Fundamentals of Corporate Finance Test B

Fundamentals of Corporate
Finance
Test Bank
th
8 Edition
1) Compute the NPV of the following project using a discount rate of 12 percent: Yr0
-$500; Yr1 -$50; Yr2 $50; Yr3 $200; Yr4 $400; Yr5 $400.
[ ] $0.00
[ ] $61.22
√ [ ] $118.75
[ ] $208.00
[ ] $269.21
2) You are going to choose one of two mutually exclusive investments. Investment
A pays $35,000 a year for 4 years and has an initial cost of $80,000. Investment B
pays $60,000 a year for 5 years and has an initial cost of $170,000. If your
required return is 13 percent, which investment should you choose and why?
[ ] A; because it costs less initially
[ ] A; because its IRR exceeds 13 percent
[ ] A; because it has a higher IRR
[ ] B; because its IRR exceeds 13 percent
√ [ ] B; because it has a higher NPV
3) What is the maximum number of internal rates of return (IRRs) that may exist for
the following project? Yr0 = -$50,000; Yr1 = -$5,000; Yr2 = $50,000; Yr3 =
$50,000; and Yr4 = -$25,000?
[ ]0
[ ]1
√[ ]2
[ ]3
[ ]4
4) An investment should be accepted if the net present value is positive.

√ [ ] True
[ ] False
5) What is the internal rate of return (IRR) decision rule?

[ ] accept a project when the IRR is greater than zero
[ ] accept a project if at the IRR the NPV is positive
[ ] reject any project if the IRR is below 10 percent
[ ] accept a project if the IRR exceeds the firm's bank borrowing rate
√ [ ] accept a project if the IRR exceeds the firm's required rate of return
6) A steep net present value (NPV) profile indicates that a project's NPV is very
sensitive to changes in the cost of capital.
√ [ ] True
[ ] False
7) A project costs $475 and has cash flows of $100 for the first three years and $75
in each of the project's last five years. If the discount rate is 10 percent, what is the
discounted payback period for the project?
√ [ ] The project never pays back on a discounted basis.
[ ] 6.29 years
[ ] 6.87 years
[ ] 7.03 years
[ ] 7.99 years
8) To use the payback rule, the average accounting return or the profitability index
you must first set an arbitrary cutoff.
[ ] True
√ [ ] False
9) The net present value decision rule is considered a better overall method of
project analysis than either the internal rate of return (IRR) or the profitability index
(PI).
√ [ ] True
[ ] False
10) A project that requires an initial cash outlay after which all remaining cash flows
are inflows is said to be:
[ ] independent.
√ [ ] conventional.
[ ] mutually exclusive.
[ ] value-creating.
[ ] short term.
11) Which one of the following is an advantage of a capital budgeting rule?

[ ] The payback rule ignores the time value of money.
[ ] The discounted payback rule requires a cutoff hurdle time period be set.
√ [ ] The profitability index is closely related to the net present value.
[ ] The average accounting return is based on accounting data.
[ ] There may be multiple internal rates of return for a given project
12) Which capital investment evaluation technique is described by the attributes

below?
1. easy to understand
2. biased towards liquidity
3. requires an arbitrary cutoff point
4. ignores the time value of money
[ ] net present value
[ ] internal rate of return
[ ] profitability index
√ [ ] payback
[ ] discounted payback
13) Two projects that are mutually exclusive are said to be independent.
[ ] True
√ [ ] False
14) Consider a project with an initial investment and positive future cash flows. As
the discount rate is increased the internal rate of return ________ while the net
present value ____
[ ] remains constant; increases.
[ ] decreases; remains constant.
√ [ ] remains constant; decreases.
[ ] increases; remains constant.
[ ] decreases; decreases.
15) According to the 1999 capital budgeting survey cited in the text, most chief
financial officers of U.S. firms:
[ ] prefer to rely exclusively on payback analysis to evaluate projects.
[ ] use the average accounting return as their primary method of evaluating
capital budgeting projects.
√ [ ] who use payback analysis appear to use it only in conjunction with some other
type of analysis.
[ ] prefer to use the profitability index to analyze their investment projects.
[ ] make use of payback analysis more heavily than discounted cash flow
methods.

below?
1. closely related to net present value
2. easy to understand and communicate
3. may lead to incorrect decisions in comparing mutually exclusive investments
4. may be useful when the available investment funds are limited
[ ] average accounting return
[ ] payback period
√ [ ] profitability index
17) An advantage of the payback rule is that it is easy to understand.
√ [ ] True
[ ] False
18) The use of which of the following could lead to incorrect decisions in comparing
mutually exclusive investments?
I. internal rate of return
II. profitability index
III. average accounting return
[ ] I only
[ ] II only
[ ] III only
√ [ ] I and II only
[ ] I and III only
19) Suppose you are evaluating two mutually exclusive projects, A and B. Project A
costs $350 and has cash flows of $250 and $250 in the next 2 years, respectively.
B costs $300 and generates cash flows of $300 and $100. What is the crossover
rate for these projects?
[ ] 26.38 percent
[ ] 27.47 percent
√ [ ] 30.28 percent
[ ] 61.80 percent
[ ] 83.48 percent
20) The profitability index, net present value, and internal rate of return are all
closely related to one another.
√ [ ] True
[ ] False
21) Suppose a firm invests $600 in a project. The initial cost is depreciated straight-
line to zero over 3 years. Net income from the project is $100, $125, and $140 in
each of the three years of the project's life. What is the average accounting return?
[ ] 18.25 percent
[ ] 20.28 percent
[ ] 35.49 percent
√ [ ] 40.56 percent
[ ] 60.83 percent
22) Your boss presents you with two capital budgeting proposals. The first one
involves buying a new delivery truck and the second one involves building
additional warehouse space. Provided there are sufficient funds for both, this is an
example:
[ ] of mutually exclusive projects.
[ ] of crossover analysis.
[ ] where the internal rate of return should not be used as an analytical tool.
√ [ ] of two independent projects.
[ ] where the net present value is unreliable as a decision making tool.
23) Which of the following questions are addressed in the capital budgeting
process?
I. What products or services will we offer or sell?
II. In what markets will we compete?
III. What new products will we introduce?
[ ] I only
[ ] III only
[ ] I and II only
[ ] I and III only
√ [ ] I, II, and III
24) In which of the following cases is it possible that the NPV and IRR rules will lead
to different decisions?
I. project cash flows are conventional
II. the IRR is negative
III. an investment decision involves mutually exclusive choices
[ ] I only
√ [ ] III only
[ ] I and II only
[ ] I and III only
[ ] II and III only
25) When multiple IRR's exist, a project must have a negative NPV at the highest
IRR.
[ ] True
√ [ ] False
26) Net present value (NPV):

[ ] is equal to the initial investment in a project.
√ [ ] compares project cost to the present value of the project benefits.
[ ] is equal to zero when the discount rate used is less than the internal rate of
return (IRR).
[ ] is simplified by the fact that future cash flows are easy to estimate.
[ ] requires a firm to set an arbitrary cutoff point for determining whether or not a
project should be accepted.
27) A disadvantage of the payback rule and the average accounting return is that
both ignore the time value of money.
√ [ ] True
[ ] False
28) Which of the following statements are correct?

I. Net present value (NPV) is the difference between the present value of an asset
or project and its cost.
II. The financial manager acts in the shareholders' best interests by identifying and
implementing positive NPV projects.
III. NPVs can normally be directly observed in the market.
IV. Investment criteria other than NPV provide additional information about whether
or not a project truly has a positive NPV.
[ ] I and II only
[ ] II and III only
[ ] II, III, and IV only
√ [ ] I, II, and IV only
[ ] I, II, III, and IV
29) Which one of the following is based on net income rather than on cash flows?
[ ] payback
√ [ ] average accounting return
30) If a project has conventional cash flows, it may also have more than one IRR.
[ ] True
√ [ ] False
31) What is the net present value, rounded to the nearest whole dollar, of the
following set of cash flows if the required return is 14 percent? Yr0 = -$50,000; Yr1
= -$5,000; Yr2 = $50,000; Yr3 = $50,000; and Yr4 = -$25,000?
[ ] -$500
√ [ ] $3,034
[ ] $9,525
[ ] $10,376
[ ] $41,410
32) You need to borrow $2,000 quickly, and Morry, the neighborhood loan shark,
will give it to you if you promise to repay him $200.92 a month for the next year.
From Morry's viewpoint, what is the IRR of this transaction?
[ ] 1.0 percent per month
√ [ ] 3.0 percent per month
33) For projects with conventional cash flows and positive discount rates, the
payback period will be shorter than the discounted payback period.
√ [ ] True
[ ] False
34) A firm that only accepts projects for which the IRR is equal to the firm's required
return will, on average, neither create nor destroy wealth for its shareholders.
√ [ ] True
[ ] False
35) Which one of the following capital investment evaluation techniques uses
readily available information in an easy to compute manner?
[ ] payback period
[ ] discounted payback period
36) Which one of the following decision rules is best for evaluating projects when
distant cash flows and the time value of money are to be ignored?
√ [ ] payback
37) Which of the following is (are) biased in favor of liquid investments?

I. payback period
II. average accounting return
III. discounted payback
[ ] I only
[ ] III only
[ ] I and II only
√ [ ] I and III only
[ ] I, II, and III
38) Which of the following methods can be used when choosing between mutually
exclusive projects?
I. AAR
II. PI
III. IRR
IV. NPV
[ ] I only
[ ] II and III only
[ ] II and IV only
√ [ ] I and IV only
[ ] I and III only
39) You are considering the following two projects:

Project : Year 0 : Year 1 : Year 2 : Year 3
A : -$200 : $100 : $100 : $100
B : -$300 : $175 : $125 : $125
Which of the following statements concerning these projects and the payback
method of analysis are correct?
I. With a payback cutoff of 1.5 years, both projects are unacceptable.
II. With a payback cutoff of 3 years, both projects are acceptable.
III. Since both projects pay back, the NPV of both must be positive.
IV. Based on the payback criteria, you would be indifferent between the two.
[ ] I and II only
[ ] III and IV only
[ ] I and IV only
[ ] I, III, and IV only
40) Suppose you are considering a project that costs $300 and has expected cash
flows of $110, $121 and $133.10 over the next three years, respectively. If the
appropriate discount rate is 10 percent, what is the net present value of this
project?
[ ] -$19.79
√ [ ] $0.00
[ ] $0.71
[ ] $19.79
[ ] $64.10
41) Both the internal rate of return and the profitability index decision rules may lead
to incorrect decisions when comparing mutually exclusive investments.
√ [ ] True
[ ] False
42) As a financial manager, rank the following decision rules in order of preference
from best to worst in terms of usefulness in making capital budgeting decisions.
I. NPV
II. discounted payback
III. payback
√ [ ] I, II, III
[ ] I, III, II
[ ] II, I, III
[ ] II, III, I
[ ] III, I, II
43) One of the risks a firm takes when it uses the ________ as the investment
criterion for proposed projects is that it may reject some profitable projects
because of the timing of their cash flows.
√ [ ] payback rule
44) The _____ is the length of time required for an investment's discounted cash
flows to equal its initial cost.
[ ] payback
√ [ ] discounted payback
45) Which one of the following factors can cause a project to have multiple IRRs?
[ ] a large initial cash outlay
√ [ ] an initial cash investment followed by positive cash flows for three years and a
negative cash flow in the final year
[ ] negative cash flows in the first three years of a project but positive cash flows
thereafter
[ ] conventional cash flows
[ ] mutually exclusive investments
46) A net present value (NPV) of zero implies that an investment's:
[ ] cost exceeds the present value of its cash inflows.
√ [ ] cost is equal to the present value of its cash inflows.
[ ] internal rate of return (IRR) is greater than the firm's required rate of return.
[ ] present value of cash inflows is positive.
[ ] present value of cash inflows exceeds the investment's cost.
47) What is the IRR, to the nearest whole percent, of an investment that costs
$77,000 and pays $27,500 a year for 4 years?
√ [ ] 16 percent
[ ] 18 percent
[ ] 20 percent
[ ] 22 percent
[ ] 24 percent
48) Which one of the following decision rules has the advantage that the information
needed for the computation is usually readily available?
[ ] payback
49) An investment's average net income divided by its average book value is called
its:
[ ] payback.
[ ] discounted payback.
[ ] net present value.
[ ] internal rate of return.
√ [ ] average accounting return.
50) Which of the following consider the time value of money in their computation?
I. payback
II. average accounting return
III. profitability index
[ ] I only
[ ] II only
√ [ ] III only
[ ] I and III only
[ ] II and III only
51) Which of the following are problems associated with net present value?
I. omission of time value of money considerations
II. bias against long-term projects
III. inability to rank mutually exclusive projects
IV. multiple results if some future cash flows are negative
[ ] I only
[ ] II only
[ ] III only
[ ] IV only
√ [ ] None of these are problems that apply to NPV.
52) Suppose a project costs $300 and produces cash flows of $100 over each of
the following six years. What is the IRR of the project?
[ ] 0 percent
[ ] 10.0 percent
√ [ ] 24.3 percent
[ ] 34.9 percent
[ ] 38.1 percent
53) The management of a firm wishes to accept projects with a high degree of
liquidity, avoid the higher forecasting error associated with distant cash flows, and
avoid projects that require a large amount of research and development. The firm
would be justified in using the ________ rule to evaluate its projects.
√ [ ] payback
54) You are considering the following independent projects but you have limited
funds to invest and can't take them all. Using the profitability index, rank the
projects in the order in which you would accept them. That is, rank them from best
to worst.
I. Project I requires an initial investment of $100,000 and has a NPV of $30,000.
II. Project II requires an initial investment of $80,000 and has a NPV of $25,000.
III. Project III requires an initial investment of $40,000 and has a NPV of $17,000.
[ ] I, II, III
[ ] II, III, I
[ ] III, I, II
√ [ ] III, II, I
[ ] I, III, II
55) A project costs $475 and has cash flows of $100 for the first three years and
$75 in each of the project's last five years. What is the payback period of the
project?
[ ] The project never pays back.
[ ] 4.75 years
[ ] 5.00 years
√ [ ] 5.33 years
[ ] 6.37 years
56) Would you accept a project which is expected to pay $10,000 a year for 7 years
if the initial investment is $40,000 and your required return is 15 percent?
√ [ ] yes; the NPV is $1,604
[ ] yes; the NPV is $1,446
[ ] yes; the NPV is $4,238
[ ] no; the NPV is -$1,369
[ ] no; the NPV is -$2,783
57) The essence of _____ is determining whether a proposed investment or project

will generate positive wealth for the owners of the firm once it is in place.
√ [ ] strategic asset allocation
[ ] capital structure analysis
[ ] cash flow analysis
[ ] payback analysis
[ ] working capital analysis
58) You undertake a project with an initial investment of $10,000. You expect to
receive $3,500 a year for the next 4 years. If the required return is 15 percent, what
is the NPV?
[ ] -$435.26
[ ] -$32.48
√ [ ] -$7.58
[ ] $4.63
[ ] $5.49
59) An advantage of the average accounting return is that the information needed to
compute it will usually be available.
√ [ ] True
[ ] False
60) You are comparing two projects using a net present value profile. At the point
where the net present values (NPV) of the two projects are equal, the:
[ ] internal rate of return (IRR) of each project is equal to zero.
[ ] IRR of each project is equal to the cost of capital.
√ [ ] interest rate that makes the net present values equal is called the crossover
rate.
[ ] projects will both have net present values equal to zero.
[ ] average accounting return (AAR) exceeds the cost of capital.
61) Your firm needs to generate income from some unused equipment which the
company owns. The president presents you with two options. First, you can sell the
equipment or second, you can rent out the equipment. This is an example of a
decision involving:
[ ] independent projects.
[ ] working capital projects.
[ ] positive NPV projects.
[ ] tax shields.
√ [ ] mutually exclusive projects.
62) To find the _____ we begin by setting the net present value of a project equal to
zero.
I. payback
II. discounted payback
III. profitability index
IV. internal rate of return
[ ] I only
[ ] II only
√ [ ] IV only
[ ] II and IV only
[ ] III and IV only
63) For all projects, the AAR will be less than the IRR.
[ ] True
√ [ ] False
64) Rank the following decision rules from worst to best in terms of their overall
usefulness in capital budgeting analysis.
I. NPV
II. Payback
III. IRR
√ [ ] II, III, I
[ ] II, I, III
[ ] III, I, II
[ ] I, III, II
[ ] III, II, I
65) A project that has a discounted payback period longer than its life also has a
positive NPV.
[ ] True
√ [ ] False
66) If a project with conventional cash flows has a profitability index (PI) that is less
than one, then the:
[ ] internal rate of return is greater than the required return.
√ [ ] discounted payback period is greater than the project's life.
[ ] average accounting return is greater than the required return.
[ ] payback period is less than the maximum acceptable period.
[ ] net present value is positive.
67) The following is a list of the primary disadvantages of which one of the following
evaluation methods as compared to the net present value method?
1. ignores cash flows beyond the cutoff date
2. requires an arbitrary cutoff point
3. biased against long-term projects
4. may reject positive NPV projects
[ ] payback period
√ [ ] discounted payback period
68) You run a small bagel shop and are considering replacing your four sales clerks
with automated machines that allow customers to buy their bagels without any
human interaction. Of the following, the most difficult task you face in computing
the net present value of this project is estimating the:
[ ] proposed reduction in wages.
[ ] tax shield of the new project.
[ ] cost of the new equipment that will be required.
[ ] cost of installing the new equipment.
√ [ ] total change in sales.
69) A manager will prefer the internal rate of return rule over the net present value
rule if the manager:
√ [ ] prefers to talk in terms of rates of return.
[ ] can accurately forecast future cash flows.
[ ] dislikes discounting cash flows.
[ ] is considering different sized projects.
[ ] is considering mutually exclusive projects.

below?
1. easy to understand and communicate
2. may result in multiple answers
3. may lead to incorrect decisions when applied to mutually exclusive investments
√ [ ] internal rate of return
[ ] payback
71) You need to borrow $2,000 quickly and Morry, the neighborhood loan shark, will
give it to you if you promise to repay him $200.92 a month for the next year.
Suppose that Morry has more customers than funds. Which capital budgeting
technique would allow him to rank his potential customers in order to maximize his
current wealth?
[ ] payback period
72) A project has a required return of 15 percent, conventional cash flows and a
five-year life. Of the following values that have been computed, which value is
inconsistent with the other four?
[ ] The discounted payback is exactly five years.
√ [ ] The profitability index is zero.
[ ] The net present value is zero.
[ ] The internal rate of return is 15 percent.
[ ] The present value of the future cash flows is equal to the initial outlay
73) A financial manager who consistently underestimates the ________ will tend to
incorrectly reject projects that would actually create wealth for the stockholders.
[ ] marginal income tax rate
[ ] initial cost of projects
[ ] future cash outlays associated with projects
[ ] required return on projects
√ [ ] future cash inflows associated with projects
74) Complete the following decision rule: A project should be accepted if its
________ exceeds the firm's required rate of return.
√ [ ] internal rate of return
[ ] payback
75) A project with a net present value equal to zero:

[ ] should be rejected.
[ ] has a profitability index that is greater than one.
√ [ ] is expected to yield a return equal to the firm's required return.
[ ] has a discounted payback period that is shorter than the life of the project.
[ ] has an internal rate of return that exceeds the required rate.
76) Very few large U.S. firms use the payback rule when making capital budgeting
decisions.
[ ] True
√ [ ] False
77) Compute the NPV, to the nearest whole dollar, for a project with an initial
investment of $40,000 and cash inflows of $11,000 a year for 5 years given a
required return of 11.649 percent.
[ ] -$1,205
[ ] -$1,103
√ [ ] $0
[ ] $567
[ ] $1,218
78) The _____ is the difference between an investment's present value and its cost.
[ ] payback
√ [ ] net present value
79) If financial managers invest only in projects that have a profitability index greater
than one then ________ should increase.
I. the value of the firm
II. shareholder wealth
III. share price
[ ] I only
[ ] II only
[ ] III only
[ ] I and III only
√[ ] I, II, and III
80) An investment is acceptable if the internal rate of return (IRR) exceeds the
required return.
√ [ ] True
[ ] False
81) Which one of the following excludes the time value of money principle?
82) Which of the following are problems associated with the internal rate of return?
III. inability to rank mutually exclusive or different sized projects
[ ] I and II only
[ ] I and III only
√ [ ] III and IV only
[ ] II and III only
[ ] II and IV only
83) Which one of the following is considered to be an advantage of the average

accounting return method of analysis?
[ ] incorporation of time value of money
[ ] estimation of the appropriate cutoff rate
[ ] reliance on net income and book values
[ ] reliance on book values and not market values
√ [ ] ease of computation
give it to you if you promise to repay him $200.92 a month for the next year. From
your viewpoint, what is the percentage cost of this transaction?
√ [ ] 3.0 percent per month
85) The average accounting return (AAR) decision rule states that a project should
be accepted whenever the AAR:
[ ] is positive.
[ ] exceeds the internal rate of return (IRR).
[ ] indicates that a project has more than recaptured its initial cost in terms of net
income.
√ [ ] exceeds the target AAR.
[ ] is less than the IRR.
86) _____ quantifies in dollar terms how stockholder wealth will be affected by
undertaking a project under consideration.
[ ] Discounted payback analysis
[ ] The average accounting return
[ ] The internal rate of return
√ [ ] Net present value
[ ] The profitability index
87) Which of the following are problems associated with the profitability index?
VI. bias against long-term projects
[ ] I only
[ ] II only
√ [ ] III only
[ ] IV only
[ ] III and IV only
88) Ranking conflicts can arise between the internal rate of return (IRR) and the net
present value (NPV) when:
[ ] the first cash flow of a project is negative and the remaining cash flows are
positive.
[ ] projects are independent of one another.
[ ] a project has more than one NPV.
√ [ ] projects are mutually exclusive.
[ ] the profitability index is greater than one.
89) The _____ is equal to the present value of an investment's future cash flows
divided by its initial cost.
[ ] payback
√[ ] profitability index
give it to you if you promise to repay him $200.92 a month for the next year.
Suppose that Morry's cost of funds is 1 percent per month. From Morry’s point of
view, what is the net present value of this deal?
[ ] $44.11
[ ] $111.01
[ ] $226.17
√ [ ] $261.37
[ ] $292.01
91) Which one of the following is computed using only accounting numbers?
[ ] payback period
92) The profitability index is computed using accounting income and accounting
book values.
[ ] True
√ [ ] False
93) The length of time required for an investment's undiscounted cash flows to
equal its initial cost is called the:
√ [ ] payback.
[ ] discounted payback.
[ ] average accounting return.
[ ] profitability index.
94) From a financial point of view, which one of the following is a correct statement?
[ ] The internal rate of return is considered to be the best project analysis
technique.
[ ] The average accounting return is preferable to the profitability index method.
√ [ ] Discounted payback analysis requires the use of a discount rate.
[ ] Internal rate of return is the preferred method for comparing mutually exclusive
investments.
[ ] Regular payback analysis is preferable to discounted payback analysis.
95) The ________ decision rule is considered the "best" in principle.

