Finance 101 Sample Questions (Term2 11/12 Final)

1. Which one of the following earned the highest risk premium over the period 1926
2005?
a. long-term corporate bonds
b. U.S. Treasury bills
c. small-company stocks
d. large-company stocks
e. long-term government bonds
2. The larger the variance, the:
I. more the actual returns differ from the average return.
II. larger the standard deviation.
III. greater the risk.
IV. higher the expected return.
a. I and III only
b. II, III, and IV only
c. I, III, and IV only
d. I, II, and III only
e. I, II, III, and IV
3. Estimates of the rate of return on a security based on an historical arithmetic
average will probably tend to _____ the expected return for the long-term while
estimates using the historical geometric average will probably tend to _____ the
expected return for the short-term.
a. overestimate; overestimate
b. overestimate; underestimate
c. underestimate; overestimate
d. underestimate; underestimate
e. accurately; accurately
4. Which one of the following is indicative of a totally efficient stock market?
a. extraordinary returns earned on a routine basis
b. positive net present values over the long-term
c. zero net present values for all stocks
d. arbitrage opportunities which develop on a routine basis
e. realizing negative returns on a routine basis
5. If you excel in analyzing the future outlook of firms, you would prefer the financial
markets be ____ form efficient so that you can have an advantage in the marketplace.
a. weak
b. semiweak
c. semistrong
d. strong
e. perfect
6. Individuals who continually monitor the financial markets seeking mispriced
securities:
a. earn excess profits over the long-term.
b. make the markets increasingly more efficient.
c. are never able to find a security that is temporarily mispriced.
d. are overwhelmingly successful provided they trade within five minutes of their
discovery.
e. are always quite successful using only historical price information as their basis of
evaluation.
7. One year ago, you purchased a stock at a price of $40 a share. Today, you sold the
stock and realized a total return of 30 percent. Your capital gain was $8 a share. What
was your dividend yield on this stock?
a. 10 percent
b. 20 percent
c. 30 percent
d. 40 percent
e. 50 percent
8. A stock had returns of 9 percent, 3 percent, 4 percent, and 15 percent over the
past four years. What is the standard deviation of this stock for the past four years?
a. 5.4 percent
b. 5.9 percent
c. 6.3 percent
d. 6.6 percent
e. 7.6 percent
9. Over the past twenty years, the common stock of Leases, Inc. has produced an
arithmetic average return of 14.6 percent and a geometric average return of 12.9
percent. What is the projected return on this stock for the next five years according to
Blume's formula?
a. 13.48 percent
b. 13.83 percent
c. 14.01 percent
d. 14.24 percent
e. 14.33 percent
10. A stock had returns of 5 percent, 16 percent, 10 percent, and 18 percent over
the past four years. What is the geometric average return for this time period?
a. 5.3 percent
b. 6.6 percent
c. 7.3 percent
d. 9.7 percent
e. 12.1 percent
11. Which one of the following indicates a portfolio is being effectively diversified?
a. an increase in the portfolio beta
b. a decrease in the portfolio beta
c. an increase in the portfolio rate of return
d. an increase in the portfolio standard deviation
e. a decrease in the portfolio standard deviation
12. The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will eliminate all of the
unsystematic risk.
b. concentrating an investment in three companies all within the same industry will
greatly reduce the systematic risk.
c. spreading an investment across five diverse companies will not lower the total risk.
d. spreading an investment across many diverse assets will eliminate all of the
systematic risk.
e. spreading an investment across many diverse assets will eliminate some of the total
risk.
13. Which one of the following statements is correct?
a. The unexpected return is always negative.
b. The expected return minus the unexpected return is equal to the total return.
c. Over time, the average return is equal to the unexpected return.
d. The expected return includes the surprise portion of news announcements.
e. Over time, the average unexpected return will be zero.
14. Which of the following statements are correct concerning diversifiable risks?
I. Diversifiable risks can be essentially eliminated by investing in thirty unrelated
securities.
II. The market rewards investors for diversifiable risk by paying a risk premium.
III. Diversifiable risks are generally associated with an individual firm or industry.
IV. Beta measures diversifiable risk.
a. I and III only
b. II and IV only
c. I and IV only
d. II and III only
e. I, II, and III only
15. A stock with an actual return that lies above the security market line has:
a. more systematic risk than the overall market.
b. more risk than warranted based on the realized rate of return.
c. yielded a higher return than expected for the level of risk assumed.
d. less systematic risk than the overall market.
e. yielded a return equivalent to the level of risk assumed.
16. You want your portfolio beta to be 1.10. Currently, your portfolio consists of
$3,000 invested in stock A with a beta of 1.65 and $2,000 in stock B with a beta of
.72. You have another $5,000 to invest and want to divide it between an asset with a
beta of 1.48 and a risk-free asset. How much should you invest in the risk-free asset?
a. $0
b. $775
c. $1,885
d. $3,115
e. $5,000
17. The rate of return on the common stock of FIDF is expected to be 15 percent in a
boom economy, 12 percent in a normal economy, and only 7 percent in a recessionary
economy. The probabilities of these economic states are 15 percent for a boom, 80
percent for a normal economy, and 5 percent for a recession. What is the variance of
the returns on this common stock?
a. .000118
b. .000256
c. .001876
d. .003492
e. .016000
18. You are comparing stock A to stock B. Given the following information, which
one of these two stocks should you prefer and why (consider standard deviation as
measure of risk)?


