††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††† PAGE 1†
† 1. Your corporation has the following cash flows:
†††††††††† †††Operating income†††††††††† †††††††† $250,000
††††††††††††† Interest received††††††††† †††††††††† ††††10,000
††††††††††††† Interest paid†††††††††††††††† †††††††††† ††††45,000
††††††††††††† Dividends received†††††††††††† †††† ††††20,000
††††††††††††† Dividends paid†††††††††††††††† ††††††† ††††50,000
If the applicable income tax rate is 40 percent (federal and state combined), and if 70 percent of dividends received are exempt from taxes, what is the corporation's tax liability?
a. $ 74,000
b. $ 88,400
c. $ 91,600
† 2. A corporation can earn 7.5 percent if it invests in municipal bonds. The corporation can also earn 8.5 percent (before-tax) by investing in preferred stock. Assume that the two investments have equal risk. What is the break-even corporate tax rate which makes the corporation indifferent between the two investments?
† 3. A 5-year corporate bond yields 9 percent. A 5-year municipal bond of equal risk yields 6.5 percent. Assume that the state tax rate is zero. At what federal tax rate are you indifferent between the two bonds?
† 4. Hayes Corporation has $300 million worth of common equity on its balance sheet, and 6 million shares of stock outstanding. The company's Market Value Added (MVA) is $162 million. What is the company's stock price?
a. $ 23
b. $ 32
c. $ 50
d. $ 77
† 5. Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero. If the annual rate of interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year Treasury bond is 12 percent, what rate of interest should you expect on a 1-year Treasury bond one year from now?
† 6. One-year Treasury bills yield 6 percent, while Treasury bills with two-year maturities yield 6.7 percent. If the pure expectations theory holds (that is, the maturity risk premium = 0), what is the market's forecast of what one-year T-bills will be yielding one year from now?
† 7. Given the following data, find the expected rate of inflation during the next year.
k* = real risk-free rate = 3%.
Maturity risk premium on 10-year T-bonds = 2%. It is zero on 1-year bonds, and a linear relationship exists.
Default risk premium on 10-year, A-rated bonds = 1.5%.
Liquidity premium = 0%.
Going interest rate on 1-year T-bonds = 8.5%.
† 8. Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6 percent, respectively. What is the average expected inflation rate over this 5-year period?
† 9. Treasury securities that mature in 6 years currently have an interest rate of 8.5 percent. Inflation is expected to be 5 percent each of the next three years and 6 percent each year after the third year. The maturity risk premium is estimated to be 0.1%(t - 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a 1-year bond is zero). The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest?
††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††††† PAGE 3†
†11. Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5 percent rate of inflation in the future. The real risk-free rate is equal to 3 percent and the market risk premium is 5 percent. Mercury has a beta of 2.0, and its realized rate of return has averaged 15 percent over the last 5 years.
†12. If the risk-free rate is 7 percent, the expected return on the market is 10 percent, and the expected return on Security J is 13 percent, what is the beta of Security J?
†14. At an effective annual interest rate of 20 percent, how many years will it take a given amount to triple in value? (Round to the closest year.)
a.† 5 years
b.† 8 years
c.† 6 years
d. 10 years
e.† 9 years
†15. You deposited $1,000 in a savings account that pays 8 percent interest, compounded quarterly, planning to use it to finish your last year in college. Eighteen months later, you decide to go to the Rocky Mountains to become a ski instructor rather than continue in school, so you close out your account. How much money will you receive?
†16. What is the future value of a 5-year ordinary annuity with annual payments of $200, evaluated at a 15 percent interest rate?
a. $† 670.44
b. $† 842.91
†17. What is the present value of a 5-year ordinary annuity with annual payments of $200, evaluated at a 15 percent interest rate?
a. $† 670.43
b. $† 842.91
†18. Assume that you will receive $2,000 a year in Years 1 through 5, $3,000 a year in Years 6 through 8, and $4,000 in Year 9, with all cash flows to be received at the end of the year. If you require a 14 percent rate of return, what is the present value of these cash flows?
a. $ 9,851
†19. Suppose the present value of a 2-year ordinary annuity is $100. If the discount rate is 10 percent, what must be the annual cash flow?
†20. If $100 is placed in an account that earns a nominal 4 percent, compounded quarterly, what will it be worth in 5 years?
