine
the annual growth rate. (PV = -50000; N = 5; I = ?; PMT = 0, and FV = 88000. I =
11.97.)

POINTS:

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REF:

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79.

If an annuity costs $200,000 and yields 7 percent annually for 5 years, how much cash can an individual
withdraw each year such that the principal is consumed at the end of the time period?

RESPONSE:
ANSWER:

This illustrates the present value of an annuity of $1.00. The interest factor at 7
percent for 5 years is 4.10.
(FVAIF)(X) = $200,000
4.1X = $200,000
X = $200,000/4.1 = $48,780
The person may withdraw over $48,778 annually for five years. (PV = -200000; N = 5;
FV = 0; I = 7; PMT = ? PMT = 48778.14.)

POINTS:

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REF:

80.

You bought a stock with a beta of 1.4 and earned a return of 8.3%. Did you outperform the market if, during
the same period, the market rose by 7.4% and you could have earned 5.4% by investing in a Treasury bill?

RESPONSE:
ANSWER:

The material in this problem was not explicitly covered in the chapter. You may use the
problem to set up the question, "What return should you have earned during a
particular investment horizon?" The answer uses the capital asset model to evaluate
performance. Thus, the return that should have been realized is
Rf + (R m - Rf) beta = 5.4% + (8.3 - 5.4)1.4 = 9.46%.
The actual return (8.3% return) is less than the return that would be expected given
the beta and the market performance. The stock under-performed the market on a
risk-adjusted basis.

POINTS:

-- / 1

REF:

81.

Construct a balance sheet from the following information.


Accrued interest payable

4,000

Accumulated depreciation

30,000

Trade accounts payable

10,000

Retained earnings

86,000

Accrued wages

11,000

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Work in process

5,000

Finished goods

30,000

Plant and equipment

100,000

Cash and marketable securities

10,000

Land

10,000

Accounts receivable

32,000

Allowance for doubtful accounts

2,000

Bank note (due in six months)

15,000

Long-term debt

15,000

Raw materials

7,000

Investments

10,000

Taxes due

1,000

Additional paid-in capital


(capital surplus)

20,000

$1 par value common stock


20,000 shares authorized
10,000 shares outstanding

RESPONSE:
ANSWER:
Firm XYZ
Balance Sheet for the Period Ending December 31, 20XX
Assets
Current assets
Cash and marketable securities
Accounts receivable

$10,000
$32,000

Less allowance for doubtful

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accounts

(2,000)

30,000

Inventory
Finished goods

30,000

Work in process

5,000

Raw materials

7,000

Total current assets

42,000
$82,000

Long-term assets
Plant and equipment

$100,000

Less accumulated
depreciation
Land

(30,000)

70,000
10,000

Total long-term assets

$80,000

Investments

$ 10,000

Total assets

$172,000

Liabilities and Stockholders' Equity


Current liabilities
Accounts payable

$10,000

Accrued wages

11,000

Bank notes

15,000

Accrued interest payable

4,000

Accrued taxes

1,000

Total current liabilities

$41,000

Long-term debt

$15,000

Total liabilities

$56,000

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Stockholders' equity
Common stock ($1 par value; 20,000
shares authorized; 10,000 shares
outstanding)

$ 10,000

Paid-in capital

20,000

Retained earnings
Total stockholders' equity

Total liabilities and stockholders' equity

POINTS:

86,000
$116,000

$172,000

-- / 1

REF:

82.

The inventory turnover for an industry is 6 (every two months) but Slow Corp. turns over its inventory 4
times a years (every three months). If annual sales are $1,000,000 and the interest cost to carry inventory
is 12 percent, what is the potential savings in interest expense if the firm achieves the industry for the
turnover of its inventory?

RESPONSE:

42/58

ANSWER:
The current level of inventory is
Inventory turnover: Sales/Average inventory
1,000,000/X = 4
X = $250,000.

The level of inventory implied by the industry average is


Inventory turnover: Sales/Average inventory
1,000,000/X = 6
X = $166,667.

The potential reduction in inventory:


$250,000 - 166,667 = $83,333.

The potential savings in interest expense (if the firm can achieve the industry
average for the turnover of its inventory):
$83,888 0.12 = $10,000.

POINTS:

-- / 1

REF:

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83.