a. Stock A; Stock A has a slightly lower expected return but appears to be
significantly less risky than stock B.
b. Stock A; Stock A has an expected return of 10.2 percent and appears to be less
risky.
c. Stock A; Stock A has a higher expected return and appears to be less risky than
stock B.
d. Stock B; Stock B has a higher expected return and appears to be just slightly more
risky than stock A.
e. Stock B; Stock B has a much higher return which compensates for the additional
risk.
19. What is the expected return on a portfolio comprised of $4,000 in stock K and
$6,000 in stock L if the economy is normal?


a. 4.65 percent
b. 6.20 percent
c. 8.95 percent
d. 13.35 percent
e. 17.80 percent
20. What is the portfolio variance if 55 percent is invested in stock S and 45 percent is
invested in stock T?


a. .001314
b. .003148
c. .009128
d. .036250
e. .056106
21. What is the beta of a portfolio comprised of the following securities?


a. .98
b. 1.04
c. 1.09
d. 1.15
e. 1.32
22. The common stock of PDS has a beta of .98 and an expected return of 12.34
percent. The risk-free rate of return is 4.1 percent and the market rate of return is
11.65 percent. Which one of the following statements is true given this information?
a. The return on PDS stock will graph below the Security Market Line.
b. PDS stock is underpriced.
c. The expected return on PDS stock based on the Capital Asset Pricing Model is
15.52 percent.
d. PDS stock has more systematic risk than the overall market.
e. PDS stock is correctly priced.
23. The expected return on Joseph's Restaurant's stock is 14.25 percent while the
expected return on the market is 12.38 percent. The stock's beta is 1.18. What is the
risk-free rate of return?
a. 1.99 percent
b. 2.04 percent
c. 2.48 percent
d. 3.23 percent
e. 3.68 percent
24. The pre-tax cost of debt for a firm:
a. is based on the yield to maturity on the firm's outstanding bonds.
b. is equal to the coupon rate for the latest bond issue.
c. is equivalent to the current yield on the outstanding bonds of the firm.
d. is based on the yield to maturity that existed when the currently outstanding bonds
were originally issued.
e. has to be estimated as it cannot be directly observed in the market.
25. If a firm uses its WACC as the discount rate for all of the projects it undertakes
then the firm will tend to:
I. reject some positive net present value projects.
II. accept some negative net present value projects.
III. favor high risk projects over low risk projects.
IV. maintain its current level of risk.
a. I and III only
b. III and IV only
c. I, II, and III only
d. I, II, and IV only
e. I, II, III, and IV
26. If a firm applies its overall cost of capital to all its proposed projects, then the
divisions within the firm will tend to:
a. receive less funding if they represent the riskiest operations of the firm.
b. avoid risky projects so that they will receive more funding.
c. become less risky over time based on the projects that are accepted.
d. have equal probabilities of receiving funding for their projects.
e. propose higher risk projects than if separate discount rates were applied to each
project.
27. Wayne's of New York specializes in clothing for female executives living and
working in the financial district of New York City. Allen's of PA. specializes in
clothing for women who live and work in the rural areas of Western Pennsylvania.
Both firms are currently considering expanding their clothing line to encompass
working women in the rural upstate region of New York state (similar to W.
Pennsylvania). Wayne's currently has a cost of capital of 11 percent while Allen's cost
of capital is 9 percent. The expansion project has a projected net present value of
$36,900 at a 9 percent discount rate and a net present value of $13,200 at an 11
percent discount rate. Which firm or firms should expand into rural New York state?
a. Wayne's only
b. Allen's only
c. both Wayne's and Allen's
d. neither Wayne's nor Allen's
e. cannot be determined from the information provided
28. HBS, Inc. has a growth rate of 6 percent and is equally as risky as the market. The
stock is currently selling for $15 a share. The overall stock market has a 12 percent
rate of return and a risk premium of 9 percent. What is the cost of equity for HBS,
Inc.?
a. 6 percent
b. 9 percent
c. 12 percent
d. 15 percent
e. 18 percent
29. The Collection Co. has a current beta of 1.6. The market risk premium is 7 percent
and the risk-free rate of return is 3 percent. By how much will the cost of equity
increase if the company expands their operations such that their company beta rises to
1.9?
a. 0.30 percent
b. 0.90 percent
c. 1.50 percent
d. 2.10 percent
e. 2.70 percent
30. Madeline's Miniatures has a zero coupon bond issue outstanding that matures in
eleven years. The bonds are selling at 53 percent of par value. The company's tax rate
is 35 percent. What is the company's aftertax cost of debt?
a. 2.99 percent
b. 3.86 percent
c. 4.16 percent
d. 5.94 percent