†21. In 1958 the average tuition for one year at an Ivy League school was $1,800. Thirty years later, in 1988, the average cost was $13,700. What was the growth rate in tuition over the 30-year period?
†22. South Penn Trucking is financing a new truck with a loan of $10,000 to be repaid in 5 annual end-of-year installments of $2,504.56. What annual interest rate is the company paying?
†23. Gomez Electronics needs to arrange financing for its expansion program. Bank A offers to lend Gomez the required funds on a loan where interest must be paid monthly, and the quoted rate is 8 percent. Bank B will charge 9 percent, with interest due at the end of the year. What is the difference in the effective annual rates charged by the two banks?
†24. Which of the following investments has the highest effective return (EAR)? (Assume that all CDs are of equal risk.)
a. A bank CD which pays 10 percent interest quarterly.
b. A bank CD which pays 10 percent monthly.
d. A bank CD which pays 10.2 percent annually.
d. A bank CD which pays 10 percent semiannually.
e. A bank CD which pays 9.6 percent daily (on a 365-day basis).
†25. Which one of the following investments provides the highest effective return?
a. An investment which has a 9.9 percent nominal rate and quarterly annual compounding.
b. An investment which has a 9.7 percent nominal rate and daily (365) compounding.
c. An investment which has a 10.2 percent nominal rate and annual compounding.
d. An investment which has a 10 percent nominal rate and semiannual compounding.
e. An investment which has a 9.6 percent nominal rate and monthly compounding.
†26. Which of the following investments would provide an investor the highest effective annual return?
a. An investment which has a 9 percent nominal rate with semiannual compounding.
b. An investment which has a 9 percent nominal rate with quarterly compounding.
c. An investment which has a 9.2 percent nominal rate with annual compounding.
d. An investment which has an 8.9 percent nominal rate with monthly compounding.
e. An investment which has an 8.9 percent nominal rate with quarterly compounding.
†27. You have just purchased a 10-year, $1,000 par value bond. The coupon rate on this bond is 8 percent annually, with interest being paid each 6 months. If you expect to earn a 10 percent nominal rate of return on this bond, how much did you pay for it?
c. $† 875.38
d. $† 950.75
e. $† 812.15
†28. A $1,000 par value bond pays interest of $35 each quarter and will mature in 10 years. If your nominal annual required rate of return is 12 percent with quarterly compounding, how much should you be willing to pay for this bond?
a. $† 941.36
e. $† 825.49
†29. The Jones Company has decided to undertake a large project. Consequently, there is a need for additional funds. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share and a par value of $30. If the required return on this stock is currently 20 percent, what should be the stock's market value?
c. $ 50
d. $ 25
e. $ 10
†30. A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00 for this preferred stock, what is your nominal (not effective) annual rate of return?
†31. Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2. If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?
b. $ 75.29
†32. A share of common stock has a current price of $82.50 and is expected to grow at a constant rate of 10 percent. If you require a 14 percent rate of return, what is the current dividend on this stock?
†33. The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein's required rate of return on equity (ks) is 12 percent. What is the current price of Klein's common stock?
†34. Your company's stock sells for $50 per share, its last dividend (Dô) was $2.00, its growth rate is a constant 5 percent, and the company would incur a flotation cost of 15 percent if it sold new common stock. Net income for the coming year is expected to be $500,000, the firm's payout ratio is 60 percent, and its common equity ratio is 30 percent. If the firm has a capital budget of $1,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?
The information below applies to the following problems.
The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
†35. What is the cost of common equity raised by selling new stock?
The information below applies to the following problems.
Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (Dô) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent.
†36. What is the maximum amount of new capital that can be raised at the lowest component cost of equity? (In other words, what is the retained earnings break point?)
†37. What is the component cost of the equity raised by selling new common stock?
†38. Assume (contrary to the situation in the question just above) that at one point along the marginal cost of capital schedule the component cost of equity is 18 percent. What is the weighted average cost of capital at that point?
The information below applies to the following problems.
Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find ks. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
†39. What is Rollins' cost of retained earnings using the CAPM approach?
†40. What is Rollins' lowest WACC?
†41. What is Rollins' retained earnings break point?
a. $† 600,000
b. $† 800,000
The information below applies to the following problems.
J. Ross and Sons Inc. has a target capital structure that calls for 40
percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in earnings over the next year. Ross's common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.
†42. What is the firm's cost of newly issued preferred stock?
