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Fall 2010 - Makeup


Savelots Stores' current financial statements are shown below:

$ 500

Accounts payable

$ 100

Other current assets


Short-term notes payable


Fixed assets


Total assets




Operating costs




Less: Interest

Common equity
Total liab. and equity



Less: Taxes (40%)
Net income


A recently released report indicates that Savelots' current ratio of 1.9 is in line with the industry average.
However, its accounts payable, which have no interest cost and which are due entirely to purchases of
inventories, amount to only 20% of inventory versus an industry average of 60%. Suppose Savelots took
actions to increase its accounts payable to inventories ratio to the 60% industry average, but it (1) kept all
of its assets at their present levels (that is, the asset side of the balance sheet remains constant) and (2)
also held its current ratio constant at 1.9. Assume that Savelots' tax rate is 40%, that its cost of short-term
debt is 10%, and that the change in payments will not affect operations. In addition, common equity would
not change. With the changes, what would be Savelots' new ROE?












The firm is not using its "free" trade credit (that is, accounts payable (A/P)) to the same
extent as other companies. Since it is financing part of its assets with 10% notes
payable, its interest expense is higher than necessary.
Calculate the increase in payables:
Current (A/P)/Inventories ratio = 100/500 = 0.20.
Target A/P = 0.60(Inventories) = 0.60(500) = 300.
Increase in A/P = 300 - 100 = 200.
Because the current ratio and total assets remain constant, total liabilities and equity
must be unchanged. The increase in accounts payable must be matched by an equal
decrease in interest bearing notes payable. Notes payable decline by 200. Interest
expense decreases by 200 ´ 0.10 = 20.
Construct comparative Income Statements:








Operating costs



Less: Interest






Less: Taxes
Net income (NI)





ROE = NI/Equity = $72/$800 = 9%. $84/$800 = 10.5%.
New ROE = 10.5%.




e. best efforts arrangement b. b. c. well-known public companies can reduce the time required to register and issue securities by using a(n) a. Large. "Red herring" registration. None of the above ANSWER: C POINTS: 0/1 FEEDBACK: REF: 3/27 . a. private placement e. Shelf registration. An agreement for the sale of securities in which the investment bank guarantees the sale by purchasing the securities from the issuer and then sells the securities in the primary is a(n) ____.2. Underwriting syndicate. underwritten arrangement d. Secondary market registration. guaranteed issue arrangement c. d. Subchapter S registration. ANSWER: A POINTS: 0/1 FEEDBACK: REF: 3.

c. equal to 10 percent b. b. while the other is a regular (or deferred) annuity. however. each paying $5. because as the problem is set up. If you are a rational wealth-maximizing investor which annuity would you choose? a. What is the effective annual return (EAR) for an investment that pays 10 percent compounded annually? a. One is an annuity due. Either one. hence we cannot tell which is better. The deferred annuity.000 per year for 5 years. the deferred annuity would be preferred. greater than 10 percent c.000. ANSWER: A POINTS: 0/1 FEEDBACK: REF: 5. Without information about the appropriate interest rate. d. they have the same present value. less than 10 percent d. The annuity due. we cannot find the values of the two annuities.4. if the payments on both were doubled to $10. ANSWER: A POINTS: 0/1 FEEDBACK: REF: 4/27 . The annuity due. Suppose someone offered you your choice of two equally risky annuities. e. e. None of the above is correct. This question cannot be answered without knowing the dollar amount of the investment.

The proportion of interest versus principal repayment would be the same for each of the 5 payments. c. With the same interest rate and the same beginning balance.000. A $10. b. regardless of whether the loan is amortized over 5 or 10 years. with annual end-of-year payments. The last payment would have a higher proportion of interest than the first payment. and if the interest rate were the same in either case. POINTS: 0/1 FEEDBACK: REF: 5/27 . ANSWER: E If the interest rate were higher. the Year 1 interest charge will be the same. and all of the increase would be attributable to interest. which is $10. which of these statements is correct? a. d.000 loan is to be amortized over 5 years. If the loan were amortized over 10 years rather than 5 years. So. e. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were higher. Given these facts. the proportion of each payment that represents interest would be higher. The annual payments would be larger if the interest rate were lower. Note that statement b is false because interest during Year 1 would be the interest rate times the beginning balance. the first payment would include more dollars of interest under the 5-year amortization plan.6. the payments would all be higher.