e. 7.72 percent
31. Cruiseliners, Inc. has 230,000 shares of common stock outstanding at a market
price of $40 a share. Next quarter, Cruiseliners' is expected to pay an annual dividend
in the amount of $1.80 per share. The dividend growth rate is 3 percent. Cruiseliners'
also has 8,000 bonds outstanding with a face value of $1,000 per bond. The bonds
carry a 9 percent coupon, pay interest annually, and mature in 5.093 years. The bonds
are selling at 102 percent of face value. The company's tax rate is 35 percent. What is
Cruiseliners' weighted average cost of capital?
a. 5.4 percent
b. 6.6 percent
c. 7.5 percent
d. 8.5 percent
e. 9.6 percent
32. Choice Golf Equipment has a beta of 1.2 and a cost of equity of 13 percent. The
risk-free rate of return is 4 percent. Choice is considering a project with a beta of .8.
An appropriate discount rate for the project is:
a. 7.2 percent.
b. 8.0 percent.
c. 9.0 percent.
d. 10.0 percent.
e. 10.8 percent.
33. Orson, Inc. uses one-third common stock and two-thirds debt to finance their
operations. The aftertax cost of debt is 6 percent and the cost of equity is 12 percent.
The management of Orson, Inc. is considering a project that will produce a cash
inflow of $48,000 in the first year. The cash inflows will then grow at 4 percent per
year thereafter. What is the maximum amount the firm can initially invest in this
project to avoid a negative net present value for the project?
a. $800,000
b. $900,000
c. $1,000,000
d. $1,100,000
e. $1,200,000
34. Parker United is considering a project which requires an initial investment of
$380,000. The firm maintains a debt-equity ratio of .40. The flotation cost of debt is 6
percent and the flotation cost of equity is 11 percent. Parker United has sufficient
internally generated equity to cover the equity cost of this project. What is the initial
cost of the project including the flotation costs?
a. $386,628
b. $396,048
c. $411,009
d. $420,221
e. $433,333


35. Cooper Enterprises sells outdoor swimming pools and currently has an aftertax
cost of capital of 12 percent. Reinhold's sells pool decks and has an aftertax cost of
capital of 9 percent. Cooper Enterprises is considering adding pool decks as part of
their sales lineup. They estimate that sales from these decks could become 15 percent
of their overall sales. The initial cash outlay for this project is $75,000. The expected
net cash inflows are $14,000 a year for eight years. What is the net present value of
this project to Cooper Enterprises?
a. -12,177.50
b. -$5,453.04
c. $2,487.47
d. $4,979.00
e. $14,110.59
36. Matt invested in Dynamo stock when the firm was unlevered. Since then, Dynamo
has become levered. To unlever his position, Matt needs to:
a. borrow some money and purchase additional shares of Dynamo stock.
b. maintain his current position as the debt of the firm did not affect his personal
leverage
c. position.
d. sell some shares of Dynamo stock and hold the proceeds in cash.
e. sell some shares of Dynamo stock and loan out the sale proceeds.
f. create a personal debt-equity ratio that is equal to exactly 50 percent of the debt-
equity ratio of the firm.
37. Which of the following statements are correct in relation to M&M Proposition II
with no taxes?
I. The return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.
a. I and III only
b. II and IV only
c. I and II only
d. III and IV only
e. I and IV only
38. The business risk of a firm:
a. depends on the level of unsystematic risk associated with the assets of the firm.
b. is inversely related to the required return on the firm's assets.
c. is dependent upon the relative weights of the debt and equity used to finance the
firm.
d. has a positive relationship with the cost of equity for that firm.
e. has no relationship with the required return on a firm's assets according to M&M
Proposition II.
39. The interest tax shield has no value for a firm when the:
I. tax rate is equal to zero.
II. debt-equity ratio is exactly equal to 1.
III. firm is unlevered.
IV. firm has no taxable income.
a. I and III only
b. II and IV only
c. I, III, and IV only
d. II, III, and IV only
e. I, II, and IV only
40. Which of the following statements correctly state implications of the pecking-
order theory?
I. Firms stockpile internally-generated cash.
II. There appears to be an inverse relationship between profits and debt levels of
firms.
III. Firms avoid external debt at all costs.
IV. A firm's capital structure is dictated by its need for external financing.
a. I and III only
b. II and IV only
c. I, III, and IV only
d. I, II, and IV only
e. I, II, III, and IV
41. United Landscaping is an all equity firm that has 140,000 shares of stock
outstanding. The company is in the process of borrowing $1.2 million at 8 percent
interest to repurchase 30,000 shares of the outstanding stock. What is the value of this
firm if you ignore taxes and bankruptcy costs?
a. $2.57 million
b. $4.14 million
c. $5.60 million
d. $7.00 million
e. $8.13 million