[ ] payback
96) If the required return is zero and a project has conventional cash flows, then:
[ ] the payback period exceeds the discounted payback period.
√ [ ] the net present value equals the difference between the undiscounted future
cash flows and the initial cash outlay.
[ ] if the net present value is negative, the internal rate of return will be greater
than zero.
[ ] the profitability index will be less than one.
[ ] the project will be acceptable according to the average accounting return
criteria.
97) If investment funds are limited and the projects under consideration are
independent from one another, then the accounting rate of return should be used
to rank projects to determine which ones should be accepted.
[ ] True
√ [ ] False
98) If an investment has a ________ of 1.2 it can be said the investment generates
$1.20 in present value benefits for each dollar invested.
[ ] payback
99) Which of the following are correct statements concerning capital budgeting
decision rules?
I. If a project has a profitability index greater than one, the project should be
accepted.
II. If a firm's target average accounting return is lower than that computed for a
given project, the project should be accepted.
III. If the cost of capital is greater than the internal rate of return, the project should
be accepted.
IV. If a project has a payback period that is less than what the company requires,
the project should be accepted.
[ ] I and II only
[ ] I and IV only
[ ] I, III and IV only
√ [ ] I, II and IV only
[ ] II, III and IV only
100) Which one of the following statements is true concerning discounted payback
analysis for projects which have conventional cash flows and for which the
discount rate is positive?
[ ] Discounted payback is better than simple payback because in simple payback
analysis the cutoff payback period is arbitrarily set by management.
[ ] Any project that never pays back on a discounted basis must have a positive
net present value.
[ ] When comparing two projects, the one with the shorter payback period on a
discounted basis will have the larger net present value.
[ ] Discounted payback is much simpler to calculate than regular payback.
√ [ ] The discounted payback period will be longer than the regular payback period.
101) If the net present value (NPV) is greater than zero for a project with
conventional cash flows, then the:
[ ] internal rate of return (IRR) is equal to the firm's required rate of return.
√ [ ] profitability index is greater than 1.
[ ] payback period is shorter than required by the firm.
[ ] average accounting return exceeds the internal rate of return.
[ ] the project does not pay back on a discounted basis.
102) According to the net present value (NPV) rule, a firm should accept a project if:
√ [ ] the estimated NPV is positive.
[ ] the estimated NPV exceeds the average accounting net income.
[ ] the estimated NPV exceeds a project's cost.
[ ] the NPV exceeds the firm's target accounting rate of return.
[ ] the NPV is negative.
103) Which of the following are problems associated with payback analysis?
IV. multiple results when some future cash flows are negative
√[ ] I and II only
[ ] II and III only
[ ] I, II, and IV only
[ ] I, II, and III only
104) What is the payback period of a $40,000 investment with the following cash
flows? Yr1 = 20,000; Yr2 = 25,000; Yr3 = 10,000; Yr4 = 10,000; Yr5 = 5,000.
[ ] 1.00 year
√ [ ] 1.80 years
[ ] 2.00 years
[ ] 2.25 years
[ ] 3.50 years
105) You are considering the following two projects:

Project : Year 0 : Year 1 : Year 2 : Year 3
A : -$200 : $100 : $100 : $100
B : -$300 : $175 : $125 : $125
Which one of the following statements concerning the profitability index (PI) is
correct if the applicable discount rate is 14 percent?
[ ] The PI of project A is less than 1.0.
[ ] The PI of project B is less than 1.0.
√ [ ] Based on the PI, project A is preferable.
[ ] Both projects would be rejected based on the PI criterion.
[ ] The project with the smaller initial investment always has the higher PI.
1) Which of the following describes project cash flow?
I. OCF - additions to NWC - capital spending
II. OCF + additions to NWC + capital spending
III. OCF + additions to NWC - capital spending
IV. OCF + reductions in NWC - capital spending
[ ] III and IV only
[ ] I and III only
[ ] II and III only
[ ] I, II, III and IV
2) A project costs $60,000, will be depreciated straight-line to zero over its 4-year
life, has a tax rate of 34 percent and a required return of 10 percent. The project
generates an operating cash flow of $18,000 and the fixed assets will be sold for
$7,000 at the termination of the project. What is the project's net present value?
√ [ ] $213
[ ] $1,133
[ ] $1,839
[ ] $2,261
[ ] $2,842
3) When we use the equivalent annual cost methodology, the projects under
consideration have different economic lives and the related assets will be replicated
more or less indefinitely.
√ [ ] True
[ ] False
life, will require a net working capital investment of $5,000 up front, has a tax rate of
34 percent and a required return of 10 percent. The fixed assets will be worthless at
the end of the project. The project generates an operating cash flow of $17,000.
What is the project's net present value rounded to the nearest whole dollar?
[ ] -$2,724
√ [ ] $1,033
[ ] $1,393
[ ] $2,394
[ ] $2,942
5) Suppose you purchase a machine for $14,000. The cost is depreciated straight-
line to a salvage value of zero over its 4-year life. If the machine is sold at the end of
the third year for $6,000, what are the after-tax proceeds from the sale assuming the
tax rate is 34 percent?
[ ] $1,010
[ ] $3,960
[ ] $5,010
√[ ] $5,150
[ ] $6,990
6) A firm moves into a higher tax bracket. All else equal, the depreciation tax shield
will:
√ [ ] be more valuable.
[ ] be less valuable.
[ ] remain unchanged since depreciation doesn't change.
[ ] remain unchanged because changes in tax rates don't matter once a project is
in place.
[ ] be either more valuable, less valuable, or unchanged, but it is impossible to tell
which without more information.
7) Your company just bought some new equipment for its manufacturing plant. The
equipment cost $130,000. Industrial equipment has a MACRS classification of 7
years. If the equipment will be sold at the end of year 3 for $85,000, what is the after-
tax cash flow from the sale? The corporate tax rate is 34 percent.
[ ] $27,784
[ ] $66,000
[ ] $72,216
√ [ ] $75,429
[ ] $97,116
8) According to the stand-alone principle, a project should be evaluated based on the

project's incremental cash flows.
√ [ ] True
[ ] False
9) The _____ approach for computing project operating cash flow explicitly measures
the depreciation-related tax benefit associated with an investment.
[ ] stand-alone
[ ] bottom-up
[ ] top-down
√ [ ] tax shield
[ ] traditional
10) You are considering investing in a cost cutting proposal. Net income from the
project is expected to equal $27.50 each of the three years of the project's life. The
process has an initial cost of $125 and will be depreciated straight-line over 3 years
to a salvage value of $0. Assume a 34 percent tax bracket and a discount rate of 15
percent. What is operating cash flow in each of the three periods?
[ ] $36.30
[ ] $43.10
[ ] $44.80
[ ] $61.80
√ [ ] $69.17
11) Assume that over the life of a project, net working capital is maintained at an
amount equal to the initial investment. If so, net working capital can be excluded from
the net present value computation, since the outflow at time zero is exactly offset by
an equal inflow at the end of the project's life.
[ ] True
√ [ ] False
12) The bottom-up approach to finding operating cash flow works for any income
statement.
[ ] True
√ [ ] False
13) Your company just bought a new distillation unit for $130,000 to be used in
R&&D. Such equipment has a 3-year MACRS classification. What is the book value
of the distillation unit at the end of year 2?
√ [ ] $28,899
[ ] $35,568
[ ] $39,899
[ ] $57,775
[ ] $58,896
14) Total project cash flow is the same as cash flow from assets. That is, it is equal
to operating cash flow minus changes in net working capital minus net capital
spending.
√ [ ] True
[ ] False
15) When considering mutually exclusive investment projects with different lives that
will not be replaced after they terminate, it is best to evaluate them using the _____
method.
[ ] equivalent annual cost
16) Given the following information and assuming straight-line depreciation to zero,
what is the net present value of this project? Initial investment = $400,000; life = 5
years; cost savings = $150,000 per year; tax rate = 34 percent; discount rate = 14
percent. The fixed assets will be sold for $30,000 at the end of year 5. (Round your
answer to the nearest whole dollar.)
[ ] -$149,841
[ ] -$33,117
[ ] $0
[ ] $19,800
√ [ ] $43,538
17) In general, adopting MACRS depreciation instead of straight-line depreciation will

increase the net present value of a project.
√ [ ] True
[ ] False
18) The managers of Poncho Parts, Inc. plan to manufacture engine blocks for
classic cars from the 1960s. They expect to sell 250 blocks annually for the next 5
years. The necessary foundry and machining equipment will cost a total of $800,000
and will be depreciated on a straight-line basis to zero over the project's life. The firm
expects to be able to sell the equipment for $150,000 at the end of 5 years. Labor
and materials costs total $500 per engine block, fixed costs are $125,000 per year.
Assume a 35 percent tax rate and a 12 percent discount rate. What will be the
annual depreciation tax shield?
[ ] $20,000
√ [ ] $56,000
[ ] $100,000
[ ] $104,000
[ ] $120,000
19) To accurately reflect the costs associated with a project, you should exclude
interest expenses in the computation of the operating cash flows.
√ [ ] True
[ ] False
20) Which one of the following describes the "bottom-up" approach to computing
operating cash flow?
[ ] EBIT + D - Taxes
√ [ ] NI + D
[ ] (S - C) X (1 - Tc) + D X Tc
[ ] S - C -Taxes
[ ] NI + D - taxes
21) The idea behind setting a bid price is to determine the minimum price at which
the net present value of a project will still be zero or positive.
√ [ ] True
[ ] False
22) By using the tax shield approach for computing operating cash flows, you can:
[ ] obtain more accurate results than with the customary methods.
[ ] more readily verify what cash flows would be without interest expenses.
[ ] more readily identify the tax shield from interest deductions.
√ [ ] more readily identify the tax benefits of depreciation.
[ ] start with the bottom line, net income, and work backwards.
23) Which one of the following is least likely to cause erosion?

√ [ ] A gas station owner expands his building to make room for a convenience store.
[ ] You begin selling coffee in new, smaller-sized foil pouches along side your
regular sizes of coffee cans.
[ ] You build a Taco Bell just down the street from your McDonalds.
[ ] Your grocery store begins to carry additional flavors of ice cream.
[ ] The concession stand at the local ball field begins to sell both hot dogs and
hamburgers rather than just hot dogs.
24) Your company just purchased a new computer system for $130,000. Computers
have a 5-year MACRS classification. What is the depreciation for this system in year
2?
[ ] $28,899
[ ] $31,837
√ [ ] $41,600
[ ] $43,329
[ ] $57,772
25) A machine costs $60 and requires $35 in maintenance for each year of its 3-year
life. After 3 years, this machine will be replaced. Suppose that the machine is
depreciable straight-line over its three-year life to a salvage value of zero and the
machine will be worthless at that time. Assuming a tax rate of 34 percent and a
discount rate of 14 percent, what is the EAC for the machine?
[ ] -$39.48
√ [ ] -$42.14
[ ] -$48.33
[ ] -$59.13
[ ] -$97.84
26) Two types of batteries are being considered for use in electric golf carts. Burnout
brand costs $36, have a 3-year life, and cost $100 per year to charge. Longlasting
brand costs $60 each, have a 5-year life, and cost $88 per year to charge. The
salvage value is zero in both cases. You must choose between the two and expect to
replace them forever. You should take the option with the:
[ ] greater net present value.
[ ] lower net present value.
[ ] greater equivalent annual cost.
√ [ ] smaller equivalent annual cost.
[ ] lowest accounting break-even point.
percent. Suppose the equipment is sold at the end of year 3 for $20, pretax. What is
the internal rate of return?
[ ] 16.3 percent
[ ] 29.5 percent
√ [ ] 33.6 percent
[ ] 45.8 percent
[ ] 62.7 percent
28) You are given the following information about equipment that is required for your
business. Assume that the equipment will be replaced as it wears out and that
straight-line depreciation to zero is used. The required return is 15 percent. Ignore
taxes. Machine A has an initial cost of $200,000, an operating cost per year of
$15,000, and an expected life of 8 years. Machine B has an initial cost of $300,000,
an operating cost per year of $17,500, and an expected life of 10 years. What is the
equivalent annual cost of machine A?
[ ] -$301,664
[ ] -$201,676
[ ] -$48,163
√ [ ] -$59,570
[ ] -$22,437
29) An increase in ________ will usually represent a net cash inflow at the beginning
or during the life of a project and an equal net cash outflow upon completion of the
project.
√ [ ] accounts payable
[ ] inventory
[ ] accounts receivable
[ ] fixed assets
[ ] accounts receivable coupled with an identical increase in accounts payable
30) Which one of the following projects would increase net working capital the most?
[ ] purchasing land for a new baseball manufacturing plant
[ ] decreasing the amount of sales your firm makes on credit
[ ] decreasing the number of product lines your firm carries
[ ] converting a manufacturing process so that you produce goods only after a
customer order has been received
√ [ ] using long-term bank credit to reduce payables
31) An opportunity cost is the most valuable alternative that is given up if a particular
investment is undertaken.
√ [ ] True
[ ] False
32) In setting the bid price, we attempt to set a price at which the firm will "break
even" in a financial sense. Which one of the following equations does NOT hold at
the lowest acceptable bid price?
√ [ ] AAR = required return
[ ] NPV = 0
[ ] discounted payback = the life of the project
[ ] IRR = required return
[ ] PI = 1
33) Your company purchased a piece of land five years ago for $150,000 and
subsequently added $175,000 in improvements. The current book value of the
property is $225,000. There are two options for future use of the land: 1) the land can
be sold today for $375,000 after-tax; or 2) your company can destroy the past
improvements and build a factory on the land. When evaluating the factory option,
what amount, if any, should be included for the use of the land?
[ ] $0
[ ] $200,000
[ ] $225,000
[ ] $325,000
√ [ ] $375,000
34) Your firm is selling a machine it purchased two years ago. The selling price is
approximately 50 percent less than the book value of the machine. As a result of this
transaction, your firm has a tax benefit in the amount of the tax rate multiplied by the
difference between the:
[ ] selling price and the original purchase price.
[ ] original purchase price and the book value.
[ ] selling price and the current market value.
√ [ ] selling price and the book value.
[ ] original purchase price and the current market value.
35) When evaluating a capital budgeting project, you ignore all cash flows of the firm
except those that change when a project is implemented. You are focusing on the:
[ ] capital expenditures.
[ ] operating cash flows.
√ [ ] incremental cash flows.
[ ] non-cash expenses.
[ ] opportunity costs.
life, will require a net working capital investment of $5,000 up front, has a tax rate of
34 percent and a required return of 10 percent. The fixed assets will be sold for
$2,000 at the end of year three. The project generates an operating cash flow of
$13,000. What is the project's net present value?
[ ] $10,724
[ ] $11,033
√ [ ] $12,077
[ ] $13,426
[ ] $15,942
37) You are considering the purchase of one of two machines required in your
production process. Machine A has a life of two years, costs $40 initially, and then
$60 per year in maintenance. Machine B costs $70, and requires $45 in maintenance
for each year of its 3-year life. Both machines must be replaced at the end of their
life. Which is the better machine for the firm? The discount rate is 15 percent and the
tax rate is zero.
[ ] Machine A is better because its net present value is higher than the net present
value of machine B.
[ ] Machine A is better because its equivalent annual cost is -$60.24, which is less
than the equivalent annual cost of -$87.54 for machine B.
[ ] Machine B is better because its equivalent annual cost is -$75.66, which is less
than the equivalent annual cost of -$90.12 for machine A.
√ [ ] Machine B is better because its equivalent annual cost is -$75.66, which is less
than the equivalent annual cost of -$84.60 for machine A.
[ ] Neither machine should be chosen since both have negative net present
values.
38) Which one of the following describes the "tax shield" approach to computing
[ ] NI + D
√ [ ] (S - C) X (1 - Tc) + D X Tc
[ ] S - C - Taxes
[ ] EBIT + D X - Tc
what is the internal rate of return of this project? Initial investment = $400,000; life =
4 years; cost savings = $125,000 per year; tax rate = 34 percent; discount rate = 12
percent. The fixed assets will be sold for $20,000 at the end of year 4.
[ ] 6.25 percent
√ [ ] 7.51 percent
[ ] 8.15 percent
[ ] 9.43 percent
[ ] 10.24 percent
40) Incremental cash flows are the difference between a firm's future cash flows if a
project is accepted and the future cash flows if the project is rejected.
√ [ ] True
[ ] False
41) You are considering a new project that will require an initial build up of raw
materials inventory. The expected life of the project's equipment is seven years. If all
goes as you expect, you will replace the equipment at the end of the seven years. If
not, you will terminate the project. You currently believe there is a fifty-fifty chance of
either occurrence. How should you treat the raw material inventory in year seven of
your present analysis and why?
[ ] treat half of it as a cash inflow because there is a 50 percent chance the project
will terminate then
[ ] treat it as a cash outflow because it is expected that the machines will be
replaced
√ [ ] treat it as a cash inflow because the replacement of the machines becomes a
new capital budgeting decision at that point
[ ] treat it as both a cash inflow and outflow with a net effect zero
[ ] treat half as a cash inflow in year seven, but also treat only half as a cash
outflow at the beginning of the project
42) The equivalent annual cost method of evaluating projects applies to projects that
have ________ economic lives and assets which will ________
[ ] equal; never be replaced.
[ ] equal; be replaced more or less indefinitely.
[ ] different; never be replaced.
√ [ ] different; be replaced more or less indefinitely.
[ ] either equal or different; never be replaced.
43) Your company may introduce a new line of tennis shoes. You have been given
the following projections: sales = 35,000 units at $40 per unit; variable costs = $25
per unit; fixed costs = $125,000 per year; initial investment = $1,000,000; project life
= 10 years. What is the net income for this project if the corporate tax rate is 34
percent? You may assume straight-line depreciation to a zero book value and a
discount rate of 12 percent.
[ ] $119,000
[ ] $165,000
√ [ ] $198,000
[ ] $264,000
[ ] $297,000
44) Which one of the following is NOT considered to be an incremental cash flow in
capital budgeting analysis?
[ ] opportunity cost
[ ] erosion
[ ] additions to NWC
√ [ ] sunk cost
[ ] fixed asset salvage values at the end of the project
45) When you set the net present value equal to zero in calculating your bid price
you are:
[ ] going to earn a net income of zero on the project.
[ ] appropriately including opportunity costs in your analysis.
[ ] certain to be the lowest bidder since any lower price will result in a negative
NPV.
[ ] assured of earning your firm's highest possible internal rate of return.
√ [ ] finding the price at which you expect to create zero wealth for your
stockholders.
what is the NPV for this project? Initial investment in fixed assets = $800,000; net
working capital requirement = $200,000; life = 4 years; cost savings = $400,000 per
year; tax rate = 35 percent; discount rate = 12 percent. The fixed assets will be sold
for $100,000 at the end of year 4. (Round to the nearest whole dollar)
[ ] $95,101
[ ] $105,967
[ ] $133,560
√ [ ] $170,738
[ ] $204,289
47) A sunk cost is:

√ [ ] a cost that has already been incurred and cannot be removed.
[ ] the same thing as an opportunity cost.
[ ] the cash flows of a new project that come at the expense of existing projects.
[ ] an important consideration in the capital budgeting process.
[ ] a form of financing cost.
48) Your firm needs a computerized line-boring machine that costs $80,000, and
requires $20,000 in maintenance for each year of its 3-year life. After 3 years, this
machine will be replaced. The machine falls into the MACRS 3-year class life
category. Assume a tax rate of 34 percent and a discount rate of 10 percent. Assume
the machine can be sold for $10,000 at the end of year three. What is the after-tax
salvage value at the end of year 3?
[ ] $4,544
[ ] $5,616
[ ] $6,600
√ [ ] $8,616
[ ] $9,678
49) Consider a $10,000 machine that will reduce pre-tax operating costs by $3,000
per year over a 5-year period. Assume no changes in net working capital and a scrap
value of zero after five years. For simplicity, assume straight-line depreciation to
zero, a marginal tax rate of 34 percent, and a required return of 10 percent. The net
present value, rounded to the nearest whole dollar, is:
√ [ ] $83.
[ ] $449.
[ ] $689.
[ ] $827.
[ ] $1,235.
50) If the assets of a project can be sold for an amount exactly equal to their book
value during the life of a project, the cash flow from the sale will be zero and can
therefore be ignored when analyzing a project.
[ ] True
√ [ ] False
51) Which one of the following is NOT a definition of operating cash flow?
[ ] NI + D
[ ] (S - C) X (1 - Tc) + D X Tc
[ ] S - C - Taxes
√ [ ] S - C - EBIT X (1 - Tc)
52) Which of the following can be depreciated for tax purposes?

I. machinery and equipment
II. land
III. buildings
[ ] I only
[ ] I and II only
[ ] II and III only
[ ] I, II, and III
53) Your company currently sells oversized golf clubs. The board of directors wants
you to look at replacing them with a line of super-sized clubs. Which one of the
following should NOT be included in an analysis of this proposed project?
[ ] $300,000 drop in sales from terminating the oversized line of clubs
[ ] $750,000 in land you own that may be used for the project
√ [ ] $200,000 spent on research and development last year on oversized clubs
[ ] $350,000 you will pay to Fred Singles to promote your new clubs
[ ] $125,000 you will receive by selling the existing production equipment which
must be replaced
54) Which one of the following statements regarding cash flow is correct?
[ ] Cash flow and net income are the same when the interest expense is ignored.
[ ] Interest expense is part of the operating cash flow of a project.
[ ] In evaluating capital budgeting decisions, cash flows should be valued on a pre-
tax basis.
[ ] After-tax cash flow is usually identical to accounting profits.
√ [ ] Incremental cash flows should include opportunity costs but not sunk costs.
55) Which one of the following statements regarding operating cash flows (OCF) is
correct?
[ ] In order to compute OCF, you need both a balance sheet and an income
statement.
√ [ ] Changes in OCF will occur when cost of goods sold changes, all else equal.
[ ] Changes in OCF result directly from changes in financing.
[ ] OCF for a project can be found by subtracting depreciation from project net
income.
[ ] An increase in depreciation will cause a decrease in OCF.
what is the payback period for this project? Initial investment = $500,000; life = 5
percent. The fixed assets will be sold for $30,000 at the end of year 5. (Round your
answer to the nearest 1/10th of a year)
[ ] 2.5 years
√ [ ] 3.6 years
[ ] 3.9 years
[ ] 4.4 years
[ ] The payback period is greater than the project's life
57) You are bidding to supply 3 jets per year for each of the next three years to the
Navy. To get set up, you will need $10 million in equipment which will be depreciated
straight-line to zero over three years and have no salvage value. Total fixed costs
per year are $5 million and variable costs are $7 million per jet. The tax rate is 30
percent and the required return is 10 percent. A reasonable bid, which leaves room
for a small margin of error, would be a price per jet of _____ million.
[ ] $5
[ ] $6
[ ] $9
√ [ ] $11
[ ] $32
58) Sunk cost is another term which describes opportunity cost.

[ ] True
√ [ ] False
59) The ________ is the present value of a project's costs calculated on an annual
basis.
√ [ ] equivalent annual cost
60) A firm experiences ________ when the cash flows of a new project come at the
expense of a firm's existing projects.
[ ] the stand-alone principle
[ ] sunk costs
√ [ ] erosion
[ ] capital analysis
[ ] a negative net present value
61) What is the difference between a project’s operating cash flow (OCF) and the
project’s cash flow (PCF)?
[ ] PCF = OCF plus the change in project change in net working capital minus plus
project capital spending
[ ] OCF = PCF minus the project change in net working capital plus depreciation
[ ] OCF = PCF plus the project change in net working capital
√ [ ] PCF = OCF minus the project change in net working capital minus the project
capital spending
[ ] PCF = OCF plus the depreciation tax shield.
62) You are advising a friend who is attempting to decide whether or not to drop one
of the courses they are currently enrolled in. If they do, they will forfeit half of the
money spent on tuition. Which of the following conclusions drawn by your friend is
consistent with capital budgeting principles?
I. Remaining in the class incurs opportunity cost because they have to reduce the
number of hours they are gainfully employed.
II. The tuition is irrelevant to the decision because it is a sunk cost.
III. The time and energy put into the course thus far is a sunk cost.
[ ] I only
[ ] I and II only
[ ] II and III only
[ ] I, II, and III
63) A taxable gain occurs when an asset is sold for more than its book value. For
capital budgeting purposes, the taxes on the sale are treated as a:
[ ] reduction in cash and added to operating cash flow.
[ ] noncash event similar to depreciation.
[ ] reduction in cash and deducted from the book value of the asset.
[ ] reduction in cash and deducted from the taxable gain.
√ [ ] reduction in cash and deducted from the sale price.
64) Consider the following balance sheet entries:

Entry : Beginning : Ending
Accounts receivable (AR) : $250 : $270
Inventory (I) : $225 : $218
Accounts payable (AP) : $250 : $241
What is the net cash flow from net working capital?
[ ] -28
√ [ ] -22
[ ] -4
[ ]4
[ ] 18
65) Which of the following describe relevant cash flows for the purpose of performing
capital budgeting analysis?
I. incremental cash flow
II. tax shield
III. changes in net working capital
IV. changes in fixed assets
[ ] I and III only
[ ] I and IV only
√ [ ] I, II, III, and IV
66) A company which has a policy of "cash sales only" is considering allowing
customers to buy on credit. Which one of the following will probably occur if this
change is implemented?
[ ] sales will decrease
[ ] there will be an immediate cash inflow
√ [ ] accounts receivable will increase
[ ] net working capital will decrease
[ ] billing and collection expenses will decrease
category. Assume a tax rate of 34 percent and a discount rate of 10 percent. What is
the depreciation tax shield for year 3?
[ ] $2,016
[ ] $3,513
√ [ ] $4,031
[ ] $5,222
[ ] $5,719
68) The depreciation tax shield is the tax savings which results from the depreciation
deduction.
√ [ ] True
[ ] False
69) Your company is considering three different methods of production: purchase

production equipment, lease production equipment, or contract with a supplier to
purchase the product from them. The methods have differing lives and cash flow
streams. You are responsible for choosing one of the methods. Of the following, the
best statement of your objective is to choose the method that:
[ ] will least affect the balance sheet of the company.
[ ] maximizes future cash inflows.
[ ] will result in the highest accounting net income.
[ ] minimizes initial cash outflows.
√ [ ] maximizes shareholder wealth.
70) The information you have on a proposed project includes the sales, net income,
depreciation, and the initial investment. The easiest method for you to use to
compute the operating cash flow is the _____ method.
[ ] conventional
[ ] tax shield
√ [ ] bottom-up
[ ] top-down
[ ] depreciation first
71) Assume a project requires additions to net working capital in each year of its life.
All of the net working capital will be recovered at the end of the project. In this case,
the present value of the net working capital recovery will exceed the total dollar
outlays for net working capital.
[ ] True
√ [ ] False
72) A decrease in the corporate tax rate decreases the value of the depreciation tax
shield, all else equal.
√ [ ] True
[ ] False

Inventory (I) : $225 : $218
Which of the accounts represent(s) a cash inflow?
[ ] AR only
[ ] AP only
√ [ ] I only
[ ] AR and AP only
[ ] I and AP only
percent. What is the value of the tax shield in each period from the investment in the
process?
[ ] $6.80
[ ] $8.50
√ [ ] $14.17
[ ] $27.50
[ ] $41.67
75) Which one of the following is true about net working capital?
[ ] Projects in which a firm expands its operations and sales will generally not lead
to changes in net working capital.
√ [ ] Changes in net working capital account for differences between accounting
sales and costs and actual cash receipts and payments.
[ ] Net working capital is typically an expense at the beginning of a project and an
equal inflow at the end, thus having no impact on NPV.
[ ] Dollar changes in the cash account and changes in net working capital are
generally equal.
[ ] Net working capital is not considered an investment for the firm.
76) The incremental cash flows related to a capital investment project are easiest to
identify when:
[ ] sunk costs exist.
[ ] opportunity costs are significant.
√ [ ] a proposed project has no effect on the current operations.
[ ] erosion of cash flow is expected to occur.
[ ] the project has no impact on total fixed assets.
what is the discounted payback period for this project? Initial investment = $500,000;
life = 5 years; cost savings = $160,000 per year; salvage = $30,000 in year 5; tax
rate = 34 percent; discount rate = 13 percent.
[ ] more than 3.0 but less than 3.5 years
√ [ ] more than 4.5 but less than 5.0 years
[ ] The discounted payback period is greater than the project's life
percent. Suppose the equipment is sold at the end of year 3 for $20, pretax. What is
the net present value? (Round to the nearest whole dollar)
[ ] $33
[ ] $37
[ ] $39
√ [ ] $42
[ ] $46
79) A sunk cost is an incremental cash flow.
[ ] True
√ [ ] False
80) An increase in which of the following is a use of funds?