20 + $3. $15. what is the present value of these cash flows? a.000. CF 1 = 2. $17.250 c. with all cash flows to be received at the end of the year. 9) = $2. CF 2 = 3. I = 14.72 » $11. and $4.866.000 a year in Years 6 through 8.714 d. Assume that you will receive $2. 5) + $3.851 b.54 » $11. Financial calculator solution: Using cash flows Inputs: CF0 = 0. If you require a 14 percent rate of return.617. $11.3075) = $6.5194) + $4.713.000 in Year 9.000. Output: NPV = $11.000 (0. CF 3 = 4.000 (3.000.353 ANSWER: C Cash flow time line: Tabular solution: PV = $2. 5) (PVIF14%.00 = $11.000 (PVIFA 14%.230. N j = 3. $13. $9.3216) (0.714.4331) + $3. POINTS: 0/1 FEEDBACK: REF: 6/27 .000 a year in Years 1 through 5.000 (2.000 (PVIFA 14%.52 + $1. $3.714. N j = 5.713.7.129 e.

8.050.675.66 ANSWER: B · Compute the quarterly payment: · Beg Bal PMT INT Principal End Bal $1.111.000. How much interest (in dollars) will your company have to pay during the second quarter? a.81.508.89 e.389.60 $925. The Desai Company just borrowed $1.440.000. The loan is to be amortized in end-of-quarter payments over its 3-year life.81 76. $21. Here are the expected returns on two stocks: Returns Probability X Y 0.60 18. $24.00 $94. $18.559.81 c.000.1 -20% 10% Portfolio 7/27 .000.33 d.40 94. quarterly compounding.559.205.678. POINTS: 0/1 FEEDBACK: REF: 9.79 849.508. $15.19 b.559.440.60 $20.00 $74. $28.61 Interest in the second quarter (payment) is $18.508.000 for 3 years at a quoted rate of 8 percent.40 925.

took its square root.0 3.5% c. we recalled the stored memory value.0 -0.1% b.5% = 16.1 40 20 If you form a 50-50 portfolio of the two stocks.5% Covariance: POINTS: 0/1 FEEDBACK: REF: 8/27 .1 30." and then use the formula to calculate the standard deviation.5% e.0% 0. 13.0% ANSWER: A Fill in the columns for "XY" and "product.1 -5. and so forth. 16.8 20 15 0. did the next calculation and added it to the first one. We did each P calculation with a calculator. and had .5 14. stored the value.0. 10. Probability Portfolio X Y Product 0. When all three calculations had been done.0 0. what is the portfolio's standard deviation? a. 8. 20.4% d.8 17.

0825 = 8.0.3)] = 0.75) = 0. POINTS: 0/1 FEEDBACK: REF: 9/27 . 40% in the project. what combination of these two possibilities will maximize Allen's effective return on the money invested? a. ANSWER: B After-tax return on the new project: 0. After-tax return on the preferred stock: 0. 40% in FPL. and that 70 percent of dividends received are excluded from taxable income. c. Allen Corporation can (1) build a new plant which should generate a before-tax return of 11 percent. invest 100 percent in the FPL preferred stock.10.T) = 0. 60% in FPL. d.11(0. e. all in the form of dividends. which should provide Allen with a before-tax return of 9%. b. All in FPL preferred stock.325%. If the plant project is divisible into small increments.08325 = 8. Therefore. All in the plant project.09[1 . 60% in the project.11(1 . Assume that Allen's marginal tax rate is 25 percent.25%. 50% in each.25(0. and if the two investments are equally risky. or (2) invest the same funds in the preferred stock of FPL.

