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You are on page 1of 8

page - 1 -

1. The primary goal of a financial manager of a publicly held corporation

should be to:

a. Minimize the risk to the shareholders.

b. Maximize the wealth of the firm s owners.

c. Maximize earnings per share.

d. Maximize the growth in annual sales revenue.

e. None of the above.

2. The Security Market Line (SML) relates risk to return, for a given set of

financial market conditions. If the general level of risk aversion among investors

suddenly decreases (all else constant), which of the following changes would

be most likely to occur?

a. The market risk premium would increase.

b. The beta of the market portfolio would decrease.

c. The SML would shift upward, but the slope of the SML would remain

unchanged.

d. The required return on the market portfolio (kM) would increase.

e. None of the indicated changes would be likely to occur.

3. Given the following distribution of returns, compute Stock W s standard

deviation:

State of Economy Probability Stock W Return

Recession

.35

10%

Average growth

.50

20%

Boom

.15

30%

a. 0.00%

b. 2.37%

c. 6.78%

d. 7.07%

e. 8.41%

4. Moltron, Inc. has a beta of 0.80. The risk-free rate is 4 percent and the

expected rate of return on the market portfolio is 13.5 percent. Using the

CAPM, Moltron s expected return on equity is:

a. 4.0 percent

b. 9.2 percent

c. 10.8 percent

d. 11.6 percent

e. 14.8 percent

MBA 8622

page - 2 -

which will increase the assets of the firm by 100% (for example, from

$1,000,000 to $2,000,000). Fairlon currently has a required rate of return of

16%, U.S. Treasury bonds yield 4%, and the return on the market portfolio

14%. If Fairlon wants to reduce its required rate of return to 14%, what is the

maximum beta coefficient the new division could have?

a. 0.8

b. 0.9

c. 1.0

d. 1.2

e. 1.4

6. Which of the statements below is most correct assuming a positive interest

rate and positive payments. Assume that all else is constant.

a. the present value of an annuity due is less than the present value of an

ordinary annuity.

b. the higher the interest rate, the higher the present value of an annuity.

c. the higher the interest rate, the higher is the present value of a single lump

sum which will be received in the future.

d. the lower the interest rate, the lower the present value of an annuity.

e. the future value of an annuity due is higher than the future value of an

ordinary annuity .

7. Carol James is considering the purchase of a car. She wants to buy the new

beetle which will cost her $ 17,600, all features included. She expects to be

able to get a loan for the entire amount for 5.9 percent, with monthly payments

over three years. How much money will she still owe on the loan at the end of

one year?

a. $ 6,572.15

b. $ 12,075.03

c. $ 17,151.90

d. $ 12,059.24

e. $ 11,733.33

8. Wachovia Bank is offering a CD that pays 5.5 percent interest compounded

annually, while South Trust Bank offers a CD that pays interest compounded

quarterly. What is the nominal annual rate that South Trust would have to offer

in order for you to be indifferent between the two investments?

a. 5.61 percent

b. 1.34 percent

c. 5.39 percent

d. 1.40 percent

e. Insufficient information

MBA 8622

page - 3 -

9. Elizabeth Carson has just won a lottery. She has two alternatives.

Alternative I is that she receives ten equal annual installments of $100,000

each, with the first installment being received today. Alternative II is for her to

receive a single lump sum today and nothing later. If her personal discount rate

is 12.3 percent, what should be the least amount paid by Alternative II for her

to choose that alternative?

a. $ 558,150.68

b. $ 100,000.00

c. $ 626,803.21

d. $1,000,000.00

e. $ 589,498.15

10. Which of the following is not true about bonds? In all of the statements,

assume other things are held constant.

a. Price sensitivity, that is, the change in price due to a given change in the

required rate of return, increases as a bond's maturity increases.

b. For a given bond of any maturity, a given percentage point increase in the

interest rate (kd) causes a larger dollar capital loss than the capital gain

stemming from an identical decrease in the interest rate.

c. When the yield to maturity on a bond is equal to the coupon rate, the price

of the bond will be equal to par value, regardless of whether the bond pays

coupon interest annually or semi-annually and regardless of the bond s

remaining term to maturity.

d. From a borrower's point of view, interest paid on bonds is tax-deductible.

e. A 20-year zero-coupon bond has less reinvestment rate risk than a 20-year

coupon bond.

11. Assuming g will remain constant, the dividend yield is a good measure of

the required return on a common stock under which of the following

circumstances?

a. g > 0.

b. g = 0.

c. g < 0.

d. Under no circumstances.

e. Answers a and b are both correct.

12. Renfroe Incorporated has 12 percent coupon bonds (coupon interest is

paid semi-annually) outstanding that have 24 years remaining to maturity.

These bonds have a par value of $1,000 and a current yield to maturity of 6.5

percent. Compute the current price of these Renfroe Incorporated bonds.

a. $1,804.98

b. $1,000.00

c. $1,659.91

d. $ 926.82

e. $1,663.88

MBA 8622

page - 4 -

14. Niven Rings Inc. just paid a regular dividend of $1.50 per share. The

regular dividend is expected to grow at a rate of 10 percent per year for the

next three years, at a rate of 7 percent per year for the next two years, and

after that at a rate of 4 percent per year forever. In addition to the regular

dividend, Niven Rings is expected to pay a special dividend of $5.00 at the

end of year 2. (NOTE: A special dividend is a one time only payment that will

not recur. It is not considered in calculating the amount of future dividends).