I. receivables
II. payables
III. inventory
IV. sales
[ ] I and IV only
[ ] II and III only
[ ] II and IV only
81) The managers of Poncho Parts, Inc. plan to manufacture engine blocks for
classic cars from the 1960s. They expect to sell 250 blocks annually for the next 5
years. The necessary foundry and machining equipment will cost a total of $800,000
and will be depreciated on a straight-line basis to zero over the project's life. The firm
expects to be able to sell the equipment for $150,000 at the end of 5 years. Labor
and materials costs total $500 per engine block, fixed costs are $125,000 per year.
Assume a 35 percent tax rate and a 12 percent discount rate. What is the expected
after-tax cash flow to the firm when the equipment is sold in year five?
[ ] $65,000
√ [ ] $97,500
[ ] $100,000
[ ] $115,000
[ ] $120,125
82) The government has been trying to decide whether or not to purchase any of the
new, advanced missiles it has developed. One of the arguments in favor of
purchasing the missiles is that so much money has been spent on their development
that it would be a waste of money not to buy any. What is the major problem with this
argument?
[ ] It ignores the opportunity cost of the money that has been spent.
√ [ ] It includes sunk costs in the decision.
[ ] It includes opportunity costs in the decision.
[ ] It includes changes in net working capital.
[ ] It includes financing costs in the decision.
83) In a cost cutting proposal, the net present value will generally be negative but the
project will still be considered acceptable.
[ ] True
√ [ ] False
84) Which of the following methods for computing project operating cash flow could
you use if the only income statement items you know are project net income and
project depreciation?
I. bottom-up approach
II. top-down approach
III. tax shield approach
√ [ ] I only
[ ] II only
[ ] III only
[ ] I and II only
[ ] I and III only
85) Your scientists just discovered that the engine-oil additive they developed three
years ago makes a great men's aftershave when diluted properly using certain
chemicals. You are analyzing the proposal to commence production of this after
shave. For this analysis, the $125,000 that was spent doing research to develop the
engine-oil additive should be treated as:
[ ] a cash outflow three years ago
[ ] an initial investment today.
[ ] an annual cost over the life of the project.
[ ] an incremental cost.
√ [ ] a sunk cost.
86) Side effects such as erosion should be considered in a capital budgeting

decision.
√ [ ] True
[ ] False
87) Which of the following is (are) explicitly considered in the calculation of MACRS
depreciation?
I. actual expected economic life of the asset
II. asset cost
III. asset property class
IV. expected salvage value
[ ] IV only
√ [ ] II and III only
[ ] I and IV only
[ ] III only
88) When we employ _______, we are evaluating a project on the basis of its
incremental cash flows, thereby ignoring the other cash flows of the firm.
√ [ ] the stand-alone principle
[ ] the equivalence theorem
[ ] the law of one price
[ ] Bell's theorem
[ ] the equivalent annual cost procedure
89) Pro forma statements:

[ ] are generally created by first estimating production costs.
[ ] for a proposed project generally consider only the first year of the project.
[ ] recap a firm’s activities for the past year.
[ ] should only be prepared when considering a capital budgeting project.
√ [ ] should use realistic assumptions.
category. Assume a tax rate of 34 percent and a discount rate of 10 percent. What is
the annual after-tax maintenance cost?
[ ] $10,000
[ ] $12,250
√ [ ] $13,200
[ ] $15,250
[ ] $27,200
91) You are given the following information about equipment that is required for your
business. Assume that the equipment will be replaced as it wears out, that you can
only buy one of the machines, and that straight-line depreciation to zero is used. The
required return is 15 percent. Ignore taxes. Machine A has an initial cost of
$200,000, an operating cost per year of $15,000, and an expected life of 8 years.
Machine B has an initial cost of $300,000, an operating cost per year of $17,500, and
an expected life of 10 years. Which machine should you buy and why?
[ ] Machine A; because it has a higher net present value
√ [ ] Machine A; because it effectively costs less to operate each year
[ ] Machine B; because it has a higher net present value
[ ] Machine B; because it effectively costs less to operate each year
[ ] Neither; because both machines have negative net present values
92) Which of the following allow you to compute operating cash flow without actually
knowing the dollar amount of depreciation?
I. bottom-up approach
II. top-down approach
III. tax shield approach
[ ] I only
√ [ ] II only
[ ] III only
[ ] II and III only
[ ] I, II, and III
93) Which one of the following describes the "top-down" approach to computing
[ ] S - C - Taxes + D
[ ] (S - C) X (1 - Tc) + D X Tc
√ [ ] S - C - Taxes
[ ] NI + D
what is the IRR for this project? Initial investment in fixed assets = $800,000; net
working capital = $200,000; life = 4 years; cost savings = $400,000 per year; salvage
= $100,000 in year 4; tax rate = 35 percent; discount rate = 12 percent.
[ ] 12.0 percent
[ ] 13.6 percent
[ ] 14.8 percent
[ ] 18.4 percent
√ [ ] 19.1 percent
95) Which one of the following is correct concerning project evaluation?

[ ] Financing costs must be included in the cash flows of a proposed project
because they are not accounted for elsewhere.
√ [ ] The stand-alone principle calls for evaluation of a project based on the project's
incremental cash flows.
[ ] Changes in net working capital are excluded from the incremental cash flows of
a project.
[ ] When fixed assets are sold at the end of a project, there are usually no tax
consequences of the sale.
[ ] The decision to use straight-line depreciation or MACRS depreciation is used
will have no impact on the net present value of a project.
what is the profitability index for this project? Initial investment = $500,000; life = 5
percent. The fixed assets will be sold for $10,000 at the end of year 5.
[ ] 0.45
[ ] 0.74
√ [ ] 0.99
[ ] 1.65
[ ] 1.98
97) Taxes are not an important consideration in evaluating capital investment

proposals.
[ ] True
√ [ ] False

I. Setting the bid price requires finding the point at which NPV is zero.
II. In a cost-cutting proposal the reduction in costs has the same effect as an
increase in sales.
III. Equivalent annual cost is used to evaluate mutually exclusive projects with
different lives if the projects are expected to be replicated forever.
[ ] III only
[ ] I and II only
[ ] I and III only
[ ] II and III only
99) Net working capital is expected to increase from $1,000 to $1,500 if a new
project is implemented. The $500 increase should be included as a part of the initial
outlay for the new project.
√ [ ] True
[ ] False

Inventory (I) : $225 : $218
Which of the accounts represent(s) a cash outflow?
[ ] AR only
[ ] AP only
[ ] I only
√ [ ] AR and AP only
[ ] I and AP only
101) A firm is considering a project that would increase accounts receivable by

$10,000, accounts payable by $35,000, and inventory by $30,000. Which one of the
following is true if the project is accepted?
[ ] sales will increase
[ ] current assets will decrease
[ ] net working capital will decrease
[ ] project net working capital will be a source of cash
√[ ] current liabilities will increase
102) It is important to identify and use only incremental cash flows in capital
investment decisions:
[ ] because they are the simplest to identify.
[ ] only when the stand alone principle fails to hold.
√ [ ] because ultimately it is the change in a firm's overall future cash flows that
matter.
[ ] in order to accommodate unforeseen changes that might occur.
[ ] whenever sunk costs are involved.
103) You are given the following information about equipment that is required for
your business. Assume that the equipment will be replaced as it wears out and that
straight-line depreciation to zero is used. The required return is 15 percent. Ignore
taxes. Machine A has an initial cost of $200,000, an operating cost per year of
$15,000, and an expected life of 8 years. Machine B has an initial cost of $300,000,
an operating cost per year of $17,500, and an expected life of 10 years. What is the
equivalent annual cost of machine B?
[ ] -$61,664
√ [ ] -$77,276
[ ] -$85,776
[ ] -$90,163
[ ] -$94,113
Ch11
1) A firm has identified positive net present value projects costing a combined total
of $240,000. The firm allocates only $200,000 to be used for capital investment
even though it has the ability to fund the entire $240,000. This is an example of:
[ ] implementing the degree of operating leverage limitation.
[ ] limiting sales to the cash break-even point.
[ ] hard rationing imposed internally.
√ [ ] soft rationing being utilized.
[ ] capital intensity limitation policy.
2) A financial manager reviewing a project is concerned about the level of

forecasting risk in the project's forecasted cash flows. The manager should use
________ analysis to identify the variable that presents the highest degree of
forecasting risk.
[ ] scenario
[ ] simulation
√ [ ] sensitivity
[ ] break-even
[ ] strategic options
3) Which one of the following statements is NOT correct?

[ ] Forecasting risk is the possibility that errors in projected cash flows lead to
incorrect decisions.
[ ] Scenario analysis is the determination of what happens to net present value
estimates if we ask "what-if" questions.
[ ] Sensitivity analysis is an investigation of what happens to net present value
when only one variable is changed.
[ ] Simulation analysis is a combination of scenario and sensitivity analysis.
√ [ ] Fixed costs are costs that change when the quantity of output changes during a
particular time period.
4) A firm that cannot raise funds in the financial markets in order to finance positive
net present value projects is said to face soft capital rationing.
[ ] True
√ [ ] False
5) The purpose of scenario analysis is to:

[ ] evaluate all possible cash flow forecasts.
[ ] evaluate all possible contingencies and prepare for the occurrence of each.
[ ] analyze highly negative net present value projects more closely.
√ [ ] assess the reasonableness of the cash flows that form the basis for a net
present value calculation.
[ ] gauge the effectiveness of a capital budgeting project after it is already
operating.
6) Simulation analysis is a combination of scenario and sensitivity analysis.

√ [ ] True
[ ] False
7) _____costs are costs that do NOT change directly with the quantity of output.
√ [ ] Fixed
[ ] Variable
[ ] Fixed and variable
[ ] Semi-fixed
[ ] Semi-variable
8) Which of the following is a possible reason for determining the accounting break-
even point?
I. It provides another test of the accuracy of the sales forecasts.
II. It is relatively easy to calculate and explain.
III. It identifies the contribution a project will make to a firm's cash flow.
IV. A project that breaks even on an accounting basis will also break even on a
financial basis.
[ ] II and IV only
9) A firm that substitutes labor for machinery and equipment is said to be capital-
intensive.
[ ] True
√ [ ] False
10) A firm has fixed costs of $30,000 per year, depreciation of $10,000 per year, a
price per unit of $50, and an accounting break-even point of 2,000 units. What is the
firm's total variable cost at the accounting break-even point?
[ ] $40,000
[ ] $50,000
√ [ ] $60,000
[ ] $70,000
[ ] $80,000
11) Which of the following statements are true concerning scenario analysis?
I. A positive net present value for a project's worst case scenario guarantees you a
positive return from the project.
II. The base case scenario generally represents an average estimate of the net
present value.
III. If the net present value of the best case scenario is negative then it is probably
unnecessary to create base and worst case scenarios.
IV. Scenario analysis is less apt than sensitivity analysis to determine which variable
has the greatest impact on the projected net present value.
[ ] I and II only
[ ] II and IV only
[ ] III and IV only
√ [ ] II, III, and IV only
12) Which of the following are true concerning the financial break-even point?
I. The net present value is zero.
II. The discounted payback period is equal to the life of the project.
III. The internal rate of return is equal to the required return.
IV. The payback period is equal to the life of the project.
[ ] I and II only
[ ] III and IV only
√ [ ] I, II, and III only
13) A project that just breaks even on a financial basis has a profitability indicator
that is equal to zero.
[ ] True
√ [ ] False
14) A project that just breaks even on an accounting basis has a discounted
payback period equal to its life.
[ ] True
√ [ ] False
15) A project has a selling price of $40 per unit, a variable cost of $20 per unit, fixed
costs of $95,000 per year, and depreciation of $35,000 per year. The sales quantity
is 10,000 units per year. What is the degree of operating leverage if the tax rate is
zero percent?
[ ] 0.9
[ ] 1.3
[ ] 1.5
√[ ] 1.9
[ ] 2.4
16) Which of the following is (are) true about a project that breaks even on a cash
basis and has an initial cash outflow of $100,000?
I. The project has a zero internal rate of return.
II. The project has a negative net present value.
III. The project has a zero net present value.
IV. The project has an internal rate of return equal to the firm's required return.
[ ] I only
√ [ ] II only
[ ] III only
[ ] II and III only
17) Which of the following describe(s) fixed costs?

I. costs which are constant for a given period of time
II. costs that are equal to zero when production is zero
III. costs that change with the quantity of output
√ [ ] I only
[ ] II only
[ ] I and II only
[ ] I and III only
[ ] II and III only
18) Which of the following will decrease if you decrease the level of fixed costs, all
else equal?
I. operating leverage
II. accounting break-even
III. operating cash flow
IV. cash break-even
[ ] I and II only
[ ] II and IV only
19) Which of the following would likely lead to the largest number of net present
value calculations?
[ ] scenario analysis
[ ] sensitivity analysis
[ ] base-case analysis
√[ ] simulation analysis
[ ] break-even analysis
20) Positive net present value projects:

√ [ ] tend to be rare in a highly competitive market.
[ ] will likely have a source of value that is difficult to determine.
[ ] tend to be rare in a highly monopolistic market.
[ ] will typically occur in international markets, but not domestic markets.
[ ] are common for firms in old, well established industries.
21) ________ analysis combines ________ analysis and ________ analysis.

[ ] Scenario; sensitivity; simulation
[ ] Sensitivity; simulation; scenario
[ ] Break-even; scenario; simulation
√ [ ] Simulation; scenario; sensitivity
[ ] Simulation; sensitivity; break-even
22) Which of the following are correct statements concerning break-even analysis?
I. Accounting break-even is the sales level that results in zero project net income.
II. The cash break-even is the sales level that results in a zero operating cash flow.
III. The financial break-even is the sales level that results in a zero net present
value.
IV. Of the three break-evens, the financial break-even level of sales is generally the
highest.
[ ] I and II only
23) If you are interested in finding out how sensitive your net present value estimate
is to changes in the variable costs, you should use scenario analysis.
[ ] True
√ [ ] False
24) Suppose that a project has a degree of operating leverage of 0.75. If the
quantity being produced increases from 96 to 100, what is the expected percent
change in operating cash flow?
[ ] -2.5 percent
√ [ ] 3.1 percent
[ ] 4.2 percent
[ ] 5.5 percent
[ ] 6.2 percent
25) Which one of the following statements concerning simulation analysis is correct?
√ [ ] In simulation analysis, several different variables can be allowed to take on a
large number of values.
[ ] An advantage of simulation analysis is that once the results of simulation
analysis are in there is often no clear decision rule to follow.
[ ] Simulation analysis is very complex and costly to perform.
[ ] Powerful computers are making the task of simulation analysis ever more
complicated.
[ ] In simulation analysis, the probability of occurrence of different cases is
generally very difficult to assess.
26) Which of the following statements regarding net present value (NPV) analysis is
correct?
√ [ ] The actual worth of any NPV calculation depends on the accuracy of the cash
flow projections used.
[ ] NPV calculations are fairly reliable even when the cash flows used are highly
questionable.
[ ] Negative NPV projects should be scrutinized to make sure there is a sound
economic basis underlying them.
[ ] Positive NPV projects that have relatively low levels of fixed costs should be
more heavily scrutinized than projects with relatively high levels of fixed costs.
[ ] NPV calculations are fairly reliable even when an inappropriate discount rate is
used.
27) A project with conventional cash flows that just breaks even on an accounting
basis:
[ ] pays back on a discounted basis.
[ ] has an operating cash flow that exceeds the amount of the depreciation.
√ [ ] has an internal rate of return that is equal to zero.
[ ] has a positive net present value.
[ ] has a profitability index that is greater than one.
28) Which one of the following statements is accurate?

[ ] A project that just breaks even on an accounting basis will not pay back.
[ ] A project that just breaks even on an accounting basis will have a positive rate
of return.
[ ] A project cannot earn a positive return unless its payback period is longer than
the project life.
√ [ ] If the net income from a project is zero, then the operating cash flow is equal to
the depreciation expense given that both interest expense and taxes are equal to
zero.
[ ] If you only know the life of a project and the project’s payback period, you can
determine the financial break-even point.
29) What is the accounting break-even for a project with a selling price of $100 per
unit, variable cost of $24 per unit, fixed cost of $40,000 per year, and depreciation of
$10,000 per year? Assume a discount rate of 10 percent, an initial project cash
outlay of $100,000, a project life of 10 years, and a zero tax rate.
[ ] 527 units
[ ] 624 units
√ [ ] 658 units
[ ] 925 units
[ ] 1,130 units
30) A project that just breaks even on ________ basis will have a payback period
that is shorter than the life of the project.
I. an accounting
II. a cash
III. a financial
[ ] I only
[ ] II only
√ [ ] III only
[ ] I and II only
[ ] II and III only
31) A project that just breaks even on a cash basis must have a zero net present
value.
[ ] True
√ [ ] False
32) What is the contribution margin of a project with a selling price of $80 per unit,
variable cost of $26 per unit, fixed cost of $30,000 per year, and a sales quantity of
10,000 units?
[ ] $49
[ ] $51
√ [ ] $54
[ ] $57
[ ] $77
33) Given a tax rate of zero, the accounting break-even point for a project:
[ ] indicates when the net present value turns positive.
[ ] excludes depreciation in its computation.
[ ] is the same as the cash break-even point.
√[ ] indicates the point at which operating cash flow is equal to depreciation.
[ ] describes the point below which the sales level results in a positive net income.
34) A project that just breaks even on a financial basis has a discounted payback
equal to the project's life.
√ [ ] True
[ ] False
35) If a division of a firm finds an exceptionally worthwhile positive net present value
project they still will not be able to obtain funding if they are under hard rationing.
√ [ ] True
[ ] False
36) A firm that faces capital rationing must select a subset of capital projects based
on some ranking criterion. The capital budgeting technique best suited for this is the:
[ ] internal rate of return.
√ [ ] profitability index.
[ ] average accounting return.
[ ] payback.
37) Which of the following describe(s) variable costs?

I. costs that can be forecasted with a high degree of accuracy
II. costs that are equal to zero when production is zero
III. costs that change with the quantity of output
[ ] II only
[ ] I and II only
[ ] I and III only
38) Which of the following requires finding the point at which at the net present
value of a project is equal to zero?
I. finding the project’s internal rate of return
II. finding the point at which the internal rate of return is equal to zero
III. finding the point at which the project pays back on a discounted basis
IV. finding the financial break-even point
[ ] I and III only
[ ] II and IV only
√ [ ] I, III, and IV only
39) _____ analysis investigates the impact on net present value of allowing one
variable to change while holding all other variables constant.
[ ] Scenario
[ ] Break-even
[ ] Strategic options
[ ] Simulation
√ [ ] Sensitivity
40) The projected cash flows of a project are typically defined as:
[ ] the most optimistic estimates that can be obtained.
√ [ ] an average of the possible cash flows from the various scenarios.
[ ] the largest possible cash flows.
[ ] the cash flows that result in a zero net present value.
[ ] the least likely cash flows.
41) What is the accounting break-even point for a project with a selling price of $50
per unit, variable cost of $35 per unit, annual fixed costs of $50,000, and
depreciation of $10,000?
[ ] 1,160 units
[ ] 2,298 units
[ ] 3,333 units
[ ] 3,429 units
√ [ ] 4,000 units
42) Which one of the following is a fixed cost over a given time period?
[ ] sales commissions
√ [ ] salary of the chief financial officer
[ ] manufacturing labor cost
[ ] shipping expense
[ ] the cost of electricity
43) A project has a required return of 10 percent and a zero tax rate. At the
accounting break-even point, the:
[ ] net present value is positive.
[ ] net income is positive.
√ [ ] project’s operating cash flow is equal to the depreciation expense.
[ ] project's cash flow is equal to zero each year.
[ ] price per unit and variable cost per unit are equal to one another.
44) A project that has an IRR equal to _____ just breaks even on a financial basis.
[ ] zero percent
[ ] its AAR
√ [ ] its required return
[ ] 100 percent
[ ] -100 percent
45) A firm has a 2.5 degree of operating leverage. If sales decline by 20 percent,
then the operating cash flow will:
[ ] decline by 20 percent.
[ ] decline by 5 percent.
[ ] rise by 20 percent.
[ ] fall by 12.5 percent.
√ [ ] fall by 50 percent.
46) Fixed costs are costs that do not change when the quantity of output changes
during a particular time period.
√ [ ] True
[ ] False
47) A project that has an internal rate of return equal to -100 percent is operating at
the ________ break-even point.
√ [ ] cash
[ ] accounting
[ ] financial
[ ] income
[ ] cost
48) If a firm revises its production process to use more labor and less machinery,
the firm will have ________, all else equal. For the sake of simplicity, assume the
operating cash flow doesn't change in this case.
I. an increased capital intensity
II. a decreased accounting break-even
III. an increased degree of operating leverage
IV. smaller changes in OCF for a given change in sales quantity
[ ] I and III only
√ [ ] II and IV only
49) If the degree of operating leverage is 1.05 and operating cash flow rises from
$10,000 to $12,500, what is the percentage change in sales?
[ ] 18.6 percent
[ ] 19.2 percent
[ ] 22.3 percent
√ [ ] 23.8 percent
[ ] 26.3 percent
50) What is the accounting break-even point for a firm with total costs of $135,000,
variable cost of $10 per unit, sales of 10,000 units, a selling price of $25 a unit, and
depreciation of $10,000?
[ ] 1,667 units
[ ] 1,750 units
[ ] 1,886 units
[ ] 2,333 units
√ [ ] 3,000 units
51) _____ describes the likelihood of making a bad investment decision because of
errors in projected cash flows.
√ [ ] Forecasting risk
[ ] Erosion
[ ] Scenario risk
[ ] Incremental cash flow risk
[ ] Operating risk
52) A division within a firm that cannot obtain funds to finance positive net present
value projects due to internal constraints is said to be facing hard capital rationing.
[ ] True
√ [ ] False
53) The higher the degree of operating leverage:

I. the greater is the risk of forecasting error.
II. the lower is the risk of forecasting error.
III. the higher the break-even point, regardless of the measure.
IV. the lower the break-even point, regardless of the measure.
[ ] I only
[ ] I and IV only
[ ] II and III only
[ ] II and IV only
54) _____ analysis is a useful tool for directly examining the relationship between
sales volume and profitability.
[ ] Scenario
√ [ ] Break-even
[ ] Strategic options
[ ] Simulation
[ ] Contingency
55) Which one of the following statements is correct?

√ [ ] A firm with high operating leverage will have higher total fixed costs than a firm
with low operating leverage, all else equal.
[ ] It is typically easier to decrease operating leverage than it is to increase it, all
else equal.
[ ] Operating leverage will rise as output increases, all else equal.
[ ] In order to compute the degree of operating leverage, you only need the
variable costs and operating cash flow estimates.
[ ] The degree of operating leverage rises as the price per unit is increased, all
else equal.
56) Which one of the following is generally the LEAST subject to forecasting risk?
[ ] projected sales
√ [ ] initial investment
[ ] projected fixed costs
[ ] price per unit
[ ] total variable costs
57) Of the break-even levels discussed, the financial break-even point is the most
critical for a firm to obtain.
√ [ ] True
[ ] False
58) A project that has a negative net present value will also:
I. have a discounted payback period less than its life.
II. exceed its accounting break-even point.
III. have an internal rate of return that is less than the required return.
IV. have a profitability ratio that is less than 1.0.
[ ] I and III only
[ ] II and III only
59) After ten years as a general auto mechanic in a local garage, Joe decides he is
tired of working for others, especially since business is typically slow and he works
partially on commission. Thus, he decides to open his own garage. After estimating
the cash flows for his new garage, he determines that having his own garage should
generate a large positive net present value. Which of the following is most likely true
about his analysis?
[ ] The discount rate he used must be too high.
√ [ ] Unless he can find a true source of value in his new venture, he probably made
a mistake in estimating his cash flows.
[ ] He has likely been overly optimistic about the future and has underestimated
future cash flows.
[ ] His estimates of initial cash outlays must be understated.
[ ] His analysis is probably correct provided there is major competition in the auto
repair business.
60) Which one of the following is a variable cost over a given time period?
√ [ ] sales commissions
[ ] salary of the chief financial officer
[ ] automobile lease expense
[ ] wages for the cleaning crew
[ ] insurance for the corporation's buildings
61) Which of the following describes accounting break-even? In this case, v is

variable cost per unit, Q is quantity sold, VC is total variable cost, D is depreciation,
and FC is total fixed cost.
√ [ ] Q = (FC + D) / (P - v)
[ ] Q = (FC - D) / (P + v)
[ ] Q = (P X v) / (FC + D)
[ ] Q = FC + [D / (P - v)]
[ ] Q = FC / (P - v)
62) A project's total fixed costs are exactly equal to its depreciation and both are
greater than zero. What is the degree of operating leverage at the financial break-
even point? The project has conventional cash flows, no salvage value and no net
working capital requirements.
√ [ ] less than 2
[ ]2
[ ] greater than 2
[ ] undefined since you can't divide by zero
[ ] cannot be determined without more information
63) What is the cash break even point for a project with a selling price of $100 per
unit, variable cost of $24 per unit, fixed cost of $40,000 per year, and depreciation of
$10,000 per year? Ignore taxes.
√ [ ] 527 units
[ ] 624 units
[ ] 658 units
[ ] 741 units
[ ] 1,130 units
64) A farmer in the Midwest hires a grain harvesting crew from Oklahoma to harvest
his wheat at the end of each summer. Because the crop yield varies from year to
year, the crew charges the farmer according to the number of bushels actually
harvested. For capital budgeting purposes, the harvesting charges should be
classified as a:
[ ] fixed cost since they must be paid each year.
[ ] fixed cost since the crew will be paid regardless of whether or not the crop is
harvested.
√ [ ] variable cost since, if the crop yield is zero bushels, the crew receives no
payment.
[ ] combination of fixed and variable cost, the variable portion of which is based
on forecasted bushels harvested.
[ ] variable cost only if the crop yield is poor in a given year.
65) Which of the following describes total cost? In this case, v is variable cost per
unit, Q is quantity sold, VC is total variable cost, and FC is total fixed cost.
[ ] TC = v X Q
[ ] TC = v + FC X Q
[ ] TC = VC - FC
√ [ ] TC = v X Q + FC
[ ] TC = v X Q + FC X Q
66) ________ analysis allows a firm to analyze the outcome of various situations
developed by asking "what if" questions.
I. Scenario
II. Sensitivity
III. Simulation
IV. Break-even
[ ] I and II only
[ ] II and III only
67) Costs that result from a small change in output are called ________ costs.
[ ] fixed
√ [ ] marginal
[ ] average
[ ] special
[ ] product
68) A project should automatically be accepted when the project's base case net
present value is positive.
[ ] True
√ [ ] False
69) Your company's scientists have developed an exciting new product that is unlike
anything presently available to consumers. The net present value of bringing this
product to market is positive yet you are uncertain about the sales projections. The
best way for you to test the validity of the sales projections is to use _____ analysis.
[ ] sensitivity and payback
[ ] payback and break-even
√ [ ] break-even and sensitivity
[ ] operating leverage
[ ] cost
70) A project that just breaks even on a cash basis has a discounted payback period
equal to its life.
[ ] True
√ [ ] False
71) A project has a selling price of $30, a variable cost of $10, fixed costs of
$25,000, depreciation of $5,000, and a tax rate of 34 percent. What is the operating
cash flow at the accounting break-even point?
[ ] $1,750
√ [ ] $5,000
[ ] $15,000
[ ] $25,000
[ ] $35,000
72) A project that just breaks even on ________ basis will not pay back.
I. an accounting
II. a cash
III. a financial
[ ] I only
√[ ] II only
[ ] III only
[ ] I and II only
[ ] II and III only
73) A project that just breaks even on an accounting basis will:

I. lose money in a financial sense.
II. have a zero operating cash flow.
III. not affect total net income for a firm.
IV. have a discounted payback period equal to the life of the project.
[ ] I and II only
[ ] III and IV only
[ ] II and IV only
74) ________ risk refers to the possibility that you make a bad decision because of
errors in the projected cash flows.
I. Scenario
II. Forecasting
III. Leverage
[ ] I only
√ [ ] II only
[ ] I and III only
[ ] II and III only
[ ] I, II, and III
75) A project that just breaks even on an accounting basis must have a positive net
present value.
[ ] True
√ [ ] False
76) The process of identifying the variable within a project that has the most
forecasting risk is known as:
[ ] scenario analysis.
√ [ ] sensitivity analysis.
[ ] contingency planning.
[ ] break-even analysis.
[ ] discretionary analysis.
77) Economic theory suggests that ________ the likelihood of discovering a positive
net present value (NPV) project.
[ ] the more competitive the market, the higher
[ ] there is a positive relationship between the competitiveness of a market and
[ ] the competitiveness of a market has an indirect impact on
[ ] the competitiveness of a market has an insignificant impact on
√[ ] competitive markets decrease
78) Which of the following is (are) true regarding soft rationing (SR) and hard
rationing (HR)?
I. HR is self imposed while SR is imposed by the marketplace.
II. SR affects individual parts of a company while HR affects the company as a
whole.
III. SR can lead to HR.
[ ] I only
√ [ ] II only
[ ] I and II only
[ ] I and III only
[ ] I, II, and III
79) The higher the degree of operating leverage, the greater the danger of
forecasting risk.
√ [ ] True
[ ] False
80) The sales level that most likely has zero earnings before interest and taxes is
called the ________ break-even point.
[ ] cash
√ [ ] accounting
[ ] financial
[ ] income
[ ] cost
81) If the cash flows of a project are positive then the net present value of the
project must be positive.
[ ] True
√ [ ] False
82) A firm's total fixed costs are exactly equal to its depreciation, and both are
greater than zero. The tax rate is zero percent. At the accounting break-even point,
the degree of operating leverage:
[ ] is equal to 1.
√ [ ] is equal to 2.
[ ] is greater than 2.
[ ] is undefined since you can't divide by zero.
[ ] cannot be determined without more information.
83) A firm has fixed costs of $30,000 per year, depreciation of $10,000 per year, a
price per unit of $50, and an accounting break-even point of 2,000 units. What is
the firm's marginal cost at the accounting break-even point?
[ ] $12
[ ] $15
[ ] $20
[ ] $25
√ [ ] $30
84) You want to determine how changes in the price of a product affect a project's
net present value and internal rate of return. To determine this impact, you should
use _____ analysis.
[ ] scenario
√ [ ] sensitivity
[ ] base-case
[ ] simulation
[ ] multiple-outcome
85) A project that is operating at its ________ break-even point will have a NPV of
zero.
[ ] cash
[ ] accounting
√ [ ] financial
[ ] NPV
[ ] OCF
86) Mondo Mfg. has a degree of operating leverage of 2.5. If the sales quantity falls
by 10 percent, Mondo's operating cash flow should:
[ ] decrease by 10 percent.
√ [ ] decrease by 25 percent.
[ ] increase by 10 percent.
[ ] increase by 25 percent.
[ ] not change at all.
87) A project that has an internal rate of return equal to _____ just breaks even on
an accounting basis.
[ ] its required return
[ ] its average accounting return
√ [ ] 0 percent
[ ] 100 percent
[ ] -100 percent
88) If you see a worst case analysis for a project, the project is likely being
evaluated using ________ analysis.
√ [ ] scenario
[ ] sensitivity
[ ] base-case
[ ] simulation
[ ] multiple-outcome
89) A firm's total fixed costs are exactly equal to its depreciation. At the cash break-
even point, the degree of operating leverage:
[ ] is equal to 1.
[ ] is equal to 2.
[ ] is greater than 2.
√ [ ] is undefined since you can't divide by zero.
[ ] cannot be determined without more information.
90) The situation that is most likely to exist if a project is accepted is known as the:
[ ] worst case scenario.
[ ] best case scenario.
√ [ ] base case scenario.
[ ] sales sensitivity situation.
[ ] variable cost sensitivity situation.
91) Which of the following is (are) true about a project that breaks even on a
financial basis?
I. The project has a zero internal rate of return.
II. The project has a negative net present value.
III. The project has a zero net present value.
IV. The project has an internal rate of return equal to the firm's required return.
[ ] I only
[ ] III only
[ ] II and IV only
[ ] I and III only
92) In previous chapters, you computed net present value based on a project's
average or expected cash flows. When doing scenario analysis, this initial estimate
is called the:
[ ] initial analysis.
[ ] first go-around.
√[ ] base case.
[ ] initial projection.
[ ] best case scenario.
93) Any time a manager replaces a variable cost with a fixed cost, the firm's
________ effectively increases.
√ [ ] operating leverage
[ ] managerial options
[ ] projected cash flow
[ ] sensitivity contribution
[ ] total variable cost
94) A project that is operating at its ________ break-even point has operating cash
flow equal to zero.
√ [ ] cash
[ ] accounting
[ ] financial
[ ] sales
[ ] cost
95) A project that just breaks even on ________ basis will have a payback period
exactly equal to the life of the project.
I. an accounting
II. a cash
III. a financial
√ [ ] I only
[ ] II only
[ ] III only
[ ] I and II only
[ ] II and III only
96) You have put together a set of cash flow forecasts for a project and have found,
on your first computation, that the net present value is positive. You should:
I. accept the project because you are certain to increase shareholder wealth.
II. try to identify some source of value in the project.
III. use scenario or sensitivity analysis to investigate the project further.
IV. try to assess the degree of forecasting risk there is in the project.
[ ] I and II only
[ ] II and IV only
97) The contribution margin is defined as the:

[ ] fixed cost minus the selling price.
[ ] selling price per unit minus the unit fixed cost.
[ ] unit variable cost minus the unit fixed cost.
√ [ ] unit selling price minus the unit variable cost.
[ ] unit variable cost minus the unit selling price.
98) Soft rationing, if it persists, is most likely bad for stockholders.

√ [ ] True
[ ] False
99) Which of the following is (are) true about a project that just breaks even on an
accounting basis?
I. The project has an internal rate of return that is equal to zero.
II. The project has an internal rate of return that is equal to 100 percent.
III. The project has a negative net present value.
IV. The project has a zero net present value.
[ ] I and IV only
[ ] II and III only
[ ] II and IV only
[ ] IV only
100) The degree of operating leverage is equal to the percentage change in the
operating cash flow divided by the percentage change in sales quantity.
√ [ ] True
[ ] False
101) Capital intensive projects have a high degree of operating leverage.

√ [ ] True
[ ] False
Ch15
1) For the purpose of estimating the firm's cost of

capital, one cannot look only at the coupon rate on the
firm's existing debt.
√ [ ] True
[ ] False
2) KCE Corporation is currently operating at its target

capital structure. The market values of the firm’s equity
is $110 million and its’ debt is $140 million. KCE plans
to finance a new $32 million project using the same
relative weights of debt and equity. Ignoring flotation
costs, how much new debt must the firm issue to fund
the project?
[ ] $14.08 million
[ ] $16.5 million
√ [ ] $17.92 million
[ ] $18.97 million
[ ] $20.00 million
3) The interest rate that should be used when

evaluating a capital investment project is sometimes
called the:
I. required internal rate of return.
II. appropriate discount rate.
III. cost of capital.
[ ] I only
[ ] II only
[ ] III only
[ ] I, II, and III
4) Which one of the following formulas correctly

describes the cost of equity capital?
[ ] RE = D0/P0 + g
[ ] RE = D1+ g/P0
√[ ] RE = D1/P0 + g
[ ] RE = Rf - β X (Rf - Rm)
[ ] RE = Rf + β X (Rm + Rf)
5) Which of the following are legitimate reasons why it

is generally considered easier to estimate the cost of
preferred stock than it is to estimate the cost of
common stock?
I. Preferred stock generally carries with it a fixed
dividend payment.
II. The cost of preferred stock can be calculated as a
perpetuity based on the fixed dividend payment and the
present price.
III. The calculation of the cost of preferred stock does
not require any information about future preferred
dividends.
IV. The cost of preferred stock is simply equal to its
dividend yield.
[ ] I and III only
[ ] II and IV only
[ ] III and IV only
6) For a profitable firm, an increase in its marginal tax

rate will increase its weighted average cost of capital if
the firm has debt in its capital structure.
[ ] True
√ [ ] False
7) The return on equity is the return that equity

investors require on their investment in the firm.
√ [ ] True
[ ] False
8) All else equal, a higher corporate tax rate will:

[ ] increase the WACC of a firm with debt and equity
in its capital structure.
√ [ ] decrease the WACC of a firm with debt in its
capital structure.
[ ] not affect the WACC of a firm with debt in its
capital structure.
[ ] decrease the WACC of a firm with only equity in its
capital structure.
[ ] change the WACC of a firm with debt in its capital
structure, but the direction of the change cannot be
determined without more information.
9) Which one of the following statements is true about

trying to estimate a firm's cost of equity capital?
[ ] We have no model that will provide reasonable
estimates.
[ ] It is relatively easy to compute the firm's cost of
debt and then back the cost of equity out of it.
[ ] The cost of equity is equal to the weighted
average cost of capital.
[ ] The cost of equity depends on the total risk of the
firm's equity.
√ [ ] There is no way to directly observe the return
required by the firm's equity investors.
10) The best way to adjust for the existence of flotation

costs is to add their percentage cost to the WACC.
[ ] True
√ [ ] False
11) Hartley Psychiatric, Inc. needs to purchase office

equipment for its 2,000 drive-in therapy centers
nationwide. The total cost of the equipment is $2
million. It is estimated that the after-tax cash inflows
from the project will be $210,000 annually forever.
Hartley has a debt-to-value ratio of 40 percent based on
market values. The firm's cost of equity is 13 percent
and its pre-tax cost of debt is 8 percent. The flotation
costs of debt and equity are 2 percent and 8 percent,
respectively. Assume the firm's tax rate is 35 percent.
What is Hartley's weighted average cost of capital?
[ ] 6.09 percent
[ ] 8.73 percent
[ ] 8.95 percent
[ ] 9.05 percent
√ [ ] 9.88 percent
12) The _____ is the firm's cost of debt based on its

historic borrowing.
[ ] actual cost
√ [ ] embedded debt cost
[ ] coupon rate
[ ] market rate
[ ] yield
13) A project has the same risk as the firm's overall

operations and must be financed externally. Equity
costs 15 percent and debt costs 4 percent after-tax.
The firm's debt/equity ratio is .8. The tax rate is 34
percent. What is the minimal internal rate of return the
project must earn to be accepted?
[ ] 9.51 percent
√ [ ] 10.1 percent
[ ] 10.6 percent
[ ] 11.2 percent
[ ] 11.5 percent
14) Which one of the following is NOT correct?
[ ] The cost of equity is the return that equity
investors require on their investment in the firm.
[ ] The cost of equity can be found by either the
dividend growth approach or the SML approach.
[ ] The cost of debt is the return that lenders require
on the firm's debt.
[ ] If the firm has preferred stock in its capital
structure the cost of preferred stock should be included
in the cost of capital.
√ [ ] Book value capital structure weights should be
used to compute the WACC rather than market value
weights.
15) The effect of flotation costs is to increase the

computed NPV of any given project.
[ ] True
√ [ ] False
16) Which one of the following is a disadvantage of the

dividend growth model presented in the text for
estimating the cost of equity?
[ ] The dividend growth model only applies to firms
whose dividend growth rate fluctuates widely.
[ ] The dividend growth model only applies to
companies that are not currently paying any dividends.
[ ] The dividend growth model explicitly considers
risk.
√ [ ] The estimated cost of equity computed using the
dividend growth model is highly sensitive to the
estimated growth rate.
[ ] Historical dividends can be used as a basis for
future dividends unless the firm has undergone a major
change or revised their dividend policy.
17) Which of the following are correct concerning the
weighted average cost of capital (WACC)? (Note: Tc is
the marginal tax rate.)
I. The WACC is equal to the firm's embedded debt cost
multiplied by (1 - Tc).
II. The WACC requires the cost of debt be decreased
by 1 - Tc.
III. The WACC is the required return on any
investments a firm makes that have a level of risk equal
to that of the firm's present operations.
IV. The WACC represents the risk and target capital
structure of a firm's existing assets as a whole.
[ ] I and II only
[ ] II and IV only
[ ] II and III only
18) JHM, Inc. has 2 million shares of common stock

outstanding with a current price of $30 per share. The
stock has a $1 par value and a beta of .5. The company
has 80,000 bonds
outstanding with a $1,000 face value per bond, a 7
percent annual coupon, and 10 years to maturity. The
bonds are selling at 108.25 percent of face value. The
market rate of return is 12 percent and the risk-free rate
is 5 percent. The tax rate is 34 percent. What is the
weighted average cost of capital for JHM, Inc.?
√ [ ] 5.77 percent
[ ] 6.54 percent
[ ] 7.90 percent
[ ] 7.97 percent
[ ] 9.61 percent
19) Roberts Co. zero-coupon bonds mature in 22 years
and have a yield-to-maturity of 12.01 percent. Each
zero has a face value of $1,000. There are 2,000 of
these bonds outstanding. The market value of Roberts'
equity is $1 million. What capital-structure weight for
debt will you use in computing the WACC if Roberts'
only debt consists of these zeros?
[ ] 11.9 percent
√ [ ] 14.2 percent
[ ] 15.8 percent
[ ] 18.9 percent
[ ] 66.7 percent
20) The calculation of the weighted average cost of

capital (WACC) requires the determination of the:
I. market value of the bonds outstanding relative to the
total market value of the firm.
II. corporate tax rate.
III. current market value of a firm's equity based on the
total number of shares outstanding and the market
value per share.
IV. market value of the equity outstanding relative to the
total market value of the firm.
[ ] I and II only
[ ] II and III only
21) Which of the following statements are correct

concerning the security market line approach (SML) to
computing the cost of equity financing?
I. The SML applies only to firms with stable dividend
growth rates.
II. Unlike the dividend growth model, the SML estimate
is adjusted for risk.
III. To implement this approach, you have to estimate a
market risk premium and a beta coefficient.
IV. The quality of the estimate from the SML approach
is sensitive to the quality of the estimates of the
variables in the model.
[ ] I and III only
[ ] II and III only
[ ] II and IV only
22) Kottinger's Kamp Supplies is considering an

investment in new manufacturing equipment. The
equipment costs $220,000 and will provide annual
after-tax inflows of $50,000 at the end of each of the
next 7 years. The firm's debt-to-equity ratio is 25
percent based on market values. The cost of equity is
15 percent and the pre-tax cost of debt is 7 percent.
The flotation costs of debt and equity are 3 percent and
9 percent, respectively. The firm's combined marginal
federal and state tax rate is 40 percent. Assume the
project is of approximately the same risk as the firm.
After considering flotation costs, what is the NPV of the
proposed project?
√ [ ] -$16,376
[ ] -$9,261
[ ] -$7,098
[ ] -$3,109
[ ] $2,122

What is Kottinger's weighted average cost of capital?
[ ] 9.91 percent
[ ] 9.99 percent
[ ] 10.86 percent
[ ] 11.15 percent
√ [ ] 12.84 percent
24) The cost of debt capital for a firm:

√ [ ] is the return that the firm's creditors demand on
new borrowing.
[ ] can be calculated by estimating the beta of the
firm's equity and then using the SML.
[ ] can be estimated by finding the yield on recently
issued, longer maturity bonds with a lower bond rating.
[ ] can be calculated by looking at the coupon rates
on existing bonds of similar risk.
[ ] can be observed directly even if the firm's bonds
are not publicly traded.
25) Suppose that Topstone Industries has a cost of

equity of 15 percent and a cost of debt of 9 percent.
The target debt/equity ratio is .75 and the tax rate is 34
percent. What is Topstone's weighted average cost of
capital (WACC)?
[ ] 9.5 percent
[ ] 9.8 percent
[ ] 10.3 percent
[ ] 10.8 percent
√ [ ] 11.1 percent
26) Rattle me Bones, Inc.'s common stock is currently

selling for $66.25 per share. You expect the next
dividend to be $5.30 per share. If the firm has a
dividend growth rate of 4 percent, what is its cost of
equity?
√ [ ] 12.0 percent
[ ] 12.3 percent
[ ] 13.5 percent
[ ] 13.9 percent
[ ] 15.1 percent
27) The Bongo Bongo Drum Co. uses debt and equity
in its capital structure and has positive earnings. A
decrease in which of the following will decrease the
firm's weighted average cost of capital (WACC), all else
equal?
I. corporate tax rate
II. investor risk aversion
III. the firm's debt rating
[ ] I only
√ [ ] II only
[ ] III only
[ ] I and III only
[ ] II and III only
28) A firm needs to raise $165 million for a project. If

external financing is used, the firm faces flotation costs
of 8 percent for equity and 2.5 percent for debt. If the
project is to be financed 60 percent with equity and the
rest with debt, how much cash must the firm raise to
finance the project?
[ ] $128.6 million
[ ] $152.2 million
[ ] $161.7 million
[ ] $171.6 million
√[ ] $175.2 million
29) Ajax Corp. has been operating as three separate

divisions over the past ten years. All capital budgeting
decisions have been made at the home office using the
firm's overall weighted average cost of capital (WACC).
Just recently, the financial officer discovered that the
divisions have significantly different risks. Given this,
which one of the following statements is most likely to
be true?
[ ] The divisions are being rewarded for decreasing
their risk.
[ ] Higher earning divisions will be less risky than the
lower earning divisions.
√ [ ] Its low earning division tends to be ignored in the
capital budgeting process even though that division
tends to maintain a lower level of risk.
[ ] The differences in risk among the divisions have
no impact on the capital budgeting process.
[ ] The highest divisional cost of capital will
approximately equal the firm's overall cost of capital.
30) The WBM Corporation has 1 million shares of

common stock outstanding at a price of $40 per share.
The stock has a $1 par value and a beta of 1.3. There
are 10,000 bonds outstanding with a $1,000 face value
per bond, an 8 percent annual coupon, 22 years to
maturity, and a market price of $1,101.23. The market
risk premium is 8.6 percent. The risk-free rate is 4.5
percent and the marginal tax rate is 34 percent. What is
WBM Corporation's weighted average cost of capital?
[ ] 7.89 percent
[ ] 9.90 percent
[ ] 12.19 percent
√[ ] 13.30 percent
[ ] 15.78 percent
31) You are comparing two firms. All you know about
them is that the weighted average cost of capital
(WACC) of Firm A is 12 percent and the WACC of Firm
B is 15 percent. Which of the following can you infer
from knowing this?
I. B is riskier
II. A uses more debt
III. A and B are not in the same line of business
IV. A uses preferred stock but B does not
[ ] I and II
[ ] I and III
[ ] II and III
[ ] I, II, and IV
√ [ ] You cannot infer any of the above based on the
information provided.
32) Anthony's Anchovies, Inc. sold a 20-year bond

issue 2 years ago. The issue has a 5.35 percent annual
coupon and a $1,000 face value. If the current market
price per bond is $751.64 and the tax rate is 35
percent, what is the after-tax cost of debt?
[ ] 4.2 percent
[ ] 4.4 percent
√ [ ] 5.2 percent
[ ] 6.6 percent
[ ] 8.0 percent
33) To use the _____ approach, we place projects into

risk classes in order to assign discount rates.
√ [ ] subjective
[ ] capital analysis
[ ] pure play
[ ] security market line (SML)
[ ] yield play
34) Suppose that new information regarding future

inflation in the U.S. causes investors to become less
risk averse. The SML approach indicates that, all else
equal, most firms will see their cost of capital increase.
[ ] True
√ [ ] False
35) Ignoring taxes, if a firm issues debt at par, then the

cost of debt:
I. is equal to its coupon rate.
II. is equal to its yield-to-maturity.
III. differs from its current yield.
[ ] I only
[ ] II only
[ ] I and III only
[ ] I, II, and III
36) Topstone Industries' preferred stock pays an annual

dividend of $4.00 per share. When issued, the shares
sold for their par value of $100 per share. What is the
cost of preferred stock if the current price is $125 per
share?
√ [ ] 3.2 percent
[ ] 3.7 percent
[ ] 4.0 percent
[ ] 4.7 percent
[ ] 31.3 percent
37) Treasury bills currently have a return of 3.5 percent
and the market risk premium is 8 percent. If a firm has a
beta of 1.6, what is its cost of equity?
[ ] 8.8 percent
[ ] 10.7 percent
[ ] 12.8 percent
√ [ ] 16.3 percent
[ ] 18.8 percent
38) Advantages of using the security market line (SML)

approach as opposed to the dividend growth approach
to estimate the cost of equity include:
I. estimating the firm's equity beta.
II. adjusting for differences in risk.
III. allowing for a non-constant growth rate in dividends.
[ ] I only
[ ] II only
[ ] I and III only
[ ] I, II, and III
39) The cost of debt is the return that lenders require on

the firm's debt.
√ [ ] True
[ ] False

project is of
approximately the same risk as the firm. Ignoring
flotation costs, what is the NPV of the proposed
project?
√ [ ] $2,236
[ ] $4,899
[ ] $9,156
[ ] $13,436
[ ] $15,984
41) Which one of the following correctly describes the

computation of a firm's weighted average cost of capital
(WACC)?
[ ] (E/V) + RE + (D/V) + RD + (1 - Tc)
[ ] (E/V) X RE X (1 - Tc) + (D/V) X RD
[ ] (D/V) X RE + (E/V) X RD X (1 - Tc)
[ ] (E/V) + RE + (D/V) + RD
√ [ ] (E/V) X RE + (D/V) X RD X (1 - Tc)
42) You can estimate a firm's cost of debt by observing

the:
√ [ ] yield-to-maturity on the firm's outstanding debt.
[ ] coupon rate on the firm's outstanding debt.
[ ] yield-to-maturity on newly-issued debt of other
firms without regard to risk.
[ ] risk-free rate of interest and adding a risk premium
to the coupon rate of existing debt.
[ ] firm's bank borrowing rate on short-term loans.
43) Suppose a firm uses a constant WACC in

determining the value of capital budgeting projects
rather than using the security market line. The firm will
tend to:
[ ] accept profitable, low risk projects and reject
unprofitable, high risk projects.
[ ] accept profitable, low risk projects and accept
unprofitable, high risk projects.
[ ] reject unprofitable, high risk projects.
√ [ ] become more risky over time.
[ ] accept profitable, low risk projects.
44) A firm should consider using the _____ approach if

it only computes the weighted average cost of capital
(WACC) for the firm as a whole, yet it has divisions with
substantially different risk characteristics.
[ ] pure play
[ ] empirical
[ ] objective
√ [ ] subjective
[ ] simulation
45) Which one of the following statements is accurate

regarding the dividend growth model approach to
estimating the cost of equity capital?
[ ] A key disadvantage to this model is its low degree
of complexity.
[ ] The results from this model are not sensitive to
changes in the dividend growth rate.
√ [ ] One method of estimating future growth rates is
the use of historical growth rates.
[ ] The model works particularly well for companies
who maintain a mostly unsteady growth in dividends.
[ ] This model explicitly considers risk.
46) In which one of the following cases is the firm’s

WACC the most appropriate to use as the discount rate
for the project?
[ ] A pizza delivery service is planning to expand by
adding a sit-down pizza restaurant.
[ ] A grocery store owner is considering adding a
bakery and a delicatessen to his store.
[ ] A gas tank manufacturer is contemplating
switching to manufacturing tie-outs for dogs.
[ ] A gas station owner is considering adding a
convenience store.
√ [ ] A manufacturer of garbage bags is considering
expanding production capacity to meet increasing
overseas demand.
47) Rattle me Bones, Inc. sold a 20-year bond issue 12

years ago. The bonds pay an 8 percent annual coupon
and have a $1,000 face value. The current price per
bond is $893.30. What is the firm's pre-tax cost of debt?
[ ] 8.0 percent
[ ] 9.2 percent
[ ] 9.5 percent
√ [ ] 10.0 percent
[ ] 10.5 percent
48) Which of the following are true regarding a firm's

cost of debt?
I. The cost of debt is the return the firm's creditors
demand on new borrowing.
II. A firm's cost of debt based on its past borrowing is
known as its embedded debt cost.
III. It is possible to determine a firm's cost of debt by
observing yields on similar bonds that were recently
issued.
IV. The coupon rate on outstanding debt is not
necessarily the firm's current cost of debt.
[ ] I and IV only
[ ] II and III only
49) Your firm is considering a project that has an initial

investment of $5 million. Your target D/E ratio is .67.
Flotation costs on equity are 8 percent and flotation
costs on debt are 2 percent. What is the true cost (in
dollars) of the project when you consider flotation
costs?
[ ] $5.00 million
[ ] $5.28 million
√ [ ] $5.30 million
[ ] $5.57 million
[ ] $5.61 million
50) The pure play approach:

[ ] cannot be used if the firm has preferred stock
outstanding.
[ ] is easier to implement than the subjective
approach.
[ ] is most useful for divisions that make a multitude
of different products.
[ ] should be used only if a firm has more than three
divisions.
√ [ ] can be used to find the cost of capital for a
division.
51) Which of the following will always decrease a firm's

cost of equity as computed using the security market
line (SML) approach?
I. a decrease in the pure time value of money
II. a decrease in amount of systematic risk
III. a decrease in the reward for bearing systematic risk
[ ] I only
[ ] III only
[ ] II only
√[ ] II and III only
[ ] I, II, and III
52) A firm has 2,000,000 shares of common stock

outstanding with a market price of $2.00 each. It has
2,000 bonds outstanding, each with a market value of
$1,200 (120 percent of face). The bonds mature in 15
years, have a coupon rate of 10 percent, and pay
coupons annually. The firm's beta is 1.2, the risk free
rate is 5 percent, and the market risk premium is 7
percent. The tax rate is 34 percent. Compute the
WACC.
[ ] 5.42 percent
[ ] 6.53 percent
[ ] 9.36 percent
√ [ ] 10.28 percent
[ ] 11.57 percent
53) A firm that uses its WACC to evaluate projects

regardless of the risk of each project will tend to
become riskier over time.
√ [ ] True
[ ] False
54) Anthony's Antiques, Inc. has preferred stock

outstanding which pays a dividend of $4 per share a
year. The current price is $32 per share. What is its
cost of preferred stock?
[ ] 8.0 percent
[ ] 9.0 percent
[ ] 10.0 percent
[ ] 11.0 percent
√ [ ] 12.5 percent
55) If a firm uses the subjective approach to evaluate
projects for its divisions, it is still possible to make
errors in its capital budgeting decisions.
√ [ ] True
[ ] False
56) The appropriate discount rate to be used when

analyzing an investment project is:
[ ] the rate of return that will result in the highest
NPV.
[ ] the internal rate of return on that investment.
[ ] equal to the cost of capital based on the firm's
existing assets.
√ [ ] the rate of return financial markets offer on
investments of similar risk.
[ ] the rate of interest the firm would pay if it sold
bonds.
57) Which of the following are potential problems

associated with the use of the dividend growth model to
compute the cost of equity?
I. The estimated cost of equity is sensitive to the
estimated dividend growth rate.
II. Everything needed for the model is directly
observable except the current dividend.
III. The dividend growth model approach explicitly
considers risk.
√ [ ] I only
[ ] II only
[ ] III only
[ ] I and II only
[ ] II and III only
58) Which of the following are generally considered to
be potential problems when estimating the cost of
equity?
I. estimating beta using historical information
II. estimating a dividend growth rate
III. estimating the market risk premium
IV. estimating the correct adjustment for the risk level of
the project
59) Suppose a firm has 10.4 million shares of common

stock outstanding with a par value of $1.00 per share.
The current market price per share is $12.00. The firm
has outstanding debt with a par value of $56.0 million
selling at 102 percent of par. What weight would you
use for debt when computing the WACC?
[ ] 0.157
√ [ ] 0.314
[ ] 0.686
[ ] 0.739
[ ] 0.843

equipment for its 2000 drive-in therapy centers
What is the dollar flotation cost for the proposed
financing?
[ ] $112,000
√ [ ] $118,644
[ ] $131,230
[ ] $152,098
[ ] $159,001
61) In using the _____ approach to estimating the cost

of capital for a division, an analyst proceeds by
observing the returns for a firm whose operations are in
the same risk class as the division.
√ [ ] pure play
[ ] conglomerate
[ ] market specialist
[ ] correspondent division
[ ] parallel risk class
62) For the purpose of estimating the firm's cost of debt

for a project, one could observe the yield-to-maturity on
recently issued bonds with a similar rating and term-to-
maturity.
√ [ ] True
[ ] False
63) One method of computing a divisional cost of

capital is to use the pure-play approach.
√ [ ] True
[ ] False

equipment for its 2000 drive-in therapy centers
After considering flotation costs, what is the NPV of the
proposed project?
[ ] -$72,957
[ ] $428
[ ] $2,091
√ [ ] $6,862
[ ] $178,675
65) Project I has a beta of 0.65 and a projected return

of 12 percent. Project II has a beta of 0.9 and a
projected return of 17 percent. Project III has a beta of
1.4 and a projected return of 19 percent. Given the risk-
free rate is 8 percent and the market risk premium is
8.5 percent, which projects should be accepted if the
firm's beta is 1.2?
[ ] I only
√ [ ] II only
[ ] III only
[ ] I and II only
[ ] None of the projects are acceptable.
66) You are considering an investment project. You

know that the cost of capital associated with the project
depends on:
[ ] the total risk of the firm's equity.
[ ] the type of security to be issued to finance the
project.
[ ] the type of assets needed for the project, that is,
whether they are long-term or short-term assets.
√ [ ] the risk associated with the project.
[ ] the coupon rate on the firm's existing long term
bonds.
67) Greene Co. is planning a project for which it will

issue new bonds. Bonds in the same risk class issued
by another firm are currently priced at $954.90, have 25
years remaining to maturity, and pay coupons of $75
every year. If Greene's marginal tax rate is 34 percent,
what is the pre-tax cost of debt for the project?
[ ] 7.20 percent
[ ] 7.50 percent
√ [ ] 7.92 percent
[ ] 8.12 percent
[ ] 9.04 percent
68) Suppose that two firms, A and B, are considering

the same project which has the same risk as firm B's
overall operations. The project has an IRR of 15.0
percent. Firm A has a beta of 1.4, while firm B's is 1.1.
The risk-free rate is 5.25 percent and the market risk
premium is 7.0 percent, which firm(s) should take the
project?
[ ] A only
[ ] B only
√ [ ] both A and B
[ ] neither A nor B
[ ] This question can not be answered based on the
information provided.
69) It is generally better to base estimates of the WACC

on book value weights of debt and equity since market
values, particularly those for equity, tend to fluctuate
widely.
[ ] True
√ [ ] False
70) By using a firm's WACC to analyze all potential

investments, we risk incorrectly accepting some
suitable projects.
[ ] True
√ [ ] False
71) The cost of capital:

I. is an opportunity cost that depends on the use of the
funds, not the source.
II. is the same thing as the required rate of return.
III. is the same as the WACC for projects with the same
risk as the firm as a whole.
IV. is different than the appropriate discount rate.
72) In general, for the purpose of estimating the cost of

preferred stock, one can ignore the current level of
common stock dividends.
√ [ ] True
[ ] False
73) The market value of May East Enterprises' debt is

$200 million and the total market value of the firm is
$600 million. The cost of equity is 15 percent, the cost
of debt is 8 percent, and the tax rate is 34 percent.
Assuming there is only debt and common equity
outstanding, what is the firm's WACC?
[ ] 11.15 percent
√ [ ] 11.76 percent
[ ] 12.25 percent
[ ] 12.67 percent
[ ] 15.07 percent
74) You need to compute the cost of equity capital for a

firm that is traded on the New York Stock Exchange.
Which one of the following is probably the least helpful
to you?
[ ] the rate of return on stocks of similar risk
√ [ ] a copy of the Wall Street Journal from six months
ago
[ ] an investment publication that provides an
estimate of the firm's beta
[ ] an investment survey that projects future dividend
growth rates for the firm
[ ] a data set containing dividends paid for the past
ten years
75) A firm has three divisions. A capital budgeting

request has just come through for Division C showing a
positive net present value (NPV) at the firm's overall
weighted average cost of capital. The financial manager
of the firm knows that Division C is the riskiest of the
three divisions. The financial manger should:
[ ] deny the request since it was computed in error.
[ ] approve the request since it has a positive NPV.
√ [ ] ask that the NPV be recomputed at a cost of
capital appropriate for the division.
[ ] approve the request if neither of the other two
divisions have any capital budgeting projects with
positive NPVs.
[ ] subjectively reduce the NPV to reflect the
difference in risk and then accept the project if the NPV
is still positive.
76) The market value of a firm that invests only in
projects equally as risky as the firm as it exists and
providing a return equal to its WACC will not change
over time.
√ [ ] True
[ ] False
77) By using a firm's WACC to analyze all potential

investments, we risk incorrectly accepting some
unsuitable projects.
√ [ ] True
[ ] False
78) A firm that uses its weighted average cost of capital

(WACC) as a cutoff without considering the risk
involved in a project will:
I. tend to become less risky over time.
II. tend to accept negative net present value projects.
III. likely see its WACC rise over time.
[ ] II only
[ ] I and II only
[ ] I and III only
[ ] I, II, and III
79) Why is it necessary to make sure a project is in the

same risk class as the firm’s existing operations before
using the weighted average cost of capital (WACC) as
the discount rate for the project?
[ ] If a project will decrease risk, then it should be
rejected.
√ [ ] A firm that uses the WACC of existing operations
to evaluate projects without regarding the risk class of
the project will tend to become riskier over time.
[ ] Only a project with risk similar to that of the firm’s
present operations can result in a positive net present
value (NPV).
[ ] A project that is in a different risk class must be
analyzed using the WACC of the firm's existing
operations.
[ ] In general, the risk class of a proposed project is
important only when it affects the firm's bond ratings.
80) For purposes of finding the market value weights of

debt (D) and equity (E) to compute the weighted
average cost of capital, which of the following is (are)
correct?
I. D/V + E/V = 1.00
II. V = D - E
III. V = A + D + E
IV. D/V + E/V = V
√ [ ] I only
[ ] II only
[ ] I and II only
[ ] I and III only
81) Topstone Industries is expected to pay a dividend

of $2.10 per share in one year. This dividend, along
with the firm earnings is expected to grow at a rate of 5
percent forever. The current market price for a share of
Topstone is $38.62. What is the cost of equity?
[ ] 6.00 percent
√ [ ] 10.44 percent
[ ] 10.71 percent
[ ] 11.00 percent
[ ] 11.22 percent
82) JLP Industries has 6.5 million shares of common
stock outstanding with a market price of $14.00 per
share. The company also has outstanding preferred
stock with a market value of $10 million and 25,000
bonds, each with a face value of $1,000 and each
selling at 90 percent of face. The cost of equity is 15
percent, the cost of preferred is 10 percent, and the
cost of debt is 7.25 percent. If the tax rate is 34 percent,
what is JLP's WACC?
[ ] 9.5 percent
[ ] 10.0 percent
[ ] 10.8 percent
[ ] 11.6 percent
√ [ ] 12.7 percent
83) TGIF Sportswear is considering expanding its T-

shirt line. The project would last 3 years and have an
initial investment of $200,000. The after-tax cash flows
are estimated at $60,000 for year one, $120,000 for
year two, and $135,000 for year 3. The firm has a target
debt-to-equity ratio of 1.2. The project cost of equity is
15 percent and its cost of debt is 9 percent. The tax rate
is 34 percent. What is the NPV of this project?
[ ] -$12,370
[ ] $13,687
[ ] $37,723
[ ] $46,120
√ [ ] $54,843
84) JEM, Inc. has a market value of equity of $50

million, a market value of debt of $30 million, a cost of
equity of 16 percent, a cost of debt of 8 percent, an
equity beta of 1.25, and a tax rate of 34 percent. Given
this information, what is JEM, Inc.'s weighted average
cost of capital?
[ ] 11.29 percent
[ ] 11.45 percent
√[ ] 11.98 percent
[ ] 12.32 percent
[ ] 13.00 percent
85) The firm's tax rate should be used in computing the

weighted average cost of capital if the firm has debt in
its capital structure.
√ [ ] True
[ ] False
86) Ponderosa Co. bonds sell for $846.04. The coupon

rate is 8 percent and the bonds mature in 25 years.
Assume interest is paid semiannually and the firm's tax
rate is 34 percent. What is Ponderosa's after-tax cost of
debt?
[ ] 3.18 percent
[ ] 4.99 percent
√ [ ] 6.36 percent
[ ] 9.34 percent
[ ] 9.64 percent
87) The XYZ Corporation has 14.2 million shares of

common stock outstanding at a price of $35 per share.
The company has one bond issue of $500 million total
face value which is selling at 102 percent of face value.
The company has a second bond issue with a total face
value of $175 million which is selling for $850 per bond.
What is the market value of XYZ Corporation?
[ ] $697.52 million
[ ] $874.82 million
[ ] $987.24 million
[ ] $1,049.43 million
√ [ ] $1,155.75 million
88) The security market line (SML) approach to
calculating the cost of equity:
I. explicitly accounts for risk.
II. applies only to companies that pay dividends.
III. considers the risk-free rate of return.
IV. considers the total risk of a project.
[ ] II and III only
[ ] I and II only
89) A firm is considering expanding its’ operations. The

expansion is in the same risk class as the existing
operations and requires issuance of either debt or
equity or both. Since flotation costs will be involved,:
[ ] the weighted average cost of capital (WACC)
should be adjusted upward to reflect the flotation costs.
[ ] the firm should determine the highest level of
flotation costs under the different financing scenarios
and incorporate this into the borrowing costs.
√ [ ] the firm should increase the amount of funds
needed by an amount equal to the estimated weighted
average flotation costs.
[ ] the WACC should be adjusted downward.
[ ] the firm should decrease the amount of the future
cash flows to reflect the level of flotation costs that will
be incurred.
90) Long-term debt of Topstone Industries is currently

selling for 104.5 percent of its face value. The issue
matures in 10 years and pays an annual coupon of 8
percent of face value. What is the cost of debt for
Topstone? Ignore taxes.
[ ] 6.75 percent
√[ ] 7.35 percent
[ ] 7.84 percent
[ ] 8.60 percent
[ ] 9.45 percent
91) The cost of capital in a firm that has both debt and
equity:
√ [ ] is what a firm must earn on a project to
compensate investors for the use of their capital.
[ ] depends on the source of the funds for a project.
[ ] is made up of only the cost of equity.
[ ] is also known as the internal rate of return.
[ ] will be the same for its different divisions.

percent based on market value. The cost of equity is 15
percent and the pre-tax cost of debt is 7 percent. The
flotation costs of debt and equity are 3 percent and 9
percent, respectively. The firm's combined marginal
What is the weighted average flotation cost, fA, for
Kottinger's?
[ ] 3.0 percent
[ ] 6.0 percent
√ [ ] 7.8 percent
[ ] 8.2 percent
[ ] 9.1 percent
What is the weighted average flotation cost, fA, for
Hartley?
[ ] 3.0 percent
√ [ ] 5.6 percent
[ ] 5.8 percent
[ ] 6.3 percent
[ ] 7.4 percent

Ignoring flotation costs, what is the NPV of the
proposed project?
[ ] $33,966
[ ] $65,990
[ ] $98,542
√ [ ] $125,506
[ ] $128,034
95) The cost of capital depends primarily on the use of
funds, not the source.
√ [ ] True
[ ] False
96) The common stock of Tommy's Tools sells for

$27.50. The firm's beta is 1.2, the risk-free rate is 4
percent, and the market risk premium is 8 percent. Next
year's dividend is expected to be $1.50. What is the
firm's anticipated dividend growth rate assuming the
dividend growth model and the CAPM estimates are
consistent with one another?
[ ] 7.6 percent
[ ] 7.8 percent
√ [ ] 8.1 percent
[ ] 9.2 percent
[ ] 10.1 percent
97) Suppose the Federal Reserve takes actions that

cause the risk-free rate to fall. All else equal, we would
expect a firm's cost of capital to:
[ ] increase if we are using the CAPM.
[ ] decrease if we are using the CAPM.
√ [ ] either increase or decrease if we are using the
CAPM but we can't determine which without more
information.
[ ] increase if we are using the dividend growth
model.
[ ] decrease if we are using the dividend growth
model.
98) A firm has paid annual dividends of $4.32, $4.29.

$3.95, $3.68, and $3.50 over the last five years, starting
with this year. The current price of the stock is $60.
Given this information, what is the firm's cost of equity?
[ ] 12.1 percent
[ ] 12.6 percent
√ [ ] 13.0 percent
[ ] 15.4 percent
[ ] 20.2 percent
99) Which of the following are correct concerning the

use of the dividend growth model to compute the cost
of equity?
I. The estimated cost of equity is sensitive to the
estimated dividend growth rate.
II. The approach does not explicitly consider risk.
III. The approach requires you to assume that the
dividend growth rate will remain constant.
IV. The approach works particularly well for firms that
currently pay no dividends.
[ ] I and III only
[ ] II and IV only
[ ] II and III only
100) For a firm with both debt and equity in its capital
structure, the weighted average flotation cost, fA, will
simply be the sum of the percentage flotation cost of
debt, fD, and the percentage flotation cost of equity, fE.
[ ] True
√ [ ] False
101) A firm has a WACC of 12 percent. It is financed

with 40 percent debt and 60 percent equity. The firm's
cost of debt is 10 percent and its tax rate is 40 percent.
If the firm's dividend growth rate is 8 percent and its
current stock price is $40, what is the value of the next
dividend the firm is expected to pay?
[ ] less than $3.00
√ [ ] between $3.01 and $3.50, inclusive
[ ] between $3.51 and $4.25, inclusive
[ ] greater than $4.25
[ ] cannot be determined with the information given.
102) A firm’s cost of debt is generally:

√ [ ] easier to calculate than the cost of equity.
[ ] based on the return creditors required when the
firm previously borrowed money.
[ ] greater than the cost of equity on a pre-tax basis.
[ ] greater than the average coupon payments on
outstanding bonds.
[ ] less on a pre-tax basis than on an after-tax basis.
103) It is considered unlikely that the dividend growth

and the SML approaches will result in different
estimates of the cost of equity for a given firm.
[ ] True
√ [ ] False
Ch 16
1) Which of the following statements are correct

concerning the costs of issuing securities?
I. Substantial economies of scale exist based on
issuance size.
II. The costs of issuing debt are generally less than the
costs of issuing equity.
III. The costs of underpricing can exceed direct
issuance costs.
IV. The total costs involved with seasoned issues are
typically higher than for IPOs.
[ ] I and III only
[ ] II and IV only
2) TOYSrYOU needs to raise $5 million. If the

subscription price is $10, the stock price is $12.50, and
there are 4,000,000 shares outstanding, what will the
stock sell for ex-rights?
[ ] $7.50
[ ] $11.46
√ [ ] $12.22
[ ] $12.36
[ ] $12.50
3) An initial public offering (IPO) occurs when a firm that

is not currently publicly traded issues stock to the
public.
√ [ ] True
[ ] False
4) Which one of the following is most apt to use
competitive underwriting?
√ [ ] public utility
[ ] mid-size firm
[ ] small firm
[ ] firms doing an initial public offering
[ ] a major national retailer such as Sears
5) Which of the following is NOT a type of dilution

potentially associated with new equity offerings?
[ ] dilution of book value
[ ] dilution of market value
[ ] dilution of proportionate ownership
[ ] dilution of earnings per share
√ [ ] dilution of venture capital
6) If a firm's articles of incorporation contains _____,

the firm is required to complete all seasoned equity
sales via a rights offering.
[ ] a privileged subscription
[ ] a Green Shoe provision
[ ] an over allotment option
√ [ ] a preemptive right
[ ] a restrictive covenant
7) Which one of the following correctly describes a

difference between privately placed and publicly offered
debt issues?
[ ] Private placements must be registered with the
SEC.
[ ] Public issues are likely to have more restrictive
covenants.
[ ] Public issues are typically easier to renegotiate
during financial distress.
√ [ ] Costs are typically lower for private placements.
[ ] A private issue may be shelf registered while a
public issue may not.
8) In a rights offering, the price of a share will drop by

approximately the value of a right on the _____ date.
[ ] standby
[ ] record
[ ] announcement
[ ] expiration
√ [ ] ex-rights
9) According to the textbook, the market value of a

firm's outstanding shares will most likely fall upon the
announcement of a new equity offering.
√ [ ] True
[ ] False
10) The _____ allows shareholders to purchase

unsubscribed shares at the subscription price in a rights
offering.
[ ] overallotment provision
[ ] take-out provision
[ ] Green Shoe provision
[ ] standby agreement
√ [ ] oversubscription privilege
11) A firm has 800,000 shares selling for $120 a share.

It wants to raise $10,000,000 via a rights offering. The
subscription price is $100 a share. How many rights
are required to purchase 1 share?
[ ] 0.1
[ ] 1.2
[ ] 2.0
[ ] 4.8
√ [ ] 8.0
12) Which one of the following statements is correct
about the steps a firm takes in issuing securities to the
public?
[ ] Unless the number of authorized shares of
common stock must be increased, management need
not obtain approval from the board of directors.
√ [ ] Management must file a registration statement
with the SEC unless it is a loan maturing in less than 9
months or an issue of less than $5 million.
[ ] While the SEC studies the proposal the company
may NOT distribute a preliminary prospectus.
[ ] At the beginning of the waiting period, the price of
the securities is set.
[ ] A final prospectus need not be delivered to
purchasers if the investor received a red herring.
13) Which one of the following statements is correct for

the following public, interstate issues?
[ ] Cindy, Co. must file only a brief offering statement
with the SEC for its $6 million, 10-year bond issue.
[ ] Zybit Co. must file only a brief offering statement
with the SEC for its $5.75 million equity issue.
√ [ ] Kismet, Inc. need not file an offering statement
with the SEC for its $7 million, 6 month bond issue.
[ ] Calamity, Inc. need not file with the SEC for its
private placement issue (20 investors) of $5.5 million in
long-term bonds and public issue of $6.25 million in
equity.
[ ] Bullet, Inc. need not file an offering statement with
the SEC if it sells its $6 million equity issue to fewer
than 40 investors.
14) According to the textbook, direct flotation costs and
the offering size (as measured by gross proceeds) are
positively related.
[ ] True
√ [ ] False
15) Which of the following statements accurately

described actions performed by underwriters?
I. They stand by, ready to take up the slack if some of
the shares in a best-efforts offering are not purchased.
II. They purchase and resell extra shares from the
issuer in an oversubscribed offering.
III. They spread the risk of issuing the securities by
forming a syndicate.
IV. They stand ready to repurchase shares from the
investing public during the aftermarket.
16) A firm pays 8.0% of the amount of cash raised in

financing in direct costs. If an investment of $6 million is
required, what is the dollar amount of the flotation
costs?
[ ]0
[ ] 80,000
√ [ ] $521,739
[ ] $542,726
[ ] $750,000
17) _____, the underwriter agrees to purchase the

entire issue of a public offering, and then attempts to
resell the issue.
[ ] In standby underwriting
√[ ] In firm commitment underwriting
[ ] In best efforts underwriting
[ ] By exercising a Green Shoe provision
[ ] By exercising an oversubscription privilege
18) Which one of the following parties will probably

benefit the most from the overpricing of a new IPO of
common stock handled on a firm-commitment basis?
[ ] existing bondholders
[ ] the underwriter
[ ] new shareholders who purchase stock in the open
market during the aftermarket
√ [ ] the issuing firm
[ ] new shareholders who purchase stock from the
syndicate

there are 4,000,000 shares outstanding, how many
rights will buy a share of stock?
[ ] 0.1
[ ] 1.2
[ ] 2.0
[ ] 4.8
√ [ ] 8.0
20) The direct costs of issuing equity include which one

of the following?
[ ] underpricing
√ [ ] filing fees
[ ] Green Shoe option
[ ] costs of management time spent working on the
new issue
[ ] abnormal returns
21) Before executing a rights offering, management
should address which of the following questions?
I. How much less than the existing stock price should
the subscription price be?
II. How many shares will each stockholder be required
to buy?
III. What will the rights offering do to the price of the
existing stock?
IV. How much money needs to be raised by the
offering?
[ ] I and IV only
22) A bond issue is considered private if it is sold to no

more than _____ investors.
[ ] 10
√ [ ] 34
[ ] 36
[ ] 49
[ ] 50
23) Classique, Inc., a manufacturer of reproduction

parts for classic automobiles, needs to raise $2 million
via a rights offering. The subscription price is $2 per
share. The firm currently has 2,000,000 shares
outstanding, and the current market price per share is
$6. What is the value of a right?
[ ] $0.75
[ ] $0.98
[ ] $1.17
√ [ ] $1.33
[ ] $5.99
24) Large rights offerings are more common in

industrialized nations other than the U.S.
√ [ ] True
[ ] False
25) At each stage of financing for a firm, the value of

the founder's stake typically grows and the probability
of success rises.
√ [ ] True
[ ] False

concerning IPOs?
[ ] An IPO is usually sold as a private placement.
[ ] Small issue IPOs are predominately sold on a firm
commitment basis.
[ ] The general form of offer for an IPO is a rights
offer.
[ ] IPOs are typically overpriced.
√ [ ] The determination of the initial price for an IPO is
relatively difficult.
27) A firm faces direct costs of 8.0% of the amount of

cash raised in financing a new project. How much
needs to be raised if initial project outlays total $6
million?
[ ] $5.520 million
[ ] $6.480 million
√ [ ] $6.522 million
[ ] $6.640 million
[ ] $6.750 million
28) A general cash offer is an offering of debt or equity
securities to fewer than 40 investors.
[ ] True
√ [ ] False
29) Over the 1975 - 2003 period, the average first-day

return on IPOs was closest to _____ percent.
[ ] -5
[ ]0
[ ]5
[ ] 10
√ [ ] 17
30) _____ is an agreement in which the underwriter is

allowed to purchase additional shares of an offering at
the subscription price.
[ ] Standby underwriting
[ ] Firm commitment underwriting
[ ] Best efforts underwriting
√ [ ] A Green Shoe provision
[ ] An oversubscription privilege
31) A company has filed a registration statement with

the SEC for a new stock issue. During the 20 day
waiting period, the firm can:
√ [ ] provide investors with a preliminary prospectus.
[ ] sell the new stock to interested investors.
[ ] approach its board of directors to get approval of
the new issue.
[ ] not place a tombstone ad.
[ ] not change the price for which it will ultimately sell
the securities.
32) Recently, an underwriter completed a sale of stock

in an under-subscribed IPO. Since then, the stock's
price has dropped 10%. If the stock is still in the _____
period, the principal underwriter may buy shares to
support the market price.
[ ] Red Herring
√ [ ] aftermarket
[ ] shelf registration
[ ] registration
[ ] moratorium
33) Which of the following has (have) been offered as a

possible explanation for why securities in an IPO are
underpriced when they are issued?
I. Underwriters typically underprice high-priced stocks
so more investors can afford them.
II. Underwriters underprice so that the average investor
will lose money on initial public offerings.
III. Underwriters underprice to minimize lawsuits by
investors, which could occur if they consistently
overpriced stocks.
[ ] I only
[ ] II only
√ [ ] III only
[ ] I and III only
[ ] I, II, and III
34) Venture capitalists are generally not long-term

investors.
√ [ ] True
[ ] False
35) One of the drawbacks of a rights offering is that the

price of the stock falls, harming existing stockholders.
[ ] True
√ [ ] False
36) A firm has 800,000 shares outstanding, selling for
$120 a share. It wants to raise $16,000,000 via a rights
offering. The subscription price is $100 a share. What
will the firm be worth after the offering?
[ ] $96.0 million
[ ] $98.4 million
[ ] $105.0 million
√ [ ] $112.0 million
[ ] $116.8 million
37) The option giving the underwriter the ability to

purchase additional shares of stock at the offer price is
called:
[ ] a shelf registration.
√ [ ] a Green Shoe provision.
[ ] dilution.
[ ] standby underwriting.
[ ] a firm commitment offering.
38) _____ is an agreement in which the shareholders

are allowed to purchase the unsubscribed portion of a
rights issue at the subscription price.
[ ] Best efforts underwriting
[ ] A Green Shoe provision
√ [ ] An oversubscription privilege
39) More than half of new corporate debt issued is sold

via a private placement.
√ [ ] True
[ ] False
40) Which of the following statements regarding the

issuance of securities to the public are correct?
I. The first step in issuing new securities is to obtain the
approval of the board of directors.
II. The price of a share of stock will drop immediately
after the stock goes ex-rights.
III. A tombstone is an advertisement used by
underwriters to convey information about a new public
offering.
IV. For some small or short-term bond issues it may not
be necessary to file a registration statement with the
SEC.
[ ] I and III only
[ ] II and III only
41) The direct costs of issuing equity include which of

the following?
I. underpricing
II. taxes
III. spread
IV. filing fees
[ ] I and II only
[ ] II and III only
42) Financing for new, often high-risk companies is

called:
√ [ ] venture capital.
[ ] an initial public offering.
[ ] a private placement.
[ ] a term loan.
[ ] a seasoned issue.
43) In _____ the risk of selling an issue falls on the
underwriting syndicate.
√ [ ] firm commitment underwriting
[ ] best efforts underwriting with a green shoe
provision
[ ] best efforts underwriting
[ ] initial public offerings
[ ] a general cash offer
44) Security issues of less than $5 million are exempted

from SEC registration because they:
[ ] do not need approval from the board of directors.
[ ] are exempt from the Securities Exchange Act of
1934.
[ ] are exempt by the Green Shoe provision.
√ [ ] governed by SEC Regulation A.
[ ] are exempt from the Securities Act of 1933.
45) The underwriter's primary form of compensation in

a firm commitment issue is the:
[ ] up-front, direct fees.
√ [ ] spread.
[ ] amount by which the shares are underpriced.
[ ] fees earned from joining the syndicate.
[ ] income earned on the Green Shoe provision.
46) The BB Drum Company recently raised several

million dollars in an initial public offering. BB received
$22.00 per share from the underwriter, the offering
price was $25.00 per share, and the market price rose
to $28.00 on the day of the offering. The spread paid by
BB was _____ percent.
√ [ ] 12.0
[ ] 13.6
[ ] 24.0
[ ] 27.3
[ ] 28.0
47) According to the figures in the text, on average,