If a bond's yield to maturity exceeds its coupon rate. and the same level of risk. If the 2 bonds have different coupon payments. Statement c is false. the n. the same yield to maturity. A zero-coupon bond's YTM exceeds its coupon rate (which is equal to zero). their prices would have to be different in order for them to have the same YTM. POINTS: 0/1 FEEDBACK: REF: 10/27 . b. by definition. d.11. its current yield is equal to zero which is equal to its coupon rate. If two bonds have the same maturity. however. ANSWER: B Statement b is correct. If a bond's YTM exceeds its coupon rate. the bonds should sell for the same price regardless of the bond's coupon rate. the bond's current yield must also exceed its coupon rate. the bond sells at a discount. None of the above answers are correct. If a bond's yield to maturity exceeds its coupon rate. Statement a is false. e. a bond's value is determined by its cash flows: coupon payments plus principal. Thus. c. the bond's price must be less than its maturity value. the bond's price is less than its maturity value. Consider zero-coupon bonds. Answers b and c are both correct. Which of the following statements is most correct? a.

062. Yankee stock c. excluding stocks sold in the United States. $939. Euro stock d. $940.29 d. If you require a 7 percent rate of return to invest in this bond. In international markets. Preferred stock ANSWER: C POINTS: 0/1 FEEDBACK: REF: 11/27 .63 e. ADRs b. $965.12.81 ANSWER: B POINTS: 0/1 FEEDBACK: REF: 13. The bond has eight years remaining until maturity.53 c. Class A stock e. what is any stock that is traded in a country other than the issuing company's home country called? a. Devine Divots issued a bond a few years ago that has a face value equal to $1.15 b.000 and pays investors $30 interest every six months. $1. what is the maximum price you should be willing to pay to purchase the bond? a. $761.

The increase in shares will bring to 25 million the number of shares outstanding.06 c. the firm's stock price dropped. -$0.06 .5 percent with the new project. -$1. Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund a new project.21 = $0. Nahanni estimates that the company's growth rate will increase to 6.06 in the market.00 dividend and the stock sells for $16.14.66 e.$15. Using the DDM constant growth model. and its current required rate of return is 12. -$0.6 percent. -$0.5 percent. The firm just paid a $1. On the announcement of the new equity issue. what is the change in the equilibrium stock price? a.85 POINTS: 0/1 FEEDBACK: REF: 12/27 .85 d. the firm's cost of capital will increase to 13.08 ANSWER: C Calculate new equilibrium price and determine change: Change in price = $16. but since the project is riskier than average. -$1.77 b. Nahanni's longterm growth rate is 6 percent.

g). ANSWER: A Statement a is the condition necessary for the constant growth model. c. All the other statements are false.15. d. The constant growth DDM model can be used to value a stock only if the stock's dividends are expected to grow forever at a constant rate which is less than the required rate of return on the stock. The constant growth DDM model may be written as P 0 = D 0/(r + g). Which of the following statements is correct? a. The constant growth DDM model may be written as P 0 = D 0/(r . e. POINTS: 0/1 FEEDBACK: REF: 13/27 . the constant growth DDM model cannot be used. If the growth rate is negative. b. The constant growth DDM model may be written as r 0 = D 0/P0 + g.

07 + (0.52% ANSWER: C Calculate the initial required return and equilibrium price rs = 0.19 = 19%. and the risk-free rate is 7 percent.75.5 = 0. what new constant growth rate will cause the common stock price of Philadelphia to remain unchanged? a.85% b. 6. Calculate the new required return and equilibrium growth rate New rs = 0.08)1.15 = 17g g = 0. The required rate of return on the market is 15 percent.21. 8.) 1.16.07 + (0. and the stock is in equilibrium.15 – 2.0 = 2g + 15g (Multiply both sides by 15. New rs = 0.88% e. P 0 = $15 (Unchanged) POINTS: 3.00 per share (D 0 = $2). The company has a constant growth rate of 5 percent and a beta equal to 1.5. combine like terms. Philadelphia is considering a change in policy which will increase its beta coefficient to 1.77% 0/1 FEEDBACK: REF: 14/27 . 5. 13.53% c. 18. If market conditions remain unchanged.75 = 0.21 = .77% d. Philadelphia Corporation's stock recently paid a dividend of $2.08)1.06765 » 6.