What is the debt/net worth ratio and the debt to total assets ratio for a firm with total debt of $600,000 and
equity of $400,000?

RESPONSE:
ANSWER:

Debt/Net worth: $600,000/$400,000 = 1.5


Debt ratio (Debt/Total assets):
$600,000/($600,000 + $400,000) = 0.6 = 60%

POINTS:

-- / 1

REF:

84.

If the industry days sales outstanding is 65 days and a firm with sales of $1,034,550 has receivables of
$268,700, how much in interest expense could the firm save if the receivables turn over as quickly as the
industry average and the cost of carrying the receivables is 9%?

RESPONSE:
ANSWER:

Desired receivables based on the industry average:


65 = X/($1,034,550/365)
X = $184,235
Reduction in receivables: $268,700 - $184,235 = $84,465
Reduction in interest expense: 0.09 $84,465 = $7,602

POINTS:

-- / 1

REF:

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85.

Construct a new balance sheet showing the impact of a 5 percent stock dividend. What will be the new
price of the stock?

RESPONSE:
ANSWER:

The new balance sheet after the 5 percent stock dividend:


Assets

Liabilities and Equity

Cash

$ 10,000,000

Accounts payable

$ 20,000,000

Accounts

250,000,000

Long-term debt

400,000,000

Common stock ($10 par;

10,500,000

receivable
Inventory

120,000,000

1,050,000 shares
outstanding)

Plant and

325,000,000

Add. paid-in capital

equipment

Retained earnings
$705,000,000

92,400,000
182,100,000
$705,000,000

The firm issues (.05)(1,000,000) = 50,000 shares with a $10 par value. The common
stock entry is increased by $500,000 to $10,500,000.
The market value of the stock is $58 50,000 = $2,900,000.
Retained earnings are reduced by $2,900,000 to $182,100,000.
Since retained earnings are reduced by $2,900,000 and common stock is increased
only by $500,000, $2,400,000 is unaccounted for. In order to balance the balance
sheet, additional paid-in capital is increased by $2,400,000.
The new price of the stock is $58 /1.05 = $55.24. This price adjustment is necessary to
adjust for the dilution of the old stock that results from the stock dividend.
Be certain to point out that in both the stock split and the stock dividend (1) assets are
not changed, (2) liabilities are not changed, and (3) total equity is not changed. All that
occurs is (1) a reduction in the price of the stock resulting from the increase in the
number of shares, and (2) some changes in the individual entries in the equity section
of the balance sheet.
POINTS:

-- / 1

REF:

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86.

Your broker recommends that you purchase Good Mills at $30. The stock pays a $2.20 annual dividend,
which (like its per share earnings) is expected to grow annually at 8 percent. If you want to earn 15 percent
on your funds, is this stock a good buy?

RESPONSE:
ANSWER:

Valuation of the stock:


The valuation of the stock is $33.94. Since the current price is $30, the stock is
undervalued and should be purchased.

POINTS:

-- / 1

REF:

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87.

What is the value of a common stock if 2


a.

the firm's earnings and dividends are growing annually at 10 percent, the current dividend is
$1.32, and investors require a 15 percent return on investments in common stock?

b.

What is the value of this stock if you add risk to the analysis and the firm's beta coefficient is 0.8,
the risk-free rate is 9 percent, and the return on the market is 15 percent?

c.

If the price of the stock is $35, what is the rate of return offered by the stock? Should the investor
acquire this stock?

RESPONSE:
ANSWER:
a.

b.

k = .09 + (.15 - .09).8 = .138 = 13.8%

c.

r = $1.32(1+.1)/$35 + .10 = 14.15%

The rate of return is less than the required rate (14.15% versus 15%) until the risk
adjustment is made. After this adjustment, the expected rate of return exceeds the
required rate of return (14.15% versus 13.8%); therefore, buy the stock.
POINTS:

-- / 1

REF:

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88.

You bought a stock for $20 and sold it for $59.72 after six years. What was the annual rate of return?

RESPONSE:
ANSWER:

$20(1 + g) 6 = $59.72
(1 + g) 6 = $59.72/$20 = 2.986
Use the future value of a dollar table to find 2.986; the return is 20%. (PV = -20; N = 6;
PMT = 0; FV = 59.72; I = ? = 20.)
The answer may also be derived as follows:
(1 + g) 6 = $59.72/$20 = 2.986
g = 2.986 .1667 - 1 = 20%

POINTS:

-- / 1

REF:

89.