IPOs:
√ [ ] are brought to the market in waves.
[ ] are overpriced.
[ ] have the same flotation costs as seasoned issues.
[ ] produce negative first-day returns.
[ ] are a profitable investment and you should buy
shares in any IPO that hits the market.
48) Empirical evidence suggests that the market price

of a firm's existing shares will most likely fall upon the
announcement of a new equity issue. Which of
following have been advanced as possible explanations
for this phenomenon?
I. Issuing new equity requires the firm to incur
substantial issue costs.
II. An equity issue is a signal that the firm may have too
little liquidity.
III. Management will issue equity only when it believes
that existing shares are undervalued.
[ ] I only
[ ] III only
[ ] II and III only
[ ] I, II, and III
49) You presently own 7.5% of the stock in IBME

Corporation. IBME is planning to issue new shares of
stock in the near future via a rights offering. You will
experience a(n) _____ as a result of the issue if you sell
your rights.
[ ] loss of wealth
[ ] dilution of your book value
[ ] increase in the number of shares you own
√[ ] dilution of your percentage of ownership
[ ] dilution of your relative purchasing power
50) _____will cause an existing investor in a firm to lose

value as a result of the firm issuing new securities.
[ ] A rights offering
√ [ ] Dilution
[ ] When a stock goes ex-rights, it
[ ] An underwriter spread that is too small
51) Dilution of market value is one of the types of

dilution discussed in the text.
√ [ ] True
[ ] False

there are 4,000,000 shares outstanding, what is the
value of a right?
[ ] $0.14
√ [ ] $0.28
[ ] $1.04
[ ] $2.50
[ ] $5.00
53) You hear on the news that an underwriter is

participating in an equity issue on a standby basis. You
know the type of offer must be a(n) _____ offer.
√ [ ] rights
[ ] initial public
[ ] seasoned
[ ] cash
[ ] firm commitment
54) Which of the following are qualifications required for

a firm to use Rule 415?
I. The issuer must not have had a violation of the
Securities Act of 1934 in the past two years.
II. The company must be rated investment grade.
III. The aggregate market value of the firm's
outstanding stock must be more than $150 million.
IV. The firm cannot have defaulted on its debt in the
past three years.
[ ] I only
[ ] II only
√ [ ] II, III and IV
[ ] I and III only
55) A shelf registration allows a company to issue

securities over a period of up to two years rather than
all at once.
√ [ ] True
[ ] False

offering. The subscription price is $100 a share. What is
the value of a right?
[ ] $2.00
√ [ ] $3.33
[ ] $4.00
[ ] $6.67
[ ] $20.00
57) Which of the following is (are) correct regarding
flotation costs?
I. On average, there are substantial economies of scale
in issuing securities.
II. The costs of issuing debt securities are greater than
the costs of issuing equity securities.
III. On average, it costs more to float a seasoned
offering than an IPO.
IV. Convertible bonds are cheaper to issue than straight
bonds.
√ [ ] I only
[ ] IV only
[ ] I and IV only
[ ] II and III only
58) More than _____ percent of all debt is issued

privately.
[ ]5
[ ] 10
[ ] 25
√ [ ] 50
[ ] 75
59) Which of the following is (are) considered to be

private debt?
I. private placements
II. general cash offers
III. term loans
IV. venture capital
[ ] I only
[ ] II only
[ ] III only
60) All else equal, the greater the subscription price of
shares in a rights offering, the smaller the number of
rights needed to buy one new share.
[ ] True
√ [ ] False

$6. How many rights are required to purchase one
share?
[ ]1
√[ ]2
[ ]4
[ ]5
[ ] 10
62) The degree of underpricing of IPO’s tends to

increase for firms with few, if any, sales.
√ [ ] True
[ ] False
63) Which of the following statements regarding rights

offerings are correct?
I. Pure rights offerings are typically cheaper than other
types of offers.
II. Rights offerings protect the proportionate ownership
of existing stockholders.
III. Rights offerings protect against underpricing.
IV. The drop in stock price will harm existing
shareholders who either sell or exercise their rights.
[ ] I and II only
[ ] III and IV only
√[ ] I, II, and III only
64) Which one of following occurs if new shares are

sold at an offering price that is too low in a firm
commitment offering?
[ ] Underwriters suffer a financial loss because they
are more likely to be unable to sell all of the shares
offered.
[ ] Markets in general suffer because this is a sign of
market inefficiency.
[ ] Investors in general suffer a financial loss because
they purchase shares at a price less than their true
value.
[ ] Investors in general suffer because the more
underpriced offerings there are, the less likely additional
IPOs will follow.
√ [ ] The shareholders of the issuing firm suffer an
opportunity loss because shares were sold at less than
their true value.

$6. What is the ex-rights price of the firm's stock?
[ ] $2.00
√ [ ] $4.67
[ ] $4.83
[ ] $5.25
[ ] $6.00
66) Empirical evidence suggests that, on average, the
shares in initial public offerings have not been
significantly underpriced.
[ ] True
√ [ ] False
67) The BangBang Drum Company recently raised

several million dollars in an initial public offering.
BangBang received $22.00 per share from the
underwriter, the offering price was $25.00 per share,
and the market price rose to $28.00 on the day of the
offering. The initial return investors earned on the stock
was _____ percent.
√ [ ] 12.0
[ ] 13.6
[ ] 24.0
[ ] 27.3
[ ] 30.0
68) Assuming a price greater than zero, it is virtually

impossible to overprice a rights offer.
[ ] True
√ [ ] False
69) The risk that new securities will be sold at a loss is

transferred from the issuing firm to the underwriter in
best efforts underwriting.
[ ] True
√ [ ] False
70) Historically, general cash offers have had average

flotation costs higher than pure rights offerings.
√ [ ] True
[ ] False
71) Which of the following statements are true
concerning the steps involved in issuing securities to
the public?
I. A full registration statement must be filed with the
SEC for long-term bond issues over $5 million.
II. The underwriter can take orders for securities while
the SEC is reviewing the registration statement.
III. Tombstone advertisements are used by underwriters
both during and after the waiting period.
IV. During the waiting period, the firm can issue a
preliminary prospectus, often called a red herring.
72) _____ is defined as an issue of securities offered

for sale to the general public on a cash basis.
[ ] An initial public offering
[ ] A rights offering
√ [ ] A general cash offering
[ ] A seasoned issue
[ ] A private issue
73) Which one of the following firms would qualify for

shelf registration?
√ [ ] A firm who last defaulted on debt four years ago.
[ ] A firm with a total market value of $140 million in
outstanding common stock.
[ ] A firm whose bonds are rated just below
investment grade.
[ ] A firm whose last violation of the Securities Act of
1934 was two years ago.
[ ] A firm undertaking a rights offering.
about gaining access to venture capital?
[ ] It is relatively easy to gain access to the venture
capital market provided you have a good product.
[ ] Venture capitalists often choose their investments
by reviewing unsolicited proposals.
√ [ ] The venture capital market is very much an
"introduction" market. That is, you need personal
contacts to gain access to the market.
[ ] Venture capitalists rely little on informal networks
of lawyers, accountants, and bankers to help identify
potential investments.
[ ] If you wish to gain access to venture capital
financing, it would likely do you little good to know
someone who obtained venture capital themselves.
75) If a firm plans a public issue of new securities but

needs the money at different stages over the coming
two years, the firm may be a candidate for a:
√ [ ] shelf registration.
[ ] private placement.
[ ] rights offering.
[ ] firm commitment underwriting.
[ ] multiplex cash offering.

$6. What will the firm be worth following the rights
offering?
[ ] $12.00 million
√ [ ] $14.00 million
[ ] $16.25 million
[ ] $16.50 million
[ ] $18.00 million
77) Empirical evidence indicates that, upon the

announcement of a new equity offering, the market
value of the issuing firm's outstanding debt _____,
while the market value of its common stock_____:
[ ] changes very little; rises.
[ ] falls; rises.
√ [ ] changes very little; falls.
[ ] rises; changes very little.
[ ] rises; falls.
78) In a rights offering, existing shares begin to trade

ex-rights two trading days:
√ [ ] prior to the holder-of-record date.
[ ] after the announcement date.
[ ] prior to the announcement date.
[ ] after the holder-of-record date.
[ ] prior to the expiration date.
79) An important difference between a direct term loan

and a long-term bond is that:
[ ] a term loan typically has higher issuance costs
than does a public bond issue.
[ ] a term loan tends to be more difficult to
renegotiate than a bond issue.
[ ] banks usually fund long-term bonds while term
loans are provided by insurance companies and
pension funds.
[ ] it is easier to sell a public issue of long-term bonds
than it is to obtain a bank term loan.
√ [ ] a direct term loan avoids the cost of Securities and
Exchange Commission registration.
80) Which of the following are direct costs of issuing
securities?
I. legal fees related to the issuance of the securities
II. management time spent working on the securities
issue
III. the decrease in the price of existing shares when
additional shares are issued
IV. the gross spread
[ ] I and III only
[ ] II and IV only
[ ] II and III only
[ ] I and II only
81) Dilution of market value occurs whenever shares of

stock are issued and the market-to-book ratio is less
than one.
[ ] True
√ [ ] False
82) Which of the following is (are) important in choosing

a venture capitalist?
I. the financial strength of the venture capitalist
II. references regarding how successful the venture
capitalist has been in the past
III. the venture capitalist's exit strategy
[ ] I only
[ ] I and III only
[ ] I and II only
[ ] II and III only
83) A registration statement becomes effective _____
days following its filing with the SEC unless the SEC
sends a letter of comment suggesting changes.
[ ] 10
√ [ ] 20
[ ] 30
[ ] 40
[ ] 50
84) Bob tells his broker to buy 100 shares of stock in

every IPO that comes along, regardless of the issuer
because he has heard about the tremendous price
increases in the first week after issue. Bob will most
likely:
√ [ ] lose money, on average, because the most
underpriced issues will likely be oversubscribed.
[ ] make money, on average, because underwriters
typically underprice new issues.
[ ] lose money, on average, because he will tend to
get few shares from overpriced issues.
[ ] make money, on average, because issues tend to
be oversubscribed, allowing him to cover his losses on
bad purchases.
[ ] make money, on average, because it is unlikely an
IPO's price will fall.
85) If the underwriter wishes to have the option to make

additional profits if an IPO is oversubscribed, they may
ask that the underwriting contract contain a:
[ ] protective covenant.
[ ] tombstone clause.
[ ] preemptive right provision.
[ ] Regulation A provision.
√ [ ] Green Shoe provision.
86) _____ is an agreement in which the underwriter is
legally bound only to attempt to sell the securities in a
public offering for the firm.
√ [ ] Best efforts underwriting
[ ] An oversubscription privilege
87) Unique Auto Parts, Inc., a manufacturer of

reproduction parts for classic automobiles, needs to
raise $2 million via a rights offering. The subscription
price is $4 per share. The firm currently has 1,000,000
shares outstanding with a current market price per
share of $5. What will the value of a right be?
[ ] $.25
√ [ ] $.33
[ ] $.40
[ ] $.50
[ ] $1.20
88) Which one of the following is correct regarding

Green Shoe provisions?
[ ] They rarely exist in either debt or equity offerings.
√ [ ] They typically expire 30 days after the issue date.
[ ] They typically involve no less than 16% of the
newly issued shares.
[ ] They are a benefit to the firm and a cost to the
underwriting syndicate.
[ ] They allow the lead underwriter, but not the other
syndicate members, to purchase additional shares at
the offer price.
89) Which one of the following statements concerning

underwriting is correct?
[ ] The issuing firm, not the underwriter, bears all of
the risk from adverse price movements in a firm
commitment sale.
[ ] The method of marketing securities to the public is
usually specified by the issuing firm, not the
underwriter.
[ ] The company, not the underwriter, will generally
set the price for a security issue.
√ [ ] The spread, or income received by the
underwriter, is the difference between the price paid by
the investor and the price the underwriter pays for the
security.
[ ] It is common for a number of underwriters to form
a syndicate so that the risk in marketing a security issue
falls on the lead underwriter.
90) Wilte, Inc. plans to raise $8 million in a rights

offering. If management sets the subscription price at
$10 and the current market price is $12.50, how many
shares need to be sold in the rights offering?
[ ] 320,000
[ ] 400,000
[ ] 640,000
√ [ ] 800,000
[ ] 1,200,000
91) Which one of the following correctly describes the

sequence of events in a new issue?
[ ] filing of registration statement; approval of the
board of directors; distribution of prospectus; sale of
securities
[ ] approval of the board of directors; distribution of
prospectus; filing of a registration statement; sale of
securities
[ ] filing of registration statement; distribution of
prospectus; approval of the board of directors; sale of
securities
√ [ ] approval of the board of directors; filing of a
registration statement; distribution of prospectus; sale
of securities
[ ] approval of the board of directors; distribution of
prospectus; sale of securities; filing of a registration
statement
92) Which one of the following is a reason why the

stock price of a firm might drop when a seasoned equity
issue is announced?
[ ] Managers know the stock is overvalued, so they
are selling shares while the price is low.
[ ] Issuing new equity may indicate the firm has too
little debt or excess liquidity.
[ ] Stockholders are just acknowledging the fact that
sales of the firm must be declining if new equity sales
need to be sold.
√ [ ] It is expensive to issue securities and stockholders
are just recognizing the loss in value the firm will incur
by paying out this money.
[ ] There may be a simple supply and demand
problem, that is, the additional shares will be in great
demand and prices usually drop when demand rises.
93) In a(n)_____, the underwriter agrees to purchase

the unsubscribed portion of a rights issue.
√ [ ] standby underwriting
[ ] firm commitment underwriting
[ ] best efforts underwriting
[ ] Green Shoe provision
[ ] oversubscription privilege
94) To finance expansion into Japan, General Motors
sells 10,000,000 shares of common stock to the public
at large. This is an example of a(n):
[ ] private placement.
√ [ ] seasoned new issue.
[ ] rights offer.
[ ] Regulation A offering.
[ ] initial public offering.
95) As an existing shareholder you have the right to

participate in a privileged subscription that gives you
the ability to do each of the following EXCEPT:
[ ] maintain your percentage of ownership.
[ ] sell some of your rights to another party.
√ [ ] receive the rights even after you have sold the
stock, provided you sell before the ex-rights date.
[ ] exercise your rights and then sell the new stock
you just acquired.
[ ] incur a loss of wealth if you let your rights expire
unexercised.
96) Which of the following terms are generally

associated with an initial public offering of common
stock?
I. tombstone
II. red herring
III. preliminary prospectus
IV. underpricing
[ ] I and III only
[ ] II and IV only
97) Central Maine Power Company, a regional electric
utility, sells 500,000 shares of common stock to
investors at large. This is most likely to be a best efforts
offering.
[ ] True
√ [ ] False
98) The _____ is the difference between the price the

issuing firm receives for its securities and the offer
price.
[ ] initial return
[ ] abnormal return
[ ] Green Shoe option
√ [ ] spread
[ ] seed money
99) Venture capitalists frequently hold voting preferred

stock giving them various priorities in the event the
company is sold or liquidated.
√ [ ] True
[ ] False
100) Best efforts underwriting is the most common type

of underwriting in the United States.
[ ] True
√ [ ] False
101) _____ considered an indirect flotation cost.

[ ] The underwriter's spread is
√ [ ] Time spent by management is
[ ] Filing fees are
[ ] Legal fees are
[ ] Taxes incurred as a result of the issue are
102) Venture capitalists usually do not actively
participate in running the firm.
[ ] True
√ [ ] False

offering. The subscription price is $100 a share. What is
the ex-rights price?
[ ] $100.00
[ ] $113.33
[ ] $116.50
√ [ ] $116.67
[ ] $120.00
Ch17
1) The Wrangler Co. has expected EBIT of $9,250 and debt with a face
and market value of $14,000 paying a 9 percent annual coupon. The
market value of the firm is $58,525. If the tax rate is 34 percent, what is
the unlevered cost of capital for the firm?
[ ] 9.00 percent
√ [ ] 11.35 percent
[ ] 12.12 percent
[ ] 12.76 percent
[ ] 12.99 percent
2) In order to avoid bankruptcy, management sometimes seeks to work

with creditors. One method of restructuring debt involves composition,
which involves a reduction in the amount of the payment to be made.
√ [ ] True
[ ] False
3) Which one of the following statements is true concerning the

weighted average cost of capital (WACC)?
[ ] WACC ignores taxes.
[ ] The optimal capital structure is the one that maximizes the
WACC.
√ [ ] The value of a firm will be maximized when the WACC is
minimized.
[ ] WACC ignores the capital structure of a firm.
[ ] Since discount rates and present values move in the same
direction, minimizing the WACC will minimize the value of the firm's
cash flows.
4) If the static theory of capital structure is true, then the optimal level
of debt for a given firm increases as its marginal tax rate increases and
decreases as the costs of financial distress increase.
√ [ ] True
[ ] False
5) A firm with no debt has 200,000 shares outstanding valued at $20
each. Its cost of equity is 12 percent. The firm is considering adding
$1,000,000 in debt to its capital structure. The coupon rate would be 8
percent and the firm's tax rate is 34 percent. What would the firm be
worth after adding the debt?
[ ] $4.033 million
[ ] $4.180 million
√ [ ] $4.340 million
[ ] $4.660 million
[ ] $5.000 million
6) The unlevered cost of capital for Red Ryder Original BBs, Inc. is 12
percent. Debt costs run 8 percent before-tax for the firm. Assuming a
capital structure of 25 percent debt and 75 percent equity, what is the
cost of equity? The tax rate is 34 percent.
[ ] 11.0 percent
[ ] 12.6 percent
√ [ ] 12.9 percent
[ ] 13.4 percent
[ ] 13.8 percent
7) Which of the following statements are correct concerning observed

capital structures in the U.S.?
I. On average, firms in the U.S. are fairly heavily leveraged.
II. On average, it appears that U.S. firms do not use the interest tax
shield to its fullest.
III. On average, there are very few industries in the U.S. for which total
debt exceeds total equity.
IV. On average, electric utilities and cable companies are some of the
most highly leveraged firms in the U.S.
[ ] I and III only
[ ] II and IV only
8) The fastest form of bankruptcy is likely to be a prepackaged filing.

√ [ ] True
[ ] False
9) The Wrangler Co. has expected EBIT of $9,250, debt with a face
and market value of $14,000 paying a 9 percent annual coupon, and
an unlevered cost of capital of 12 percent. If the tax rate is 39 percent,
what is the value of the equity of the firm?
√ [ ] $38,481
[ ] $52,481
[ ] $55,635
[ ] $58,525
[ ] $65,600
10) The cost of debt is generally lower than the cost of equity;
however, according to _____, replacing equity with debt will not
change the value of the firm because the savings attributable to the
lower cost of debt financing will be offset by the higher required return
on the remaining equity.
[ ] M&&M Proposition I with taxes
√ [ ] M&&M Proposition I without taxes
[ ] the static theory of capital structure
[ ] M&&M Proposition II without taxes
[ ] M&&M Proposition II with taxes
11) Which one of the following individuals has NOT acquired a

marketed claim against RDJ corporation?
[ ] John purchased 250 shares of RDJ common stock.
[ ] Tom acquired rights allowing him to purchase 50 shares of RDJ
common stock.
√ [ ] Suzie just won a lawsuit against RDJ.
[ ] Susan recently purchased 200 shares of preferred stock in RDJ
Corporation.
[ ] Jim purchased a long-term bond issued by RDJ.
12) The Wrangler Co. has expected EBIT of $9,250, debt with a face
and market value of $14,000 carrying a 9 percent annual coupon, and
an unlevered cost of capital of 12 percent. If the tax rate is 39 percent,
what is the value of the firm?
[ ] $47,021
√ [ ] $52,481
[ ] $55,635
[ ] $58,525
[ ] $65,600
13) According to the M&&M propositions without taxes, there is an

optimal amount of leverage for a firm.
[ ] True
√ [ ] False
14) Which of the following statements are true?

I. The total systematic risk of a firm's equity has two parts: business
risk and financial risk.
II. The interest tax shield reduces the weighted average cost of capital
(WACC) of a firm, all else constant.
III. Most firms in the U.S. maintain relatively low debt-to-equity ratios.
IV. The costs of bankruptcy decrease the attractiveness of debt
financing.
[ ] I and III only
[ ] II and IV only
15) Business risk declines as the systematic risk of a firm's assets

increases.
[ ] True
√ [ ] False
16) For a levered firm, the cost of equity, RE, is equal to the required
return on the firm's assets, RA.
[ ] True
√ [ ] False
17) Which one of the following correctly describes M&&M Proposition II

with taxes?
√ [ ] RE = RU + (RU - RD) X (D/E) X (1 - TC)
[ ] RE = RD + (RD - RA) X (D/E) X (1 - TC)
[ ] RE = RU X (RU - RA) + (D/E) X (1 + TC)
[ ] RE = RU + (RU - RD) X (E/D) + (1 + TC)
[ ] RE = RU + (RA - RD) X (E/D) + (1 - TC)
18) According to M&&M Proposition I with taxes, the:

[ ] WACC increases as leverage increases.
[ ] unlevered value of the firm is equal to the levered value.
√ [ ] present value of the tax shield can be expressed as “Tc X D”.
[ ] capital structure of a firm is irrelevant.
[ ] WACC remains constant as the debt-equity ratio changes.
19) Suppose you draw a graph with EBIT on the horizontal axis and
EPS on the vertical axis. Which one of the following is true if you
compare a levered firm versus an unlevered firm using this graph?
Assume there are no taxes.
[ ] The levered firm has a lower intercept than the unlevered firm but
we cannot say anything about the slope.
√ [ ] The levered firm has a lower intercept and a higher slope than
does the unlevered firm.
[ ] The levered firm has a higher intercept and a lower slope than
does the unlevered firm.
[ ] The unlevered firm has a higher intercept than the levered firm
but we cannot say anything about the slope.
[ ] The unlevered firm has a lower intercept and a higher slope than
does the levered firm.
20) Business risk is a positive function of the systematic risk of a firm's
assets.
√ [ ] True
[ ] False
21) According to _____, a firm's cost of equity rises with increases in

the amount of debt but the WACC remains unchanged.
[ ] M&&M Proposition I without taxes
√ [ ] M&&M Proposition II without taxes
22) Which of the following correctly describes M&&M Proposition II

without taxes?
[ ] RE = RA X (RA - RD) + (D/E)
[ ] RE = RD + (RD - RA) X (D/E)
[ ] RE = RD + (RA - RD) X (E/D)
[ ] RE = RA + (RA - RD) X (E/D)
√ [ ] RE = RA + (RA - RD) X (D/E)
23) A firm has an unlevered cost of capital of 10 percent, a cost of debt

of 9 percent, and a tax rate of 34 percent. If it desires a cost of equity
of 14 percent, what must its target debt/equity ratio be?
[ ] 2.49
[ ] 3.89
[ ] 4.68
[ ] 5.14
√ [ ] 6.06
24) _____ suggests that value-maximizing financial managers will look

to the asset side of the balance sheet to increase firm value, since the
mix of debt and equity employed is unlikely to affect firm value.
√[ ] M&&M Proposition I without taxes
[ ] The static theory of capital structure
25) A firm has 10,000 bonds outstanding, each with a face value of
$1,000 and a coupon payment of $55 every six months. If the
corporate tax rate is 34 percent, what is the interest tax shield each
year?
[ ] $187,000
√ [ ] $374,000
[ ] $748,000
[ ] $976,000
[ ] $1,240,000
26) The Brassy Co. has expected EBIT of $910, debt with a face and
market value of $2,000 paying an 8.5 percent annual coupon, and an
unlevered cost of capital of 12 percent. If the tax rate is 34 percent,
what is the value of the equity of Brassy Co.?
[ ] $3,258
√ [ ] $3,685
[ ] $5,685
[ ] $6,325
[ ] $7,005
27) The equity risk that arises from the capital structure of the firm is
called _____ risk.
[ ] systematic
[ ] business
[ ] unsystematic
√ [ ] financial
[ ] diversifiable