b. but the required return on an average risk stock will not change. assuming the stocks are all equally risky. and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0. then the two mutual funds would have betas of 1. each of which had a beta of 1. If the yield curve were upward-sloping. c. c. e. Assume that the required rate of return on the market . Statements a. r M. then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF . b.0 and thus would be equally risky from an investor's standpoint.17. but r RF remains constant. If investors become more risk averse. ANSWER: D POINTS: 0/1 FEEDBACK: REF: 15/27 . Since the holder of the 1-stock portfolio is exposed to more risk. he or she can expect to earn a higher rate of return to compensate for the greater risk. Which of the following statements is most correct? a. An investor who holds just one stock will be exposed to more risk than an investor who holds a portfolio of stocks. is given and fixed.0. If Mutual Fund A held equal amounts of 100 stocks. d. the required return on low beta stocks will decline. the required rate of return on high beta stocks will rise. and d are all false.

Now the expected rate of inflation built into r RF falls by 3 percentage points.5) = 9 Difference POINTS: 6% 0/1 FEEDBACK: REF: 16/27 . while LR Corporation's beta is 0. 6. and the betas remain constant. 1. When all of these changes are made. Now SML: ri = r RF + (r M .5% c. rM = 15%.0. Falls to 11%.7%)0.5. the required return on the market falls to 11%. the real risk-free rate remains constant. what will be the difference in required returns on HR's and LR's stocks? a.rRF )bI rHR = 7% + (11% .18. 5. HR Corporation has a beta of 2. rRF = 10%. No changes occur. bLR = 0. 4.0.7%)2 = 7% + 4%(2) = 15% rLR = 7% + (11% .5.5% d.0% ANSWER: E bHR = 2. 2. and the required rate of return on an average stock is 15%.4% e.5 = 7% + 4%(0. The risk-free rate is 10%. Decreases by 3% to 7%.0% b.

210 Output: IRR = 5. An insurance firm agrees to pay you $3. a.310 Output: I = 5. 9% b. = -100.0% POINTS: 0/1 FEEDBACK: REF: 17/27 . Find the internal rate of return to the nearest whole percentage point. 5% d.19. FV = 3.310 at the end of 20 years if you pay premiums of $100 per year at the end of each year of the 20 years. PMT = -100.0% Alternate method annuity calculation Inputs: N = 20. = 3. 11% ANSWER: C Cash flow time line: Financial calculator solution: Inputs: = 0. 7% c. 3% e. Nj = 19.

e. Overcomes the problem of multiple rates of return. Which of the following statements is correct? a. The NPV and IRR methods both assume that cash flows are reinvested at the required rate of return. c. Always leads to the same ranking decision as NPV for independent projects. the MIRR method assumes reinvestment at the MIRR itself. and then we discount the TV at the required rate of return to find the PV. ANSWER: E POINTS: 0/1 FEEDBACK: REF: 21. d. e. b. and if their NPV profiles cross. d. Answers b and c are both correct. To find the MIRR. i. 18/27 . Which of the following is most correct? The modified IRR (MIRR) method: a. we first compound CFs at the regular IRR to find the TV. NPV will never indicate acceptance if IRR indicates rejection. Compounds cash flows at the required rate of return.20.. independent project. However. b. If you are choosing between two projects which have the same cost. There can never be a conflict between NPV and IRR decisions if the decision is related to a normal.e. A change in the required rate of return would normally change both a project's NPV and its IRR. Overcomes the problem of cash flow timing and the problem of project size that leads to criticism of the regular IRR method. c. then the project with the higher IRR probably has more of its cash flows coming in the later years.

