Final exam on finance : (finc 620).

Question 1

1. Which of the following statements is CORRECT?

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Limited liability of its stockholders is an advantage of the corporate form of organization, but corporations have more trouble raising money in financial markets because of the complexity of this form of organization.

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A hostile takeover is the main method of transferring ownership interest in a corporation.

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Unlimited liability and limited life are two key advantages of the corporate form over other forms of business organization.

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Although its stockholders are insulated by limited legal liability, the legal status of the corporation does not protect the firm’s managers in the same way, i.e., bondholders can sue its managers if the firm defaults on its debt, even if the default is the result of poor economic conditions.

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A corporation is a legal entity that is generally created by a state, and it has a life and existence that is separate from the lives of its individual owners and managers.

8 points

Question 2

1. Below is the common equity section (in millions) of Teweles Technology’s last two year-end balance sheets:

2007 2006

Common Stock $2000 $1000

Retained Earnings 2000 2340

Total Common Equity $4000 $3340

Teweles has never paid a dividend to its common stockholders. Which of the following statements is CORRECT?

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The market price of Teweles’ stock doubled in 2007.

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Teweles had positive net income in both 2006 and 2007, but the company’s net income in 2007 was lower than it was in 2006.

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The company has more equity than debt on its balance sheet.

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The company’s net income in 2007 was higher than in 2006.

[removed]

Teweles issued common stock in 2007.

8 points

Question 3

1. Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. Under these conditions, then firms that have high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios.

[removed] True

[removed] False

8 points

Question 4

1. Companies E and P each reported the same earnings per share (EPS), but Company E’s stock trades at a higher price. Which of the following statements is CORRECT?

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Company E probably has fewer growth opportunities.

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Company E must have a higher market-to-book ratio.

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Company E must pay a lower dividend.

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Company E is probably judged by investors to be riskier.

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Company E trades at a higher P/E ratio.

8 points

Question 5

1. Which of the following statements is NOT CORRECT?

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All else equal, secured debt is less risky than unsecured debt.

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The expected return on a corporate bond must be less than its promised return if the probability of default is greater than zero.

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All else equal, senior debt has less default risk than subordinated debt.

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A company’s bond rating is affected by its financial ratios and provisions in its indenture.

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Under Chapter 11 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off its debt according to the seniority of the debt as spelled out in the Act.

8 points

Question 6

1. Which of the following statements is CORRECT?

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If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.

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If the maturity risk premium (MRP) equals zero, the yield curve must be flat.

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If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the yield curve will have an upward slope.

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Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.

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The yield curve can never be downward sloping.

8 points

Question 7

1. A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0 and a perfect positive correlation with the market. Potential new Stocks A and B both have expected returns of 15%, and both are equally correlated with the market, with r = 0.75. However, Stock A’s standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice matter?

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Either A or B, i.e., the investor should be indifferent between the two.

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Add A, since its beta must be lower.

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Neither A nor B, as neither has a return sufficient to compensate for risk.

[removed]

8 points

Question 8

1. If two firms have the same current dividend and the same expected dividend growth rate, their stocks must sell at the same current price or else the market will not be in equilibrium.

[removed] True

[removed] False

8 points

Question 9

1. Stock X has a required return of 10%, while Stock Y has a required return of 12%. Which of the following statements is CORRECT?

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Stock Y must have a higher dividend yield than Stock X.

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If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

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If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price.

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If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X.

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The stocks must sell for the same price.

8 points

Question 10

1. Deeble Construction Co.’s stock is trading at $30 a share. Call options on

the company’s stock are also available, some with a strike price of $25 and

some with a strike price of $35. Both options expire in three months. Which

of the following best describes the value of these options?

[removed]	A.	The options with the $35 strike price have an exercise value greater than $0.
[removed]	B.	The options with the $25 strike price will sell for less than the options with the $35 strike price.
[removed]	C.	The options with the $25 strike price will sell for $5.
[removed]	D.	If Deeble’s stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5.
[removed]	E.	The options with the $25 strike price have an exercise value greater than $5.

8 points

Question 11

1. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC)?

[removed]	A.
[removed]	B.
[removed]	C.
[removed]	D.
[removed]	E.

8 points

Question 12

1. When working with the CAPM, which of the following factors can be determined with the most precision?

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The market risk premium (RP_M).

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The most appropriate risk-free rate, r_RF.

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The beta coefficient of “the market,” which is the same as the beta of an average stock.

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The expected rate of return on the market, r_M.

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The beta coefficient, b_i, of a relatively safe stock.

8 points

Question 13

1. You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project can be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?

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You should recommend that the project be rejected because (1) although its NPV is positive and (2) it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted.

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You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that that the firm’s value will increase if the project is accepted.

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You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC.

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You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC.