42. Thompson Feed has a cost of equity of 11.9 percent and a pre-tax cost of debt of 9
percent. The required return on the assets is 11 percent. What is the firm's debt-equity
ratio based on M&M II with no taxes?
a. .40
b. .45
c. .50
d. .55
e. .60

43. Denver Dry Goods has expected earnings before interest and taxes of $14,600, an
unlevered cost of capital of 15 percent, and a tax rate of 35 percent. The company also
has $3,500 of debt that carries a 6 percent coupon. The debt is selling at par value.
What is the value of this firm?
a. $63,267
b. $64,184
c. $64,492
d. $65,211
e. $66,267

44. Uptown Appliances has an unlevered cost of capital of 14 percent, a tax rate of 35
percent, and expected earnings before interest and taxes of $8,200. The company has
$15,000 in bonds outstanding that have a 7.5 percent coupon and pay interest
annually. The bonds are selling at par value. What is the cost of equity?
a. 16.03 percent
b. 16.11 percent
c. 16.24 percent
d. 16.48 percent
e. 16.97 percent

45. The Pizza Palace has a cost of equity of 14.4 percent and an unlevered cost of
capital of 10 percent. The company has $18,000 in debt that is selling at par value.
The levered value of the firm is $32,000 and the tax rate is 35 percent. What is the
pre-tax cost of debt?
a. 4.73 percent
b. 6.18 percent
c. 6.59 percent
d. 7.38 percent
e. 9.92 percent

46. Webb Street Books has a $130,000 bond issue outstanding. These bonds have an 8
percent coupon, pay interest semiannually, and have a current market price equal to
101.5 percent of face value. The tax rate is 35 percent. What is the amount of the
annual interest tax shield?
a. $3,515
b. $3,640
c. $4,480
d. $5,920
e. $6,760
47. Joe's BBQ Grill has $21,000 of debt outstanding that is selling at par and has a
coupon rate of 6.5 percent. The tax rate is 35 percent. What is the present value of the
tax shield?
a. $478
b. $790
c. $1,365
d. $4,780
e. $7,350
48. Arguments that have been presented to support IPO underpricing include:
I. counteracting the "winner's curse".
II. rewarding institutional investors for sharing their opinion of a stock's market value.
III. diminishing the risk to the underwriters who have agreed to a firm commitment
underwriting.
IV. reducing the probability that investors will sue the investment banks involved in
the IPO offering.
a. I and III only
b. II and IV only
c. I and II only
d. I, II, and III only
e. I, II, III, and IV
49. When a firm announces an upcoming seasoned stock offering, the market price of
the firm's existing shares tends to:
a. increase.
b. decrease.
c. remain constant.
d. respond but the direction of the response is not predictable as shown in past studies.
e. decrease momentarily and then immediately increase substantially within the hour.
50. Which one of the following statements concerning venture capital financing is
correct?
a. Venture capitalists desire shares of common stock but avoid preferred stock.
b. Venture capital fund is good investment b/c its high return and low risk.
c. Venture capitalists rarely assume active roles in the management of the financed
firm.
d. Venture capitalists often require at least a forty percent equity position as a
condition of financing.
e. Venture capital is relatively inexpensive in today's competitive markets.
51. Which one of the following statements correctly describes your situation as the
holder of an American call option?
a. You are obligated to buy if the option is exercised.
b. You have a right to sell.
c. You have a right to buy but only on the expiration date.
d. You are obligated to sell if the option is exercised.
e. You have a right to buy at any time before the option expires.
52. What is the intrinsic value of the August 35 put?