2. i. then IRR says accept. 3. Here is the reasoning: 1. so NPV will also say accept. One can sketch out two NPV profiles on a graph to see that these three conditions are indeed required. which means that only one NPV profile will appear on the graph. which is the situation if r = 0. and its IRR would also be higher. The only way the profiles can cross is for the project with more total cash inflows to get a relatively high percentage of those inflows in distant years. But in that case. so the profiles would not cross. For the NPV profiles to cross. 4. because it has the higher NPV when cash flows are not discounted. If the project with more total cash inflows also had its cash flows come in earlier. it would dominate the other project¾its NPV would be higher at all discount rates. To see this. The third condition necessary for profiles to cross is that the project with the higher NPV at r = 0 have the lower IRR. one project must have a higher NPV at r = 0 than the other project. independent project. NPV > 0. The project with the higher NPV at r = 0 must have more cash inflows. Statement d is false. Most students either grasp this intuitively or else just guess at the question! POINTS: 0/1 FEEDBACK: REF: 19/27 .. If r < IRR.e. A second condition for NPV profiles to cross is that one have a higher IRR than the other. sketch out a NPV profile for a normal. so that their PVs are low when discounted at high rates. their vertical axis intercepts will be different. 5.ANSWER: A Statement a is true.

000. 11.9% b.22.000. it must spend $1 million immediately (at t = 0) and another $1 million at the end of Year 1 (t = 1). All cash inflows and outflows are after taxes.000. and it uses the modified IRR criterion for capital budgeting decisions. Output: I = 11. = 1.857. and it expects to sell the property and net $1 million at the end of Year 6.6995% » 11. PV = -1.424. What is the project's modified IRR (MIRR)? a. It will then receive net cash flows of $0. Output: NFV = $3. The company's required rate of return is 12 percent. 11.424. POINTS: 0/1 FEEDBACK: REF: 20/27 .5% e.676.676. 11. 12. FV = 3. 11.892.70%.4% d. I = 12. = 500.7% ANSWER: E Financial calculator solution: Calculate TV (Terminal value) Inputs: = 0.0% c.5 million at the end of Years 2-5. Nj = 4. Calculate MIRR Inputs: N = 6. If the company goes ahead with the project. Capitol City Transfer Company is considering building a new terminal in Salt Lake City.

ANSWER: D POINTS: 0/1 FEEDBACK: REF: 21/27 . Equipment sold for more than its book value at the end of a project's life will increase income and. Thus.23. b. Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions. An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project. these cash flows are included only at the start of a project. will generate a greater cash flow than if the same asset is sold at book value. d. e. c. It is unrealistic to expect that increases in net working capital that are required at the start of an expansion project are simply recovered at the project's completion. despite increasing taxes. Which of the following statements is correct? a. All of the above are false.

Old required rate: 18% = 7% + (5%) b beta = 2. and it can sell as much debt as it wishes at this rate.0.5.24. The firm's current after-tax cost of debt is 6 percent. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share. 10 percent preferred stock. Ross and Sons Inc. 22/27 . Treasury bonds yield 7 percent.. Sun State Mining Inc. an all-equity firm.3333(b) = 0. J. however. Total assets = 1.0 c. is considering the formation of a new division which will increase the assets of the firm by 50 percent.0 ANSWER: B Old assets = 1. and 50 percent common equity. has a target capital structure that calls for 40 percent debt. but the firm will net only $34 per share from the sale of new common stock. Ross and Sons Inc. 1. POINTS: 0/1 FEEDBACK: REF: J.8.5. New assets = 0. New b must not be greater than 1. 2. 1. what is the maximum beta coefficient the new division could have? a. Ross' common stock currently sells for $40 per share. and the market risk premium is 5 percent. Sun State currently has a required rate of return of 18 percent.S.8. U.3333 b = 1.6 e.2. and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. 2.8 d. The firm recently paid a dividend of $2 per share on its common stock. beta of the new division cannot exceed 1.0. If Sun State wants to reduce its required rate of return to 16 percent. 1. New required rate: 16% = 7% + (5%) b beta = 1. Ross expects to retain $15. Therefore.000 in earnings over the next year. therefore 0.0. the firm will net only $80 per share from the sale of new preferred stock.2 b.