[removed]

You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm’s value will decline if it is accepted.

8 points

Question 14

1. Edmondson Electric Systems is considering a project that has the following cash flow and WACC data. What is the project’s NPV? Note that if a project’s projected NPV is negative, it should be rejected.

WACC: 10.00%

Year: 0 1 2 3

Cash flows: -$1000 $500 $500 $500

[removed]	A.
[removed]	B.
[removed]	C.
[removed]	D.
[removed]	E.

8 points

Question 15

1. Which of the following statements is CORRECT?

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Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV.

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A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.

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A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

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A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.

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A good example of a sunk cost is a situation where a retailer opens a new store, and that leads to a decline in sales of some of the firm’s existing stores.

8 points

Question 16

1. Which of the following statements is CORRECT?

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Using MACRS depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project’s forecasted NPV.

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Using MACRS depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project’s forecasted NPV.

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Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.

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Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.

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Corporations must use MACRS depreciation for both stockholder reporting and tax purposes.

8 points

Question 17

1. Which of the following statements is CORRECT?

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The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales.

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The AFN equation method produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy and economies of scale exist.

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The capital intensity ratio gives us an idea of the physical condition of the firm’s fixed assets.

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Perhaps the most important step when developing pro forma financial statements is to determine the breakdown of common equity between common stock and retained earnings.

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Pro forma financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management’s historical performance is evaluated.

8 points

Question 18

1. 1. Based on the corporate valuation model, Hunsader’s value of operations is $300 million. The balance sheet shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock’s price per share?

[removed]	A.	$16.00
[removed]	B.	$16.80
[removed]	C.	$14.44
[removed]	D.	$15.20
[removed]	E.	$13.72

8 points

Question 19

1. Which of the following does NOT always increase a company’s market value?

[removed]	A.	Increasing the expected operating profitability (NOPAT/Sales).
[removed]	B.	Increasing the expected growth rate of sales.
[removed]	C.	Increasing the expected rate of return on invested capital.
[removed]	D.	Decreasing the capital requirements (Capital/Sales).
[removed]	E.	Decreasing the weighted average cost of capital.

8 points

Question 20

1. Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms’ expected EBITs could actually be identical.

[removed] True

[removed] False

8 points

Question 21

1. Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company’s interest expense. The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock. The company’s CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO’s estimates are correct, which of the following statements is CORRECT?

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Since the plan is expected to increase EPS, this implies that net income is also expected to increase.

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If the plan reduces the WACC, the stock price is also likely to decline.

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If the plan does increase the EPS, the stock price will automatically increase at the same rate.

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Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.

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Since the proposed plan increases Volga’s financial risk, the company’s stock price still might fall even if EPS increases.

8 points

Question 22

1. Other things held constant, which of the following will cause an increase in net working capital?

[removed]	A.	Cash is used to buy marketable securities.
[removed]	B.	Long-term bonds are retired with the proceeds of a preferred stock issue.
[removed]	C.	A cash dividend is declared and paid.
[removed]	D.	Missing inventory is written off against retained earnings.
[removed]	E.	Merchandise is sold at a profit, but the sale is on credit.

8 points

Question 23

1. Which of the following statements is most CORRECT?

[removed]	A.	Since depreciation is a non-cash charge, it does not appear on nor have an effect on the cash budget.
[removed]	B.	The typical actual cash budget will reflect interest on loans and income from investment of surplus cash. These numbers are expected values and actual results might vary from budgeted results.
[removed]	C.	The target cash balance is set optimally such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it is changed to reflect long-term changes in the firm’s operations.
[removed]	D.	The cash budget and the capital budget are planned separately and although they are both important to the firm, they are independent of each other.
[removed]	E.	Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control.

8 points

Question 24

1. In 1985, a given Japanese imported automobile sold for 1,476,000 yen, or $8,200. If the car still sold for the same amount of yen today but the current exchange rate is 144 yen per dollar, what would the car be selling for today in U.S. dollars?

[removed]	A.	$13,525
[removed]	B.	$10,250
[removed]	C.	$12,628
[removed]	D.	$5.964
[removed]	E.	$8,200

8 points

Question 25

1. You are negotiating to make a 7-year loan of $25,000 to Breck Inc. To repay you, Breck will pay $2,500 at the end of Year 1, $5,000 at the end of Year 2, and $7,500 at the end of Year 3, plus a fixed but currently unspecified cash flow, X, at the end of Years 4 through 7. Breck is essentially riskless, so you are confident the payments will be made, and you regard 8% as an appropriate rate of return on low risk 7-year loans. What cash flow must the investment provide at the end of each of the final 4 years, that is, what is X?

[removed]	A.
[removed]	B.	$5,218.30
[removed]	C.
[removed]	D.
[removed]	E.

Final exam on finance : (finc 620).

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