If an investor buys shares in a closed-end investment company for $46 and the net asset value is $53,
what is the discount? If the company distributes $1, the net asset value rises to $58, and the investor sells
the shares for a premium of 5 percent over the net asset value, what is the percentage earned on the
investment?

RESPONSE:
ANSWER:

The discount is $53 - 46 = $7 (The shares initially sell for a discount of $7/53 = 13.2
percent from net asset value.)
The percentage return is ($1 + 1.05(58) - 46)/$46 = 34.6%.

POINTS:

-- / 1

REF:

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90.

Using the corporate tax rates given in the text (p. 345), what is the corporate income tax paid on earnings
of (a) $1,000, (b) $10,000, (c) $100,000, (d) 1,000,000, and (e) 10,000,000?

RESPONSE:
ANSWER:
a.

for $1,000: ($1,000)0.15 = $150

b.

for $10,000: ($10,000)0.15 = $1,500

c.

for $100,000: ($50,000).15 + (25,000).25 +


25,000(.34) = $22,250

d.

for $1,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(235,000).39 + (665,000).34 = $340,000

e.

for $10,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(335,000).39 + (665,000).34 + (9,000,000)x.34 =
$3,400,000

POINTS:

-- / 1

REF:

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91.

Given the following information, answer the following questions.


TR = $3Q
TC = $1,500 + $2Q
a.

What is the break-even level of output?

b.

If the firm sells 1,300 units, what are its earnings or losses?

c.

If sales rise to 2,000 units, what are the firm's earnings or losses?

d.

If the total cost equation were


TC = $2,000 + $1.80Q,
what happens to the break-even level of output units?

RESPONSE:
ANSWER:
a.

Break-even level of output:


$1,500/($3 - $2) = 1,500 units

b.

Earnings

= $3Q - $1,500 - $2Q


= $3(1,300) - 1,500 - 2(1,300) = ($200)

c.

Earnings

= $3Q - $1,500 - $2Q


= 3(2,000) - 1,500 - 2(2,000) = $500

d.

Break-even level of output:


$2,000/($3 - $1.80) = 1,667 units

POINTS:

-- / 1

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REF:

92.

(This is a simple problem that replicates the example in the chapter.) A firm needs $100 to start and
expects
Sales

$200

Expenses

$185

Tax rate

33% of earnings

a.

What are earnings if the owners invest the $100?

b.

If the firm borrows $40 of the $100 at any interest rate of 10%, what are the firm's net earnings?

c.

What is the return on the owners' investment in each case? Why do the returns differ?

d.

If expenses rise to $194, what will be the returns in each case?

e.

In which case did the returns decline more?

f.

What generalization can you draw form the above?

RESPONSE:
ANSWER:
a.

and b.

Sales
Expenses

no financial

with financial

leverage

leverage

$200

$200

185

185

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EBIT

15

15

Interest

EBT

15

11

Taxes

c.

3.63

Net earnings

10

Return on equity

$10/$100 = 10%

7.37

$7.37/$60 = 12.28%

The return for b is higher because of the successful use of financial leverage.
(Point out that operating income is 15% of assets versus the 10% interest rate
and the reduction in taxes that results from the interest expense.)

d.

Sales

no financial

with financial

leverage

leverage

$200

$200

194

194

Expenses

e.

EBIT

Interest

EBT

Taxes

0.66

Net earnings

Return on equity

$4/$100 = 4%

1.34

$1.34/$60 = 2.23%

The return on equity fell more for the firm that was financially leveraged.

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f.

POINTS:

The generalization is that the use of financial leverage to increase the return
on equity works both ways. If revenues fall and/or expenses rise, the use of
financial leverage will magnify the swing in the firm's return on equity.

-- / 1

REF:

93.

Fill in the table using the following information.


Assets required for operation: $2,000
Case A

- firm uses only equity financing

Case B

- firm uses 30% debt with a 10% interest rate and 70% equity

Case C

- firm uses 50% debt with a 12% interest rate and 50% equity

Debt outstanding

300

300

300

Stockholders' equity
Earnings before
interest and taxes
Interest expense
Earnings before taxes
Taxes (40% of earnings)
Net earnings
Return on stockholders'
investment

What happens to the rate of return on the stockholders' investment as the amount of debt increases? Why
did the rate of interest increase in case C?