25.5% b.5%(0.5% c. What will be the WACC above this break point? a. Refer to J.1% ANSWER: D WACC = 6%(0. 12. 14.5% e.5%(0. What is the firm's cost of newly issued preferred stock? a. 16.50) = 11. 12. Refer to J.90%.3% c. 8.40) + 12.5% d.0% b. 10.10) + 16. 15. 18.6% d. POINTS: 0/1 FEEDBACK: REF: 23/27 .0% ANSWER: B POINTS: 0/1 FEEDBACK: REF: 26. 11. Ross and Sons Inc . Ross and Sons Inc .9% e. 10.

they must preserve the longrun viability of the enterprise. Which of the following are practical difficulties associated with capital structure and degree of leverage analyses? a. All of the above. b. c.27. Managers often have a responsibility to provide continuous service. Thus. the goal of employing leverage to maximize short-run stock price and minimize capital cost may conflict with long-run viability. Managers' attitudes toward risk differ and some managers may set a target capital structure other than the one that would maximize stock price. e. It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates (r s values) are affected by different degrees of financial leverage. d. ANSWER: D POINTS: 0/1 FEEDBACK: REF: 24/27 . None of the above represent a serious impediment to the practical application of leverage analysis to capital structure determination.

Different countries use essentially the same international accounting conventions with respect to reporting assets on a historical versus replacement cost basis. firms should have more equity and less debt than firms in Japan and Germany.28. b. corporations in comparison to their German and Japanese counterparts.S. Debt monitoring costs are probably lower in the United States than in Japan and Germany. Equity monitoring costs are higher in the United States than in Japan and Germany. An analysis of both bankruptcy and equity reporting costs leads to the conclusion that U.S. Which of the following statements is correct? a. e. c. There have been no significant observed differences in the capital structures of U. d. ANSWER: C POINTS: 0/1 FEEDBACK: REF: 25/27 .

c. b.29. Generally. can support the large interest costs associated with higher debt levels. Which of the following is correct? a. Wide variations in capital structures exist between industries and also between individual firms within industries and are influenced by unique firm factors including managerial attitudes. using accounting values provides an accurate picture of a firm's capital structure. d. e. Since most stocks sell at or around their book values. The drug industry has a high debt to common equity ratio because their earnings are very stable and thus. Utilities generally have very high common equity ratios due to their need for vast amounts of equity supported capital. ANSWER: D POINTS: 0/1 FEEDBACK: REF: 26/27 . debt to total assets ratios do not vary much among different industries although they do vary for firms within a particular industry.

25 = % DEPS/ % DEBIT = 0. Alternate solution: Use DFL expression to calculate change in EBIT and previous EBIT: DFL = 1.0.25 = 2.000.60($100.$32. What will be the EBIT for this firm if sales do not increase? a. DOL = DTL/DFL = 3. Old EBIT = $100. POINTS: 0/1 FEEDBACK: REF: 27/27 .0.40. and it will have an EBIT of $100.48 = $67.432.432 = $67.000) .DEBIT)] = [0.000/ [1 + (0. If sales increase by 20 percent. $113.60(DEBIT)]/DEBIT 1.412 b.60(DEBIT) 1.85DEBIT = $60.000 .568.40)] = $100.000 DEBIT = $32.000 .000 .60/ [ DEBIT/($100.0.375 d.115 ANSWER: D DTL = DEPS/DSales = 60%/20% = 3. Old EBIT = $100. the firm will experience a 60 percent increase in EPS. $84.20)(2. Assume that a firm has a DFL of 1. $42.000 c. $100.30.000/1.25.0/1.568. $67.568 e.25DEBIT = $60.