[ ] Decisions regarding a firm's debt and equity can be called capital
budgeting decisions.
[ ] The asset beta is a measure of the unsystematic risk of a firm's
assets.
[ ] In a pure capital restructuring, the composition of the assets of the
firm will change.
[ ] The value of the overall firm will not change as a result of a capital
restructuring unless the NPV of the restructuring is negative.
√ [ ] The use of personal leverage by an investor to alter the degree of
financial leverage to which the investor is exposed is called homemade
leverage.
29) Which of the following statements are correct regarding financial

leverage?
I. Whenever a firm's debt increases faster than its equity, financial
leverage increases.
II. Leverage is most beneficial when EBIT is relatively high.
III. Increasing financial leverage will always increase the ROE and EPS
of stockholders.
IV. The level of financial leverage that produces the highest firm value
is the one most beneficial to stockholders.
[ ] I and III only
[ ] II and IV only
[ ] I and II only
30) The Brassy Co. has expected EBIT of $910, debt with a face and
market value of $2,000 paying an 8.5 percent annual coupon, and an
unlevered cost of capital of 12 percent. If the tax rate is 34 percent,
what is the value of the firm?
[ ] $3,258
[ ] $3,685
√ [ ] $5,685
[ ] $6,325
[ ] $7,005
31) When choosing a capital structure, the objective of the firm should
be to choose:
[ ] the one that maximizes the current value of the firm's bonds.
[ ] the one that minimizes the value of the firm.
√ [ ] the one that minimizes the firm's WACC.
[ ] the one that results in the largest interest tax shield.
[ ] any capital structure since capital structure is always irrelevant.
32) According to _____, a firm's cost of equity is a positive linear

function of its degree of leverage.
[ ] the dynamic theory of capital structure
√ [ ] M&&M Proposition II without taxes
[ ] M&&M Proposition III with taxes
33) _____ suggests that value-maximizing financial managers will

employ capital structures composed of that mix of debt and equity for
which the interest tax shield is equal to the cost associated with the
probability of financial distress.
√ [ ] The static theory of capital structure
34) If a firm fails to meet the required interest payment on its long-term
bonds, it is said to be in:
[ ] business failure.
[ ] Chapter 11 bankruptcy.
[ ] accounting insolvency.
√ [ ] technical insolvency.
[ ] Chapter 7 bankruptcy.
35) Which one of the following is true concerning the rates of return
earned on shares of a levered firm in terms of the possible range of
earnings? Assume there are no taxes.
[ ] The rates do not differ from those of an unlevered firm.
[ ] The rates are higher than an unlevered firm on the upside, but
unchanged on the downside.
[ ] The rates are unchanged from an unlevered firm on the upside,
but lower on the downside.
√ [ ] The rates are higher than an unlevered firm on the upside, but
lower on the downside.
[ ] The rates are unchanged from an unlevered firm on the upside,
but higher on the downside.
36) Which one of the following formulas is associated with M&&M

Proposition II without taxes?
[ ] VL = VU + TC X D
[ ] RE = RU + (RU - RD) X (D/E) X (1 – TC)
√ [ ] RE = RA + (RA - RD) X (D/E)
[ ] VL = VU
[ ] RE = RA
37) Which one of the following actions would result in an increase in

the debt-to-equity ratio? (Assume there are no flotation costs.)
[ ] A firm issues common stock and uses the proceeds to repurchase
an equal amount of preferred stock.
[ ] A firm issues preferred stock and uses the proceeds to
repurchase an equal amount of bonds.
[ ] A firm with positive additions to retained earnings uses the cash it
generates to retire existing debt.
[ ] A firm uses excess cash to repurchase common stock in an
amount equal to additions to retained earnings for the year.
√ [ ] A firm issues bonds and uses the proceeds to purchase short-
term assets.
38) _____ risk arises from decisions that affect the left-hand side of the
balance sheet; while _____ risk arises from decisions that affect the
right-hand side of the balance sheet.
[ ] Systematic; financial
√ [ ] Business; financial
[ ] Unsystematic; systematic
[ ] Business; diversifiable
[ ] Systematic; unsystematic
39) Below the breakeven EBIT, increased financial leverage will

_____, all else equal. Assume there are no taxes.
[ ] increase EPS
√ [ ] decrease EPS
[ ] not affect EPS
[ ] either increase or decrease EPS but you can’t tell which
[ ] increase EBIT and EPS.
40) All else equal, which one of the following will alter the capital
structure of a firm?
√ [ ] A firm sells bonds and uses the proceeds to buy back stock.
[ ] A firm refunds a bond issue by issuing new bonds.
[ ] A firm uses the proceeds of a sale of bonds to pay off bank debt.
[ ] A firm pays all of its earnings out to stockholders in the form of
dividends, retaining nothing.
[ ] A firm makes an interest payment on its bonds.
41) Which of the following correctly describes the value of a levered

firm under M&&M Proposition I with corporate taxes?
[ ] VL = VU + TC + D
[ ] VL = VU X TC X D
[ ] VL = VU - TC X D
√ [ ] VL = VU + TC X D
[ ] VL = VU X TC - D
42) Which one of the following statements is correct concerning a
bankruptcy reorganization under Chapter 11 of the Federal Bankruptcy
Reform Act of 1978?
[ ] Only voluntary petitions can be filed for Chapter 11.
[ ] A bankruptcy judge must accept all voluntary petitions for Chapter
11 bankruptcy.
[ ] In most cases, a trustee is appointed to manage a firm that is in
Chapter 11 bankruptcy.
[ ] Everyone in a class must accept the reorganization plan for the
plan to be approved.
√ [ ] New shares of stock may be issued as a result of a Chapter 11
bankruptcy.
43) _____ describes the situation in which a firm is having trouble

meeting its financial obligations.
[ ] Technical bankruptcy
[ ] Legal bankruptcy
√ [ ] Financial distress
[ ] Direct bankruptcy cost
[ ] Business risk
44) It has been observed that, when firms get into financial trouble,
they often find it difficult to attract and retain high-quality employees.
The additional costs incurred in this situation would be considered
direct bankruptcy costs.
[ ] True
√ [ ] False
45) Ignoring financial distress costs, borrowing money decreases the

value of the firm by increasing the firm's tax liability.
[ ] True
√ [ ] False
46) Which one of the following describes a correct priority of claims in

a bankruptcy liquidation?
[ ] Wages, government tax claims, consumer claims, preferred
stockholders
[ ] Government tax claims, bankruptcy expenses, unsecured
creditors, preferred stockholders
[ ] Bankruptcy expenses, consumer claims, unsecured creditors,
government tax claims
[ ] Government tax claims, unsecured creditors, preferred
stockholders, bankruptcy expenses
√ [ ] Bankruptcy expenses, wages, unsecured creditors, preferred
stockholders
47) According to _____, the value of the firm is independent of its

capital structure.
√ [ ] M&&M Proposition I without taxes
48) The Brassy Co. has expected EBIT of $910, an unlevered cost of
capital of 12 percent, and debt with a face and market value of $2,000
paying an 8.5 percent annual coupon. If the tax rate is 34 percent,
what is the cost of equity of Brassy Co.?
[ ] 12.99 percent
√ [ ] 13.25 percent
[ ] 13.76 percent
[ ] 14.64 percent
[ ] 18.45 percent
49) Which of the following are correct rankings of priorities if the claims
are ranked from strongest to weakest?
I. wages and salaries; consumer claims; unsecured creditors
II. contributions to employee benefit plans; consumer claims; common
stockholders
III. government tax claims; preferred stockholders; unsecured creditors
IV. bankruptcy-related administrative expenses; wages and salaries;
common stockholders
[ ] I and II only
[ ] III and IV only
50) Of the following, _____ would MOST likely lead to a Chapter 7

bankruptcy liquidation.
[ ] the need to escape long-term leases on closed stores
[ ] a prepackaged bankruptcy filing
√ [ ] technical insolvency
[ ] accounting insolvency
[ ] financial distress

the amount of debt while the WACC first falls and then rises as debt is
added.
√ [ ] the static theory of capital structure
52) _____ suggests that value-maximizing financial managers will

employ capital structures composed almost entirely of debt.
√ [ ] M&&M Proposition I with taxes
[ ] The static theory of capital structure
53) An unlevered firm has an EBIT of $250,000, net income after tax of
$175,000 and a cost of capital of 12 percent. A levered firm with the
same assets and operations has debt with a face and market value of
$1.25 million carrying an 8 percent annual coupon. What is the value of
the levered firm? The tax rate is 34 percent.
[ ] $1,250,000
[ ] $1,375,000
[ ] $1,666,667
√ [ ] $1,800,000
[ ] $2,625,000
54) Suppose you draw a graph illustrating M&&M Proposition II. Let the
vertical axis represent the cost of capital and the firm's debt-to-equity
ratio represent the horizontal axis; then if the slope of the line
representing the firm's WACC has a negative slope, we must be
incorporating taxes into the analysis.
√ [ ] True
[ ] False
55) According to the extended pie model, the value of all of the claims
against a firm's cash flows is not affected by capital structure, but the
relative values of claims within the pie change as the amount of debt
financing is increased.
√ [ ] True
[ ] False
56) Which of the following statements regarding leverage are correct?

I. The ultimate effect of leverage depends on the firm's EBIT.
II. As a firm levers up, shareholders are exposed to more and more
risk.
III. The benefits of leverage will not be as great in a firm with
substantial accumulated losses or other types of tax shields as for a
firm without many tax shields.
IV. Beyond a certain point, the costs of financial distress outweigh the
benefits of leverage.
[ ] I and III only
[ ] II and IV only
57) A firm that wishes to proceed with a straight liquidation will file
under Chapter 7 of the Federal Bankruptcy Reform Act of 1978.
√ [ ] True
[ ] False
58) Because investors can use homemade leverage to create any level
of financial leverage they desire, the capital structure of a firm does not
matter to them.
√ [ ] True
[ ] False
59) Assume there are no corporate or personal taxes. According to

M&&M Proposition:
[ ] I, the total value of the firm depends on how cash flows are
divided up between stockholders and bondholders.
[ ] I, a firm's capital structure is relevant.
√ [ ] II, the cost of equity rises as the firm increases its use of debt
financing.
[ ] II, the cost of equity depends on the firm's business risk but not its
financial risk.
[ ] I and II, as debt increases, the increase in the cost of equity is
more than offset by the lower cost of debt and the WACC falls.
60) All else equal, the financial leverage of a firm will:

[ ] decrease as the amount of debt increases relative to equity.
√ [ ] decrease as the firm's retained earnings account grows.
[ ] increase by the amount of equity it issues in a given year.
[ ] decrease if the firm has negative net income.
[ ] decrease as the firm uses debt to fund expansion projects.
61) All else equal, which one of the following statements is true
concerning the interest tax shield of a firm that has positive earnings
before interest and taxes?
[ ] The higher the corporate tax rate, the less valuable the interest
tax shield.
[ ] If the firm dramatically increases its depreciation expense it may
have more of a need for an interest tax shield.
√ [ ] The present value of the interest tax shield is the amount of debt
multiplied by the corporate tax rate.
[ ] The interest tax shield increases as a firm reduces its level of debt
outstanding.
[ ] Since the interest tax shield is valuable for a firm, the firm would
rather pay a high coupon rate on its bonds than a low coupon rate.
62) The interest tax shield for a firm:

√ [ ] is the tax benefit a firm derives from paying interest.
[ ] will decrease as the corporate income tax rate is increased.
[ ] is the yield-to-maturity on a firm's bonds multiplied by the market
value of the bonds outstanding and by the firm's tax rate.
[ ] is equal to the coupon interest rate of the firm's debt.
[ ] will be positive at all levels of EBIT.

[ ] The capital structure of a firm does not matter even when taxes
are considered.
[ ] Firms with substantial tax shields from other sources such as
depreciation will benefit the most from leverage.
[ ] Firms in lower tax brackets will tend to benefit more from
increases in financial leverage.
[ ] The financial structure that minimizes WACC is the one that will
minimize the value of the firm.
√ [ ] Relatively speaking, a firm with mostly tangible assets that can be
sold without great loss in value will have an incentive to borrow more.
64) Which of the following is (are) true regarding observed capital
structures?
I. Drug companies appear to use less debt than electric utility
companies do.
II. It appears that many firms choose to pay substantial taxes rather
than increase debt to further benefit from the interest tax shield.
III. It appears that, for whatever reason, capital structures vary quite a
bit across industry groups.
[ ] I only
[ ] III only
[ ] I and III only
[ ] I and II only
65) Direct bankruptcy costs are those costs that are directly associated
with bankruptcy, such as legal and administrative expenses.
√ [ ] True
[ ] False
66) An unlevered firm has a net income after tax of $125,000. The
unlevered cost of capital is 13 percent and the corporate tax rate is 34
percent. What is the value of this firm?
[ ] $594,102
[ ] $634,615
[ ] $729,654
√ [ ] $961,538
[ ] $1,051,591
67) All else equal, which one of the following is a correct statement?
√ [ ] The business risk of a firm increases when it takes on a risky
project.
[ ] The business risk of a firm increases when it takes on more debt.
[ ] The financial risk of a firm decreases when it takes on a risky
project.
[ ] The financial risk of a firm increases when it takes on more equity.
[ ] The higher the business risk for a firm, the higher the financial risk
as well.
68) You are a secured creditor in a Chapter 11 bankruptcy. Listed

below, in chronological order, are the steps in a bankruptcy
proceeding. Just prior to which step would you expect to have to
document the strength of your claim on the firm's assets?
[ ] The corporation files a bankruptcy petition.
[ ] The petition is approved or denied by a federal judge.
√ [ ] Creditors are divided into classes.
[ ] The court confirms the bankruptcy plan.
[ ] Payments are made to creditors and shareholders.
69) Given the following information, what is GEM Corporation's

WACC? EBIT = $2 million; tax rate = 34 percent; market value and
book value of debt = $4 million; unlevered cost of capital = 14 percent;
cost of debt = 9 percent.
[ ] 11.4 percent
[ ] 11.9 percent
√ [ ] 12.2 percent
[ ] 12.6 percent
[ ] 13.1 percent
70) According to the static theory of capital structure:

[ ] a firm is fixed in terms of its debt-equity ratio and only considers
changes in its assets.
√ [ ] a firm will borrow up to the point where the benefit from an extra
dollar of debt is just equal to the cost of the increased probability of
financial distress.
[ ] the value of the firm will differ from the M&&M value without taxes
by the loss from leverage, net of distress costs.
[ ] the optimal level of debt is found when a firm is 100 percent
financed by debt.
[ ] the value of the unlevered firm in M&&M I with taxes is overstated
by the loss in value due to possible financial distress.
71) A firm that has negative net worth is said to be:
[ ] experiencing a business failure.
[ ] in legal bankruptcy.
[ ] experiencing technical insolvency.
√ [ ] experiencing accounting insolvency.
[ ] in Chapter 11, bankruptcy reorganization.
72) Which one of the following is considered an indirect bankruptcy

cost?
[ ] the cost of the extra insurance a bankruptcy court may require a
firm to carry on its assets
[ ] the cost a firm must pay to the court when filing its bankruptcy
petition
[ ] the cost of any appraisals a bankruptcy court requires a firm to
obtain
[ ] the fee the firm pays its lawyer to draw up the bankruptcy petition
√ [ ] the cost of projects in progress that are terminated in order to
preserve cash to prevent a bankruptcy
73) ABC, Inc. has a debt/equity ratio of 1.2. The firm has a cost of
equity of 12 percent and a cost of debt of 8 percent. What will the cost
of equity be if the target capital structure becomes 67 percent debt and
33 percent equity? The cost of debt does not change. Ignore taxes.
[ ] 10.56 percent
[ ] 11.12 percent
√ [ ] 13.52 percent
[ ] 13.64 percent
[ ] 14.45 percent
74) When a firm files for bankruptcy, the firm often must hire
appraisers to determine the fair value of the firm's assets. This is an
example of a direct cost of bankruptcy.
√ [ ] True
[ ] False
75) In a(n) _____ a business is terminated, usually with a loss to
creditors.
[ ] violation of protective covenants
[ ] bankruptcy reorganization
[ ] technical insolvency
[ ] accounting insolvency
√ [ ] business failure
76) Which one of the following correctly describes the value of an

unlevered firm under M&&M Proposition I with corporate taxes?
[ ] VU = EBIT / [RU X (1 - TC)]
[ ] VU = [EBIT + (1 - TC)] / RU
[ ] VU = [EBIT X (1 + TC) X (D/E)] / RU
[ ] VU = [EBIT X (1 - TC) X (D/E)] / RU
√ [ ] VU = [EBIT X (1 - TC)] / RU
77) Which of the following statements is (are) true regarding corporate

borrowing when EBIT is positive?
I. Increasing financial leverage increases the sensitivity of EPS and
ROE to changes in EBIT.
II. The effect of financial leverage depends on the company's EBIT,
that is, leverage is unfavorable when EBIT is relatively high, and
leverage is favorable when EBIT is relatively low.
III. High leverage decreases the returns to shareholders, as measured
by ROE.
√ [ ] I only
[ ] II only
[ ] III only
[ ] I and II only
[ ] I, II, and III
78) The main lesson to be learned from the M&&M theory of capital
structure is that:
[ ] a firm can affect its value by changing its capital structure.
[ ] the size of a pie is determined by how many slices it has.
[ ] the WACC increases as financial leverage decreases.
[ ] a firm's capital structure should be one hundred percent equity.
√[ ] the value of a firm is determined by its total cash flows.
79) The optimal capital structure is that mixture of debt and equity
which:
I. maximizes the value of the firm.
II. minimizes the firm's weighted average cost of capital.
III. maximizes the market price of the firm's bonds.
[ ] I only
[ ] III only
[ ] I and III only
[ ] I, II, and III
80) When a firm defaults on a legal obligation,:

[ ] it is called a business failure.
[ ] the firm is in legal bankruptcy.
√ [ ] the firm is in technical insolvency.
[ ] the firm is in accounting insolvency.
[ ] the firm is in violation of protective covenants.
81) A firm's systematic risk will _____ as its debt-to-equity ratio_____:

√ [ ] increase; increases.
[ ] decrease; increases.
[ ] remain unchanged; decreases.
[ ] remain unchanged; increases.
[ ] not be affected; increases, but its unsystematic risk will increase.
82) According to M&&M Proposition II without taxes, a firm's cost of

equity is a function of which of the following factors?
I. the required rate of return on the firm's assets
II. the firm's debt/equity ratio
III. the firm's cost of debt
[ ] II only
[ ] I and II only
[ ] I and III only
[ ] II and III only
√[ ] I, II, and III
83) Based on M&&M II without taxes, what is the cost of equity for a
firm with a required return on assets of 14 percent, a cost of debt of 11
percent, and a target debt/equity ratio of .50?
[ ] 11.0 percent
[ ] 12.5 percent
[ ] 14.0 percent
√ [ ] 15.5 percent
[ ] 17.0 percent
84) All else equal, which of the following claims to a firm's cash flows
will tend to increase with decreases in the debt-to-equity ratio
assuming there are taxes?
I. the government's claim in the form of taxes
II. the claims from bankruptcy costs
III. the claims of stockholders
IV. the claims of bondholders
[ ] I and IV only
[ ] II and IV only
85) When the value of a firm's assets equals the value of its debt (i.e.,
the firm's equity has no value) the firm is in:
√ [ ] economic bankruptcy.
[ ] technical insolvency.
[ ] legal bankruptcy.
[ ] liquidation.
[ ] default.
86) Which of the following statements concerning leverage are
correct?
I. Shareholders can offset the financial leverage of a firm through the
use of homemade leverage.
II. The effect of financial leverage depends on a company’s earnings
before interest and taxes.
III. The use of leverage by a firm does not affect the earnings per
share.
IV. Homemade leverage involves the use of personal borrowing or
personal lending.
[ ] I and III only
[ ] II and IV only
87) According to the static theory of capital structure, value-maximizing

financial managers will borrow to the point where the firm's business
risk is just equal to its financial risk.
[ ] True
√ [ ] False
88) According to the static theory of capital structure, because financial

distress costs exist there is an optimal capital structure.
√ [ ] True
[ ] False
89) The legal proceeding for liquidating or reorganizing a business is

called:
[ ] a lawsuit.
[ ] accounting insolvency.
[ ] technical insolvency.
√ [ ] legal bankruptcy.
[ ] business failure.
90) Which of the following are true about bankruptcy and its costs?
I. If a firm is insolvent on an accounting basis, then an ensuing legal
bankruptcy may end with the bondholders not receiving all they are
owed.
II. Direct bankruptcy costs include the legal and administrative costs
incurred during the bankruptcy process.
III. A firm faces technical insolvency if it is unable to meet its financial
obligations.
IV. Direct bankruptcy costs are a disincentive to debt financing.
[ ] I and II only
91) M&&M Proposition I with taxes implies that:

[ ] the value of an unlevered firm exceeds the value of a levered firm
by the amount of the present value of the interest tax shield.
[ ] a levered firm can increase its value by reducing debt.
[ ] the optimal amount of leverage for a firm is not possible to
determine.
[ ] the value of a levered firm is equal to after-tax EBIT discounted by
the unlevered cost of capital.
√ [ ] there is a linear relationship between the amount of debt in a
levered firm and its value.
92) Which of the following statements is (are) correct if there are no

personal or corporate income taxes and the overall cost of capital of a
firm is unaffected by its capital structure?
I. A firm's cost of equity depends on the firm's business and financial
risks.
II. The value of the firm is dependent on its capital structure.
III. The cost of equity increases as the firm's leverage decreases.
√ [ ] I only
[ ] II only
[ ] III only
[ ] I and III only
[ ] II and III only
93) Homemade leverage is the use of personal borrowing to change

the overall amount of financial leverage to which an individual is
exposed.
√ [ ] True
[ ] False
94) Which of the following statements are true as a firm approaches

bankruptcy?
I. Stockholders will try to push the firm into bankruptcy as rapidly as
possible.
II. Bondholders will attempt to push the firm into bankruptcy to prevent
their position from deteriorating.
III. It will be harder to retain company personnel.
IV. Indirect bankruptcy costs such as opportunity costs will tend to
decrease.
[ ] I and IV only
95) The equity risk that arises from the nature of the firm's operating
activities is called _____ risk.
√ [ ] business
[ ] systematic
[ ] unsystematic
[ ] financial
[ ] diversifiable
96) The effect of financial leverage depends on a company's EBIT.

√ [ ] True
[ ] False
97) Indirect bankruptcy costs include the costs of avoiding a

bankruptcy filing incurred by a financially distressed firm.
√ [ ] True
[ ] False
98) The target capital structure is the debt-to-equity ratio that

maximizes the:
√ [ ] value of the firm.
[ ] firm's weighted average cost of capital.
[ ] market price of the firm's preferred stock.
[ ] current earnings per share.
[ ] market value of the firm's bonds.
99) The Brassy Co. has expected EBIT of $910, an unlevered cost of
capital of 12 percent and debt with a face and market value of $2,000
paying an 8.5 percent annual coupon. If the tax rate is 34 percent,
what is the WACC of Brassy Co.?
√ [ ] 10.56 percent
[ ] 11.12 percent
[ ] 13.25 percent
[ ] 13.64 percent
[ ] 14.45 percent

the amount of debt but the WACC decreases.
√ [ ] M&&M Proposition II with taxes
Ch18
1) Rocky Ground Camping Supply, Inc. has 200,000 shares of stock

outstanding, each with a par value of $5 and a market value of $15. In
addition, on the balance sheet there is additional paid-in capital of
$950,000 and retained earnings of $1,450,000. If the firm declares a 4-
for-1 stock split what is the stock's market value after the split?
Assume there are no taxes or transaction costs.
√ [ ] $3.75
[ ] $5.00
[ ] $7.50
[ ] $10.00
[ ] $12.50
2) Sesame Sweet, Inc. has 220,000 shares outstanding with a par

value of $1 per share and a market price of $12.00 per share. Capital
in excess of par amounts to $540,000, while retained earnings is
$275,000. There is no treasury stock and there are no transactions
costs. Suppose Sesame Sweet declares a 2-for-1 stock split. What
happens to the capital in excess of par account on the balance sheet?
√ [ ] The account remains unchanged.
[ ] The account increases by $22,000.

costs. Suppose Sesame Sweet declares a 100 percent (large) stock
dividend. What happens to the retained earnings account on the
balance sheet?
[ ] The account remains unchanged.
√ [ ] The account decreases by $220,000.
[ ] The account decreases by $242,000.
4) In a world with no taxes or transaction costs, dividend policy is
irrelevant.
√ [ ] True
[ ] False
5) If the clientele effect holds, then financial managers cannot increase

the demand (and therefore the market value) of their firms' shares by
increasing the rate of dividend payout.
√ [ ] True
[ ] False
6) A cash payment to shareholders that is truly unusual and won't be

repeated is called a (an) _____ dividend.
[ ] extra
√ [ ] special
[ ] homemade
[ ] residual
[ ] liquidating
7) Martha’s Gym has projected quarterly earnings of $650,000,

$800,000, $550,000, and $1,000,000 over the four quarters of the next
year, starting with the first quarter. The company retains 60 percent of
its earnings and follows a stable dividend policy each year. What is the
dividend for the 2nd quarter?
[ ] $220,000
[ ] $260,000
√ [ ] $300,000
[ ] $320,000
[ ] $400,000
8) Goodbooks Publishing, Inc. plans to issue a 15 percent (small) stock

dividend. Which of the following is (are) likely to occur?
I. The par value per share will increase by 15 percent.
II. The total shareholders' equity will remain unchanged.
III. The proportional ownership of each existing shareholder will
decrease by 15 percent.
IV. The number of shares outstanding will remain unchanged.
√ [ ] II only
[ ] II and III only
[ ] III and IV only
9) Which of the following are accurate regarding share repurchases?