†43. Where will a break in the MCC schedule occur?
e. There will be no breaks in the MCC schedule.
†44. What will be the WACC above this break point?
†45. The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day. What is the payback period for this investment?
a. 5.23 years
b. 4.86 years
c. 4.00 years
d. 6.12 years
e. 4.35 years
†46. As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows:
†††††††††††††††† Year††††† Project X††††† Project Z
†††††††††††††††††† 0†††††† -$100,000††††† -$100,000
†††††††††††††††††† 1††††††††† 50,000†††††††† 10,000
†††††††††††††††††† 2††††††††† 40,000†††††††† 30,000
†††††††††††††††††† 3††††††††† 30,000†††††††† 40,000
†††††††††††††††††† 4††††††††† 10,000†††††††† 60,000
If Denver's cost of capital is 15 percent, which project would you choose?
a. Neither project.
b. Project X, since it has the higher IRR.
c. Project Z, since it has the higher NPV.
d. Project X, since it has the higher NPV.
e. Project Z, since it has the higher IRR.
†47. You have recently accepted a one-year employment term by a firm. The firm has given you the option of receiving your salary as a lump sum value of $30,000 at the end of the year or as 12 monthly payments of $2,400 starting one month after you start work. If your relevant discount rate is 2 percent per month, then which salary options would you prefer? (Ignore taxes, risk, and consumption needs.) Choose the best answer.
a. The lump sum payment, since it has the larger future value.
b. Monthly payments, since you do not have to wait so long to receive your money.
c. Either one, since they have the same present value.
d. The lump sum payment, since it has the larger present value.
e. Monthly payments, since it has the larger present value.
†48. Two projects being considered are mutually exclusive and have the following projected cash flows:
††††††††††††††† Year††††† Project A††††† Project B
††††††††††††††††† 0††††††† -$50,000†††††† -$50,000
††††††††††††††††† 1††††††††† 15,625††††††††††††† 0
††††††††††††††††† 2††††††††† 15,625††††††††††††† 0
††††††††††††††† ††3††††††††† 15,625††††††††††††† 0
††††††††††††††††† 4††††††††† 15,625††††††††††††† 0
††††††††††††††††† 5††††††††† 15,625†††††††† 99,500
If the required rate of return on these projects is 10 percent, which would be chosen and why?
a. Project B because it has the higher NPV.
b. Project B because it has the higher IRR.
c. Project A because it has the higher NPV.
d. Project A because it has the higher IRR.
e. Neither, because both have IRRs less than the cost of capital.
†49. Green Grocers is deciding among two mutually exclusive projects. The two projects have the following cash flows:
†††††††††††††††††††††††† Project A†††††† Project B
†††††††††††††† Time††††† Cash Flows††††† Cash Flows
†††††††††††††††† 0††††††† -$50,000††††††† -$30,000
††††††††††††† †††1††††††††† 10,000†††††††††† 6,000
†††††††††††††††† 2††††††††† 15,000††††††††† 12,000
†††††††††††††††† 3††††††††† 40,000††††††††† 18,000
†††††††††††††††† 4††††††††† 20,000††††††††† 12,000
The company's cost of capital is 10 percent (WACC = 10%). What is the net present value (NPV) of the project with the highest internal rate of return (IRR)?
a. $ 7,090
b. $ 8,360
†50. The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40 percent, what is the project's IRR?
†51. An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100 per year at the end of each year for 20 years. Find the internal rate of return to the nearest whole percentage point.
†52. An investment of $1,000 will return $60 annually forever. What is its internal rate of return?
a. Cannot be determined.
†53. Which of the following is not one of the things that causes a corporation to have a significant advantage over a partnership or a proprietorship?
a. Limited liability.
b. Ease of transfer of ownership interest.
c. Unlimited life.
d. Elimination of double taxation.
e. Ability to retain earnings and thus convert income from personal income to capital gains.
†54. Which of the following statements is true?
a. One of the benefits of incorporating your business is that you become entitled to receive unlimited liability.
b. Sole proprietorships are subject to more regulations than corporations.
c. Sole proprietorships do not have to pay corporate tax.
d. All of the above are correct.
e. None of the answers above is correct.