RESPONSE:

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ANSWER:
A
0

$ 600

$1,000

Debt outstanding

Stockholders' equity

2,000

1,400

1,000

Earnings before

300

300

300

Interest expense

60

120

Earnings before taxes

300

240

180

Taxes (40% of earnings)

120

96

72

Net earnings

$ 180

$ 144

$ 108

Return on stockholders'

9%

10.3%

10.8%

interest and taxes

investment

The rate of return to stockholders rises because the after tax cost of debt in B is .1(1 .4) = 6%. The after tax cost of debt in C is .12(1 - .4) = 7.2%. These costs are less
than the 9 percent the firm earns after taxes on its assets ($180/$2,000). The interest
rate increases because the firm becomes riskier when it uses more financial leverage.
POINTS:

-- / 1

REF:

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94.

A firm with the following investment opportunities has a capital budget of $10,000. According to the net
present value technique, which investment(s) should the firm make if the firm's cost of capital is 10%?
Investment
A

Cost

$10,000

$7,000

$3,000

Cash inflow

$12,000

$8,600

$4,000

RESPONSE:
ANSWER:

The firm should select that combination of investments which uses the available funds
and maximizes the combined net present value.
NPVA

= $12,000(PVIF 10% 1y) - $10,000


= $12,000/(1 + .1) - 10,000
= $12,000(.909) - $10,000 = $908

NPVB

= $8,600/(1 + .1) - $7,000


= $8,600(.909) - $7,000 = $817

NPVC

= $4,000/(1 + .1) - $3,000


= $4,000(.909) - $3,000 = $636

NPVA is less than NPV B + NPV C. Therefore, select B + C over A even though A has
the highest individual NPV.
POINTS:

-- / 1

REF:

95.

A firm has three investment opportunities. Each costs $1,000, and the firm's cost of capital is 10 percent.
The cash inflow of each investment is as follows:
cash inflow

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year
1

$300

500

100

300

400

200

300

200

400

300

100

500

a.

If the net present value method is used, which investment(s) should the firm make?

b.

What is the internal rate of return of investment A? The internal rate of return of investment B is
10.22% and 6.15% for investment C. Which investment(s) should the firm make?

c.

What is the payback period for each investment?

RESPONSE:
ANSWER:
A.

Discount the cash inflows by the cost of capital. For each investment, that is

$300 .909

$272.70

$500 .909

$ 454.50

300 .826

247.80

400 .826

330.40

300 .751

225.30

200 .751

150.20

300 .683

100 .683

204.90
$950.70

68.30
$1,003.40

C
$100 .909

$ 90.90

200 .826

165.20

400 .751

300.40

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500 .683

341.50
$898.00.

Since investment A is an annuity, the present value could be determined by


using the interest table for the present value of an annuity. That is, $300
3.170 = $951, which is essentially the same answer except for rounding.

Next subtract the cost from the present value to determine the net present
value:

A:

$950.70 - $1,000 = ($49.30)

B:

$1,003.40 - $1,000 = $3.40

C:

$898.00 - $1,000 = ($102.00).

Since only B has a net present value that is positive, it is the only investment
that covers the firm's cost of capital and hence is the only one that should be
selected.

b.

Internal rate of return for A:

Since investment A is an annuity, the annuity table for the present value of an
annuity may be used to solve the problem. Restated the equation is
$1,000 = $300X
X = $1,000/$300 = 3.33.

3.33 is the interest factor for the present value of an annuity for four years.
Find this interest factor in the table to determine the internal rate of return. In
this case the internal rate of return is approximately 8 percent, which is less
than the firm's cost of capital. (The IRR is 7.7 percent using a financial
calculator.) Therefore, the investment should not be made. (This answer is
consistent with the answer given by the net present value in the previous
question.) The internal rates of return for investments B and C were given.
Only the internal rate of return of B exceeds the cost of capital; thus it is the
only investment the firm should make.

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c.

The payback periods for the investments are


A

three and one-third years

two and one-half years

three and two-thirds years.

Notice that in this case the payback method gives the same ranking of
investments as the net present value. However, the payback method does not
tell if any of the investments should be made.

POINTS:

-- / 1

REF:

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