I. In a world without imperfections, there is essentially no difference
between a share repurchase and a cash dividend.
II. Share repurchases cannot be undertaken for the sole purpose of
avoiding taxes.
III. Repurchasing shares is a useful method of stabilizing cash
dividends.
IV. Share repurchases result in an increase in earnings per share.
[ ] IV only
[ ] I and III only
[ ] II and IV only
10) If dividend clienteles exist then:

√ [ ] it is all the more likely that dividend policy is irrelevant.
[ ] investors will prefer higher dividend payouts, on average.
[ ] homemade dividends are irrelevant.
[ ] a firm should NOT follow a residual dividend approach.
[ ] a firm can boost its share price by raising its dividend.
11) The board of directors of DDT Inc. declared a dividend of $0.75 per
share payable on Monday, January 26 to shareholders of record as of
Monday, January 12. You owned 500 shares of DDT on Wednesday,
January 7 when the price was $7.50 per share. Under NYSE rules, you
sell your 500 shares of DDT on Friday, January 9. What amount of
money will you receive assuming the only change in the price of the
stock is due to the dividend?
[ ] $3,000
√ [ ] $3,375
[ ] $3,500
[ ] $3,750
[ ] $4,250
12) According to Fischer Black, firms pay dividends because investors
dislike them.
[ ] True
√ [ ] False
13) On January 2, the board of directors of DDT, Inc. declared a

dividend of $0.75 per share payable on Monday, January 26 to
shareholders of record as of Monday, January 12. Under NYSE rules,
if you bought 500 shares of DDT stock on Friday, January 2 for $7.50
per share, how much will you receive in dividends?
[ ] $0.00
[ ] $1.50
[ ] $37.50
[ ] $55.00
√ [ ] $375.00
14) Suppose a firm wishes to pay cash to its shareholders. The only
way to do so is to pay a dividend.
[ ] True
√ [ ] False
15) Which one of the following would increase the desirability of high-
dividend shares from the viewpoint of the shareholder?
√ [ ] the imposition of a tax exemption on the first $100 of dividend
income
[ ] the imposition of a reduced tax rate on capital gains income
[ ] the imposition of a tax exemption on the first $100 of capital gains
income
[ ] a reduction in brokerage commissions on purchases and sales of
shares
[ ] an increase in the number of positive net present value projects
available to the firm
16) All else equal, an investor is likely to prefer a firm with a low
dividend payout rate if:
[ ] the firm doesn't have any positive net present value projects in
which it could invest.
[ ] marginal corporate tax rates exceed marginal personal tax rates.
√ [ ] flotation costs are significant.
[ ] the firm's dividend payout is not restricted by a bond indenture.
[ ] the investor is a tax-exempt entity.
17) Rank the following goals in increasing order of importance in a

compromise dividend policy.
I. avoid dividend cuts
II. maintain a target debt/equity ratio
III. avoid the need to sell equity
IV. avoid cutting back on positive NPV projects
[ ] IV, II, I, III
[ ] II, III, IV, I
[ ] IV, I, II, III
[ ] I, II, IV, III
√ [ ] IV, I, III, II
18) Suppose a firm wishes to have its stock listed on an exchange but
its share price is not high enough to meet the minimum price level
specified by the exchange. How might the firm remedy this situation
and reduce the number of shares outstanding at the same time?
[ ] pay a liquidating dividend
[ ] pay a stock dividend
[ ] pay a regular cash dividend
√ [ ] execute a reverse stock split
[ ] execute a stock split
19) A firm unexpectedly decreases its dividend payout and its stock
price falls. The information content effect at least partially explains the
fall in stock price since:
[ ] an unexpected decrease in dividends means management is
signaling that the firm has no positive NPV projects in which to invest.
[ ] investors will always react unfavorably to changes in dividends.
√ [ ] investors react to the change in new information regarding
expected future dividends.
[ ] this unexpected decrease may likely be viewed as an attempt by
management to manipulate the stock price.
[ ] unexpected changes in dividends will not affect stock prices if the
firm has a written dividend policy.
20) A cash payment to shareholders that will not be repeated in the
future is called a (an) _____ dividend.
[ ] regular
[ ] extra
[ ] liquidating
[ ] residual
√ [ ] special
21) A _____ is a cash payment made to shareholders from sources

other than current or accumulated retained earnings.
√ [ ] distribution
[ ] stock dividend
[ ] extra dividend
[ ] special dividend
[ ] regular cash dividend
22) Jim’s Gym has projected quarterly earnings of -$25,000, $50,000,

$185,000, and $115,000 over the four quarters of the next year,
starting with the first quarter. The company retains 40 percent of its
earnings and follows a cyclical dividend policy. What is the dividend for
the 4th quarter?
[ ] $31,000
[ ] $46,000
[ ] $65,000
√ [ ] $69,000
[ ] $105,000
23) Lucky Mike's, Inc. has a target debt/equity ratio of 0.75. After-tax
earnings for the year were $850,000. The firm needs $1,150,000 for
new investments. If the company follows a residual dividend policy,
what dividend will be paid?
[ ] $0
[ ] $67,240
√ [ ] $192,857
[ ] $213,164
[ ] $862,500
24) Dividend stability is usually viewed as a desirable objective for a

firm.
√ [ ] True
[ ] False
25) Which one of the following is given in the text as a possible reason
for a reverse stock split?
[ ] to decrease the stock price and, thereby, increase the stock's
respectability
[ ] to fall below the minimum listing requirements of a stock
exchange
√ [ ] to force out minority shareholders
[ ] to increase the par value of the stock
[ ] to increase the transaction costs of shareholders
costs. Suppose Sesame Sweet declares a 10 percent (small) stock
dividend. What is the stock's new price per share after the dividend?
[ ] $10.48 per share
√ [ ] $10.91 per share
27) A dividend that is a truly unusual or one time event is called a

_____ dividend.
[ ] stock
[ ] regular cash
[ ] cash liquidating
[ ] extra
√ [ ] special
28) Which of the following are main goals of a compromise dividend

policy?
I. avoid the need to sell equity
II. maintain a target dividend payout ratio
III. avoid cutting back on positive net present value projects to pay a
dividend
IV. maintain a target debt/equity ratio
[ ] I and III only
[ ] II and IV only
costs. If Sesame Sweet declares a 2-for-1 stock split what is the
stock's par value after the split?
[ ] $0.00
√ [ ] $0.50
[ ] $1.00
[ ] $1.50
[ ] $2.00
30) The _____ is based on the argument that stocks attract particular
groups based on dividend yield.
[ ] dividend irrelevance proposition
[ ] information content effect
[ ] dividend signaling effect
√ [ ] clientele effect
[ ] tax minimization proposition
31) Stock splits, stock dividends, and reverse stock splits are often
pursued with the objective of:
[ ] decreasing the owners' equity of the firm.
√ [ ] making the firm's stock more desirable to the average investor.
[ ] benefiting shareholders since regular dividends are irrelevant.
[ ] avoiding the need to pay a regular cash dividend.
[ ] enhancing the cash flow of the firm.
32) There are groups of investors who prefer a high dividend payout to
a low one.
√ [ ] True
[ ] False
33) Goodbooks Publishing, Inc. plans to issue a 15 percent (small)
stock dividend. Which of the following would most likely NOT occur?
[ ] The par value per share will remain unchanged.
√ [ ] The total shareholders' equity will increase by 15 percent.
[ ] The price per share will fall by 15 percent.
[ ] The number of shares outstanding will increase.
[ ] The retained earnings will decline if the current market price
exceeds the par value of the stock.
34) Suppose you purchase 100 shares of stock for $3.00 per share
cum dividend just before the market closes on Friday. The-ex dividend
date is Monday and the dividend is $0.25 per share. Ignoring taxes,
your total wealth just after the market opens on Monday morning (all
else equal) will be equal to:
[ ] $250.
[ ] $275.
√ [ ] $300.
[ ] $325.
[ ] $350.
35) In the real world, share repurchases are detrimental largely as a

result of tax considerations.
[ ] True
√ [ ] False
happens to the common stock account on the balance sheet?
37) The basic types of cash dividends include regular cash dividends,
extra dividends, special dividends, and liquidating dividends.
√ [ ] True
[ ] False
38) Suppose the personal tax rate on dividend income increases. All
else equal, one would expect the cost of equity for high-dividend firms
to decrease.
[ ] True
√ [ ] False
costs. Suppose Sesame Sweet declares a 3-for-1 stock split. If you
owned 750 shares before the split, how many do you have after the
split?
[ ] 187 shares
[ ] 250 shares
[ ] 375 shares
[ ] 1,500 shares
√ [ ] 2,250 shares
40) A common-stock dividend that results in a distribution of capital is

called a (an) _____ dividend.
[ ] cumulative
[ ] extra
[ ] special
√ [ ] liquidating
[ ] stock distribution
41) The information content effect is the market's reaction to a change

in corporate dividend payout.
√ [ ] True
[ ] False
dividend. What happens to the common stock account on the balance
sheet?
√ [ ] The account increases by $22,000.
43) Which of the following are goals in a compromise dividend policy?

I. avoid dividend increases
II. maintain target D/E ratio
III. avoid the need to sell new equity
IV. maintain a target retention ratio
[ ] I and II only
[ ] II and IV only
44) Which of the following is consistent with the inability of researchers

to determine the existence of an optimal dividend policy for a firm?
√ [ ] the ability of investors to create homemade dividends
[ ] the existence of different personal tax rates on dividend income
and capital gains income
[ ] the existence of unsatisfied dividend clienteles
[ ] the existence of high flotation costs associated with the sale of
shares
[ ] the existence of a significant number of tax-exempt investors in
the market for the firm's shares
45) Which of the following is (are) a valid reason for managers to avoid
paying cash dividends?
I. The firm is approaching financial distress and needs to conserve
cash to meet contractual financial obligations.
II. The firm faces insignificant costs of issuing securities.
III. The firm has few growth opportunities for which funds are required.
IV. It is easy for the firm to access the capital markets.
√ [ ] I only
[ ] I and III only
[ ] III and IV only
46) Suppose BREX Corp. believes its recent increase in stock price
has made the price of a share of stock too expensive for the average
investor. To remedy this situation, BREX could:
[ ] pay a liquidating dividend.
[ ] complete a reverse stock split.
[ ] pay a regular cash dividend.
[ ] execute a stock repurchase.
√ [ ] complete a stock split.
47) BDJ, Inc. has 31,000 shares of stock outstanding with a market
price of $15 per share. If net income for the year is $155,000 and the
retention ratio is 80 percent, what is the dividend yield on BDJ Inc.'s
stock?
[ ] 3.4 percent
[ ] 3.7 percent
[ ] 5.5 percent
√ [ ] 6.7 percent
[ ] 8.3 percent
costs. What is total stockholders' equity for Sesame Sweet?
[ ] $220,000
[ ] $495,000
[ ] $760,000
√ [ ] $1,035,000
[ ] $3,455,000
49) Consider a firm called Alex, Inc. which is financed 100 percent with
equity. The firm has 100,000 shares of stock outstanding, with a
market price of $5 per share. Total earnings for the most recent year
are $50,000. The firm has cash of $25,000 in excess of what is
necessary to fund its positive net present value projects. The firm has
other assets worth $475,000 (market value). There are no transaction
costs, taxes, or other market imperfections. Assume the firm pays the
$25,000 excess cash out in the form of a cash dividend. What will the
market price of a share of Alex's stock be after the dividend?
[ ] $4.50
√ [ ] $4.75
[ ] $5.00
[ ] $5.25
[ ] $5.50
50) A stock split is essentially the same thing as a stock dividend.

√ [ ] True
[ ] False
retention ratio is 80 percent, what is the dividend per share on BDJ
Inc.'s stock?
[ ] $0.68
[ ] $0.83
√ [ ] $1.00
[ ] $1.25
[ ] $1.89
52) The board of directors of DDT Inc. has declared a dividend of

$0.75 per share payable on Monday, January 26 to shareholders of
record as of Monday, January 12. Under NYSE rules, if you bought
500 shares of DDT stock on Friday, January 9 for $7.50 per share,
how much will you receive in dividends?
√ [ ] $0.00
[ ] $1.50
[ ] $37.50
[ ] $55.00
[ ] $375.00

I. Once declared, a dividend is a liability of the firm.
II. The value of a firm's stock is ultimately determined by its dividend
policy.
III. The existence of an information content effect of dividends tends to
make it easy to determine the effects of dividend policy.
IV. Dividend stability is usually viewed as a desirable objective.
[ ] I and III only
[ ] II and III only
[ ] II and IV only
[ ] I and II only
54) A firm that follows a strict residual dividend policy is likely to

maintain a stable pattern of dividends over time.
[ ] True
√ [ ] False
costs. Suppose Sesame Sweet declares a 3-for-1 stock split. What is
the market price of a share of the company's stock after the split?
√ [ ] $4.00 per share
[ ] $5.75 per share
[ ] $6.00 per share
[ ] $8.00 per share
56) If stock issuance costs are high, investors will prefer low-dividend
stocks to high-dividend stocks, all else equal.
√ [ ] True
[ ] False
57) If a firm has excess cash and management believes the firm's
shares are currently undervalued by market participants, the firm is a
likely candidate for a:
[ ] liquidating dividend.
[ ] stock dividend.
[ ] regular cash dividend.
√ [ ] stock repurchase.
[ ] stock split.
dividend per share is $2.00, what is the retention ratio for BDJ, Inc.?
[ ] 21.6 percent
[ ] 40.0 percent
√ [ ] 60.0 percent
[ ] 78.4 percent
[ ] 83.2 percent
59) One argument in favor of stock splits and stock dividends is that
there is a popular trading range in which a stock is traded.
√ [ ] True
[ ] False
60) You own stock in a firm that has 1.25 million shares outstanding.
The current stock price is $13.50 per share. If the company does a 3-
for-1 stock split, what would you expect the stock price to be after the
split?
[ ] $3.67 per share
[ ] $4.33 per share
√ [ ] $4.50 per share
61) Once it is declared, a common stock dividend becomes a legal

financial obligation of the firm.
√ [ ] True
[ ] False
62) Internest Inc., an Internet-based firm that caters to bird watchers

had an exceptionally profitable year this year. Since management is
uncertain about whether future years will be as successful they should
declare a(n) _____ if they wish to share the firm's good fortune with
their investors.
√ [ ] extra dividend
[ ] stock dividend
[ ] liquidating dividend
[ ] distribution
[ ] increase in the regular cash dividend
63) Which of the following are consistent with the existence of an

information content effect of dividends?
I. IBM's share price rises upon the announcement of unexpectedly high
earnings and a larger than expected increase in its current quarterly
dividend
II. GM's share price falls on the same day the firm announces a stock
dividend
III. Con Ed's share price drops by 33 percent after it announces it is
omitting its regular quarterly dividend payment
[ ] I only
[ ] II only
[ ] III only
[ ] I and II only
64) You own stock in a firm that has 1.25 million shares outstanding.
The current stock price is $13.50 per share. If the company issues a 10
percent stock dividend, what would you expect the stock price to be
after the dividend is paid?
√ [ ] $12.27 per share
65) All else equal, an investor is likely to prefer a firm with a high
dividend payout rate if:
I. the firm has many positive NPV projects in which it could invest.
II. marginal corporate tax rates exceed marginal personal tax rates.
III. flotation costs are significant.
IV. the firm's dividend payout is restricted by a bond indenture.
√ [ ] II only
[ ] I and III only
[ ] II and III only
66) Of the following, only _____ will likely affect the three equity
accounts of common stock, retained earnings, and additional paid in
capital.
[ ] the payment of a regular cash dividend
√ [ ] the payment of a stock dividend
[ ] the payment of a cash liquidating dividend
[ ] the payment of a special cash dividend
[ ] a stock split
67) Which of the following is (are) correct?

I. Based on the homemade dividend argument, dividend policy is
irrelevant.
II. Because of tax effects for individual investors and new issue costs,
a low-dividend policy is preferable.
III. Because of the desire for current income and related factors, a
high-dividend policy is preferable.
[ ] I only
[ ] II and III only
[ ] I and III only
[ ] III only
68) A firm can make it easier for an investor to create a homemade

dividend policy if the firm:
√ [ ] offers an automated dividend reinvestment plan.
[ ] issues a stock dividend.
[ ] pays a regular cash dividend.
[ ] completes a stock split.
[ ] executes a reverse stock split.
69) In the chronology of a dividend payment, the date of record

precedes the ex-dividend date.
[ ] True
√ [ ] False
70) A firm that follows a cyclical dividend policy will:

[ ] establish and attempt to maintain a stable dividend payment.
[ ] pay dividends on a residual basis.
[ ] establish and attempt to maintain a target debt-to-equity ratio.
[ ] make more special dividend payments than firms that follow a
stable dividend payout.
√ [ ] pay dividends that vary according to income.
71) Stansfield, Inc. currently has 400,000 shares of stock outstanding,

each with a market price of $20 and a par value of $2. If net income
for the year is $295,000 and the dividend per share is $0.50, what is
the retention ratio?
[ ] 23.9 percent
√ [ ] 32.2 percent
[ ] 42.5 percent
[ ] 47.5 percent
[ ] 56.1 percent
72) Of the following, a _____ would lead to a reduction in the number

of shares of stock outstanding and an increase in par value.
[ ] stock dividend
[ ] stock repurchase
[ ] liquidating dividend
[ ] stock split
√ [ ] reverse stock split
$950,000 and retained earnings of $1,450,000. Suppose the firm
declares a 20 percent (small) stock dividend. What is the stock's new
price per share? Assume there are no taxes or transaction costs.
[ ] $7.50
[ ] $9.25
[ ] $10.00
√ [ ] $12.50
[ ] $13.25
$950,000 and retained earnings of $1,450,000. Suppose the firm
declares a 20 percent (small) stock dividend. What happens to
additional paid-in capital on the balance sheet? Assume there are no
taxes or transaction costs.
75) Consider the following statements:

I. Dividends are irrelevant in determining share value.
II. Dividend policy is irrelevant in determining share value.
[ ] Both statements are definitely false.
[ ] Both statements are definitely true.
[ ] Statement I is definitely false; statement II is definitely true.
√ [ ] Statement I is definitely false; statement II is true if investors can
create homemade dividends.
[ ] Statement II is definitely false; statement I is true if investors can
create homemade dividends.
76) You purchase 100 shares of stock for $20.00 per share cum
dividend just before the market closes on Thursday. The ex-dividend
date is Friday and the dividend is $1.50 per share. Assuming there are
no taxes, just after the market opens on Friday morning your total
wealth, all else equal, will:
[ ] fall from the previous day's wealth by $300.
√ [ ] still be equal to $2,000.
[ ] fall from the previous day's wealth by $150.
[ ] increase by the amount of the dividend since you can now sell the
stock for $18.50 per share and keep the dividend.
[ ] increase by the amount of the dividend received.
77) Which of the following is the correct chronology of a dividend

payment?
[ ] declaration date, date of record, ex-dividend date, date of
payment
√ [ ] declaration date, ex-dividend date, date of record, date of
payment
[ ] declaration date, date of record, date of payment, ex-dividend
date
[ ] declaration date, date of payment, date of record, ex-dividend
date
[ ] declaration date, ex-dividend date, date of payment, date of
record
dividend. What happens to the capital in excess of par account on the
balance sheet?

each with a market price of $20 and a par value of $2. The firm would
prefer to have its stock trade at a value of between $30 and $35 per
share. Of the following choices, which one would allow the firm to
achieve its objective?
[ ] 2-for-1 stock split
[ ] 50 percent stock dividend
√ [ ] 2-for-3 reverse stock split
[ ] 1-for-2 reverse stock split
[ ] $2 per share cash dividend
80) Which of the following is (are) consistent with both a residual and a
compromise dividend policy?
I. avoid dividend cuts
II. avoid cutting back on positive NPV projects
III. avoid new equity sales
IV. maintain the current capital structure
[ ] I and III only
[ ] II and IV only
√[ ] II, III, and IV only
81) When a firm is short of cash yet wishes to distribute something to

shareholders it should consider issuing a:
[ ] liquidating dividend.
√ [ ] stock dividend.
[ ] regular cash dividend.
[ ] stock repurchase.
[ ] stock split.
82) In a world with no taxes or transactions costs, dividend policy

matters but dividends do not.
[ ] True
√ [ ] False
83) All else equal, which one of the following statements is NOT a
possible effect of a regular cash dividend?
[ ] The cash account is decreased.
[ ] The retained earnings account is decreased.
[ ] Shareholders of record receive the dividend payment.
[ ] The value of a share of stock will decline by about the dividend
amount when the stock goes ex-dividend.
√ [ ] The common stock account, which is based on the par value of
the stock, will decrease.
84) A _____ is sometimes undertaken by a firm that wishes to make its

stock price more appealing to the average investor.
I. special dividend
II. stock dividend
III. reverse stock split
[ ] II only
[ ] I and II only
[ ] I and III only
[ ] I, II, and III
85) All else equal, which of the following are correct concerning stock
splits and stock dividends? All of the statements refer to book values,
not market values.
I. The par value of the stock will change only with the stock split.
II. Total owners' equity will not change with either a stock split or a
stock dividend.
III. The primary effect of either is to increase the number of shares
outstanding.
IV. Earnings per share will likely decrease only with the stock dividend.
[ ] I and III only
[ ] II and IV only
[ ] I and II only
√ [ ] I, II and III only
86) When a shareholder acts on his or her own to alter a corporation's

dividend policy by means of buying and selling shares of stock they are
creating a _____ dividend.
[ ] special
[ ] regular
[ ] residual
√ [ ] homemade
[ ] liquidating
87) Which of the following types of investors most likely prefers a firm
with a high dividend payout rate?
I. corporate investor
II. tax-exempt investor
III. investor who does not need current income
IV. investor in a relatively high personal income tax bracket
[ ] III only
[ ] II and IV only
[ ] III and IV only
88) Dividends are unimportant because the value of a share of stock is

not determined by the dividends that will be paid.
[ ] True
√ [ ] False
89) Dividend policy is the time pattern of dividend payout.

√ [ ] True
[ ] False
90) Which one of the following cannot be used to enhance dividend

stability?
[ ] share repurchases
[ ] payment of an extra dividend
√ [ ] the implementation of a residual dividend policy
[ ] payment of a special dividend
[ ] establishment of a target dividend payout ratio
91) The residual dividend approach is based on the premise that:

[ ] the sale of new equity is a desirable alternative to altering the
dividend payout.
√ [ ] maintaining a predictable dividend payout is not a primary
objective.
[ ] dividends on preferred stock must be paid first with common
shareholders getting what's left.
[ ] a clientele effect exists.
[ ] a firm's investment needs are of secondary concern behind its
dividend policy.
92) A cash payment to shareholders that results from the sale of

assets is called a (an) _____ dividend.
[ ] regular
[ ] extra
[ ] residual
√ [ ] liquidating
[ ] homemade
dividend. What happens to total owners' equity on the balance sheet?
√ [ ] It remains unchanged.
94) Sweep Deep Enterprises announced the payment of a $1.50 per

share cash dividend to holders of record on Wednesday, June 22. In
order to receive the dividend, you must therefore purchase the stock
no later than:
[ ] Wednesday, June 22.
[ ] Tuesday, June 21.
[ ] Monday, June 20.
√ [ ] Friday, June 18.
[ ] Thursday, June 16.

each with a market price of $20 and a par value of $2. If net income
for the year is $295,000 and the firm's retention ratio is 60 percent,
what is the dividend per share on the firm's stock?
[ ] $0.19
[ ] $0.26
√ [ ] $0.30
[ ] $0.45
[ ] $0.51
96) When a cash payment is made to shareholders as it has been at

the end of each quarter for the past 20 years, it is called a _____
dividend.
[ ] homemade
[ ] special
[ ] residual
√ [ ] regular
[ ] liquidating
97) Splitsville Inc. plans to split its stock 2-for-1. Which of the following
most likely will NOT occur?
[ ] The par value per share will be reduced by half.
√ [ ] The total shareholders' equity will fall by half.
[ ] The price per share will fall by half.
[ ] The number of shares outstanding will double.
[ ] The number of shares owned by each individual investor will
double.
98) Consider a firm called Alex, Inc. which is financed 100 percent with
equity. The firm has 100,000 shares of stock outstanding, with a
market price of $5 per share. Total earnings for the most recent year
are $50,000. The firm has cash of $25,000 in excess of what is
necessary to fund its positive NPV projects. The firm has other assets
worth $475,000 (market value). There are no transaction costs, taxes,
or other market imperfections. Assume the firm uses the $25,000
excess cash to buy back stock at $5 per share. What will the market
price of a share of Alex's stock be after the share repurchase?
[ ] $4.50
[ ] $4.75
√ [ ] $5.00
[ ] $5.25
[ ] $5.50
dividend. What happens to the retained earnings account on the
balance sheet?
[ ] It remains unchanged.
√ [ ] The account decreases by $264,000.
100) If the marginal tax rate on capital gains is less than the marginal
tax rate on dividends, a tax conscious investor will:
√ [ ] prefer capital gains to dividends especially since unrealized
capital gains can be deferred indefinitely.
[ ] prefer a low dividend payout rate because the taxes on dividends
can be deferred.
[ ] prefer a high dividend payout rate if they do not have a need for
current income.
[ ] prefer a high dividend payout since dividends are considered
ordinary income but capital gains are not.
[ ] search for firms that frequently pay higher dividends as opposed
to using stock buybacks.
101) A reverse split is a stock split in which a firm's number of shares

outstanding is reduced.
√ [ ] True
[ ] False
102) If a firm wishes to have enough funds to satisfy its capital

budgeting needs and to maintain a target debt-to-equity ratio it would
likely be best to follow a policy of paying a (an) _____ dividend.
[ ] extra
[ ] special
[ ] liquidating
[ ] homemade
√ [ ] residual
happens to total owners' equity on the balance sheet?

Fundamentals of Corporate Finance Test B

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Fundamentals of Corporate

4) An investment should be accepted if the net present value is positive.

5) What is the internal rate of return (IRR) decision rule?

11) Which one of the following is an advantage of a capital budgeting rule?

12) Which capital investment evaluation technique is described by the attributes

16) Which capital investment evaluation technique is described by the attributes

26) Net present value (NPV):

28) Which of the following statements are correct?

37) Which of the following is (are) biased in favor of liquid investments?

39) You are considering the following two projects:

57) The essence of _____ is determining whether a proposed investment or project

70) Which capital investment evaluation technique is described by the attributes

75) A project with a net present value equal to zero:

83) Which one of the following is considered to be an advantage of the average

95) The ________ decision rule is considered the "best" in principle.

105) You are considering the following two projects:

8) According to the stand-alone principle, a project should be evaluated based on the

17) In general, adopting MACRS depreciation instead of straight-line depreciation will

23) Which one of the following is least likely to cause erosion?

47) A sunk cost is:

52) Which of the following can be depreciated for tax purposes?

58) Sunk cost is another term which describes opportunity cost.

64) Consider the following balance sheet entries:

69) Your company is considering three different methods of production: purchase

73) Consider the following balance sheet entries:

80) An increase in which of the following is a use of funds?

86) Side effects such as erosion should be considered in a capital budgeting

89) Pro forma statements:

95) Which one of the following is correct concerning project evaluation?

97) Taxes are not an important consideration in evaluating capital investment

98) Which of the following statements are correct?

100) Consider the following balance sheet entries:

101) A firm is considering a project that would increase accounts receivable by

2) A financial manager reviewing a project is concerned about the level of

3) Which one of the following statements is NOT correct?

5) The purpose of scenario analysis is to:

6) Simulation analysis is a combination of scenario and sensitivity analysis.

17) Which of the following describe(s) fixed costs?

20) Positive net present value projects:

21) ________ analysis combines ________ analysis and ________ analysis.

28) Which one of the following statements is accurate?

37) Which of the following describe(s) variable costs?

53) The higher the degree of operating leverage:

55) Which one of the following statements is correct?

61) Which of the following describes accounting break-even? In this case, v is

73) A project that just breaks even on an accounting basis will:

97) The contribution margin is defined as the:

98) Soft rationing, if it persists, is most likely bad for stockholders.

101) Capital intensive projects have a high degree of operating leverage.

1) For the purpose of estimating the firm's cost of

2) KCE Corporation is currently operating at its target

3) The interest rate that should be used when

4) Which one of the following formulas correctly

5) Which of the following are legitimate reasons why it

6) For a profitable firm, an increase in its marginal tax

7) The return on equity is the return that equity

8) All else equal, a higher corporate tax rate will:

9) Which one of the following statements is true about

10) The best way to adjust for the existence of flotation

11) Hartley Psychiatric, Inc. needs to purchase office

12) The _____ is the firm's cost of debt based on its

13) A project has the same risk as the firm's overall

15) The effect of flotation costs is to increase the

16) Which one of the following is a disadvantage of the

21) analysis combines analysis and analysis.