a. $0.10
b. $0.22
c. $3.88
d. $4.10
e. $7.98
53. An increase in which of the following will increase the value of a call?
I. time to expiration
II. underlying stock price
III. risk-free rate of return
IV. price volatility of the underlying stock
a. I and III only
b. II, III, and IV only
c. I, III, and IV only
d. I, II, and III only
e. I, II, III, and IV
54. Trenton Industrial Fans has a pure discount loan with a face value of $250,000
due in one year. The assets of the firm are currently worth $315,000. The shareholders
in this firm basically own a _____ option on the assets of the firm with a strike price
of:_____
a. put; $250,000.
b. put; $315,000.
c. warrant; $315,000.
d. call; $250,000.
e. call; $315,000.
55. Several rumors concerning Nu-Tek stock are causing the market price of the stock
to be quite volatile. Given this situation, you decide to buy both a one-month
European $10 put and a one-month European $10 call on this stock. The call premium
is $.35 and the put premium is $1.60. What will your net profit or loss be on these
option positions if the stock price is $7 on the day the options expire? Ignore trading
costs and taxes.
a. $495
b. $35
c. $105
d. $140
e. $175
56. The common stock of Trynor's, Inc. is currently priced at $37.90 a share. One year
from now, the stock price is expected to be either $38 or $43 a share. The risk-free
rate of return is 3.5 percent. What is the current value of one call option on this stock
if the exercise price is $40?
a. $0.64
b. $0.71
c. $0.77
d. $0.82
e. $0.91

57. Which of the following statements are correct concerning warrants?
I. Warrants are similar to put options.
II. Warrants are similar to call options.
III. When a warrant is exercised, the issuer is not involved in the transaction.
IV. When a warrant is exercised, the issuer must issue new shares of stock.
a. I only
b. II only
c. I and III only
d. II and IV only
e. I and IV only
58. Doug owns a convertible bond that matures in five years. The bond has a 7
percent coupon and pays interest annually. The face value of the bond is $1,000 and
the conversion price is $24. Similar bonds have a market return of 8.25 percent. The
current price of the stock is $23.15. What is the conversion value of this bond?
a. $555.60
b. $748.40
c. $942.11
d. $964.58
e. $1,000.00

59. Today, you purchased one share of Diaz Motors stock at a market price of $54
along with a put on that one share of stock. The put is for one year, has a strike price
of $50 and has an option premium of $.20. What is the maximum amount you can
lose over the next year?
a. -$4.20
b. -$4.00
c. -$3.80
d. -$2.50
e. -$0.20

60. Dial Tone stock has a current market price of $23 a share. The one-year call on
Dial Tone stock with a strike price of $25 is priced at $2.05 while the one-year put
with a strike price of $25 is priced at $2.60. What is the risk-free rate of return?
a. 5.98 percent
b. 6.03 percent
c. 6.16 percent
d. 6.29 percent
e. 6.37 percent

Suppose the payoffs of the contracts MS025H, MS025L are defined as follows

At the maturity date (June 17
th
, 2011), if the price of Microsoft is above $25, then the
holder (seller) of one MS025H gets (pays) $1, otherwise zero. If the price of
Microsoft is below or equal to $25, then the holder (seller) of one MS025L gets
(pays) $1, otherwise zero.

Investors can buy the two contracts individually. They can also buy a unit portfolio
which consists of one share of each contract.

(Hint: What should be the price for a unit portfolio?)

61. If the current contract prices are as follows:

Contract Bid Ask
MS025H 0.821 0.825
MS025L 0.193 0.197

You can make an arbitrage profit by:

a. Buying the unit portfolio and buying MS025H and MS025L
b. Buying the unit portfolio and selling MS025H and MS025L
c. Selling the unit portfolio and buying MS025H and MS025L
d. Selling the unit portfolio and selling MS025H and MS025L


62. Two days before liquidation, you observe the following best ask prices:


MS025H: 0.75
MS025L: 0.27

Which one of the prices below is the most reasonable guess for Microsofts price on
liquidation day?
a. $25
b. $20
c. $30
d. $22