†57. Current tax laws have which of the following effects?
a. Favor dividends because there are no capital gains taxes on dividends.
b. Do not favor capital gains because the tax must be paid as the value of the stock increases, whether or not the stock is sold.
c. Favor capital gains because the maximum tax rate applicable to capital gains is 28 percent and the tax does not have to be paid until the stock is sold.
d. Do not favor dividends or capital gains for most people because different people are in different tax brackets.
e. Favor dividends since dividends are tax-deductible for the paying corporation whereas retained earnings, which produce capital gains, are not tax-deductible.
†63. Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's criteria?
a. AAA bond with 10 years to maturity.
b. BBB perpetual bond.
c. BBB bond with 10 years to maturity.
d. AAA bond with 5 years to maturity.
e. BBB bond with 5 years to maturity.
†69. Which of the following statements is most correct?
a. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.
b. Portfolio diversification reduces the variability of returns on an individual stock.
c. When company specific risk has been diversified, the inherent risk that remains is market risk which is constant for all securities in the market.
d. A stock with a beta of -1.0 has zero market risk.
e. The SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by the financial manager.
†70. Choose the most correct answer for the following: (1) Which is the best measure of risk for choosing an asset which is to be held in isolation? (2) Which is the best measure for choosing an asset to be held as part of a diversified portfolio?
a. Variance; correlation coefficient.
b. Standard deviation; correlation coefficient.
c. Beta; variance.
d. Coefficient of variation; beta.
e. Beta; beta.
†72. The market risk associated with an individual stock is most closely identified with the
a. Standard deviation of the returns on the stock.
b. Standard deviation of the returns on the market.
c. Beta of the stock.
d. Coefficient of variation of returns on the stock.
e. Coefficient of variation of returns on the market.
†73. The Security Market Line (SML) relates risk to return, for a given set of financial market conditions. If investors conclude that the inflation rate is going to increase, which of the following changes would be most likely to occur?
a. The market risk premium would increase.
b. Beta would increase.
c. The slope of the SML would increase.
d. The required return on an average stock, kA = kM, would increase.
e. None of the indicated changes would be likely to occur.
†74. Which of the following statements is incorrect?
a. The slope of the security market line is measured by beta.
b. Two securities with the same stand-alone risk can have different betas.
c. Company-specific risk can be diversified away.
d. The market risk premium is affected by attitudes about risk.
e. Higher beta stocks have a higher required return.
†75. Which of the following statements is most correct?
a. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio.
b. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the nonmarket (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless.
c. The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return.
d. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock.
e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.
†76. As the discount rate increases without limit, the present value of the future cash inflows
a. Gets larger without limit.
b. Stays unchanged.
c. Approaches zero.
d. Gets smaller without limit, i.e., approaches minus infinity.
e. Goes to ekn.
†84. Other things held constant, if a bond indenture contains a call provision, the yield to maturity that would exist without such a call provision will generally be _________________ the YTM with it.
a. Higher than
b. Lower than
c. The same as
d. Either higher or lower, depending on the level of call premium, than
e. Unrelated to
†87. An increase in a firm's expected growth rate would normally cause the firm's required rate of return to
d. Remain constant.
e. Possibly increase, possibly decrease, or possibly remain unchanged.
†88. If the expected rate of return on a stock exceeds the required rate,
a. The stock is experiencing supernormal growth.
b. The stock should be sold.
c. The company is probably not trying to maximize price per share.
d. The stock is a good buy.
e. Dividends are not being declared.
†94. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC?
a. A reduction in the market risk premium.
b. An increase in the flotation costs associated with issuing common equity.
c. An increase in the company's beta.
d. An increase in expected inflation.
e. An increase in the flotation costs associated with issuing preferred stock.
†95. Which of the following statements about the cost of capital is incorrect?
a. A company's target capital structure affects its weighted average cost of capital.
b. Weighted average cost of capital calculations should be based on the after-tax costs of all the individual capital components.
c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will increase.
d. The cost of retained earnings is equal to the return stockholders could earn on alternative investments of equal risk.
e. Flotation costs can increase the weighted average cost of capital.
†98. Which of the following statements is most correct?
a. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider the inflation premium.
e. The IRR method does not consider all relevant cash flows, and particularly cash flows beyond the payback period.
†99. If the calculated NPV is negative, then which of the following must be true? The discount rate used is
a. Equal to the internal rate of return.
b. Too high.
c. Greater than the internal rate of return.
d. Too low.
e. Less than the internal rate of return.