The appropriate discount rate is 14 percent per year. What is the price of the

stock?

a. $19.02

b. $21.67

c. $22.43

d. $22.86

e. $24.36

15. Hard Hat Construction's stock is currently selling at an equilibrium price of

$30 per share. The firm s long run growth rate is expected to remain equal to 6

percent per year, forever. Last year's earnings per share, E0, were $4.00, and

the dividend payout ratio is 40 percent. The risk-free rate is 8 percent, and the

market risk premium is 5 percent. If systematic risk (beta) increases by 50

percent, and all other factors remain constant, by how much will the stock

price change? (Hint: Use four decimal places in your calculations.)

a. ($ 7.31)

b. $ 7.14

c. ($15.00)

d. ($15.22)

e. $22.63

16. The Jackson Company wants to purchase an asset costing $6 million. The

firm just reported a net income (NI0) of $10 million; its payout ratio is 10

percent; and the firm has 1 million shares of stock outstanding. Jackson's

market value capital structure, shown below, is considered to be optimal

(assume that there is no short-term debt):

Long-term Debt $18,900,000

Equity 12,600,000

Total Capital $31,500,000

Jackson expects its earnings (and therefore its dividends) to continue to grow

at their historical rate of 4 percent per year for the indefinite future. The current

risk free rate is 5 percent and the expected return on the market portfolio is 16

percent. Jackson's cost of debt (kd) is 8 percent and the firm's tax rate is 40

percent. Calculate Jackson's weighted average cost of capital.

a. 7.78 percent.

b. 9.23 percent.

c. 12.15 percent.

d. 14.72 percent.

e. 18.99 percent.

MBA 8622

page - 5 -

17. Martin Corporation's common stock is currently selling for $50 per share.

The current dividend is $2.00 per share. If dividends are expected to grow at

6 percent per year, what is the firm's cost of retained earnings?

a. 10.71%

b. 11.38%

c. 10.24%

d. 9.31%

e. There is no cost because retained earnings are free.

19. 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 of higher NPV.

b. Project B because of higher IRR.

c. Project A because of higher NPV.

d. Project A because of higher IRR.

e. Neither, because both have IRRs less than the cost of capital.

MBA 8622

page - 6 -

20. The present value of the expected net cash inflows for a project will most

likely exceed the present value of the expected net profit after tax for the same

project because:

a. Income is reduced by taxes paid, but cash flow is not.

b. There is a greater probability of realizing the projected cash flow than the

forecasted income.

c. Income is reduced by dividends paid, but cash flow is not.

d. Income is reduced by depreciation charges, but cash flow is not.

e. Cash flow reflects any change in net working capital, but sales do not.

21. Michigan Mattress Company is considering the purchase of land and the

construction

of a new plant. The land, which would be bought immediately (at t = 0), has a

cost of $100,000 and the building, which would be erected at the end of the

first year (t = 1), would cost $500,000. It is estimated that the firm's after-tax

cash flow will be increased by $90,000 starting at the end of the second year,

and that this incremental flow would increase at a 10 percent rate annually over

the next 10 years. What is the approximate payback period?

a. 2 years

b. 4 years

c. 6 years

d. 8 years

e. 10 years

22. Two of your classmates are evaluating a project with the following net cash

flows:

Year Cash Flow

0 ($ 10,000)

1 $100,000

2 ($100,000)

One classmate says that the project has an IRR of between 12 and 13%. The

other classmate calculates an IRR of just under 800%, but fears his calculator's

battery is low and may have caused an error. You agree to settle the dispute

by analyzing the project cash flows. Which statement best describes the IRR

for this project?

a. There is a single IRR of approximately 12.7 percent.

b. This project has no IRR, because the NPV profile does not cross the X

axis.

c. This project has two imaginary IRRs.

d. There are an infinite number of IRRs between 12.5 percent and 790 percent

that can define the IRR for this project.

e. There are multiple IRRs of approximately 12.7 percent and 787 percent.

MBA 8622

page - 7 -

THREE QUESTIONS

Topsider Inc. is considering the purchase of a new leather-cutting machine to

replace an existing machine that has a book value of $3,000 and can be sold

for $1,500. The old machine is being depreciated on a straight-line basis, and

its estimated salvage value 3 years from now is zero. The new machine will

reduce costs (before taxes) by $7,000 per year. The new machine has a

3-year life, it costs $14,200, and it can be sold for an expected $2,000 at the

end of the third year. Our tax accountant has told Topsider that the new

machine would be depreciated using the following depreciation schedule; Year

1 @ 33%, Year 2 @ 45%, Year 3 @ 15%, and Year 4 @ 7% Assuming a

40 percent tax rate and a cost of capital of 16 percent, answer the following

three questions:

23. For this project, Topsider s cash flows in Year 0 for this project are

closest to:

a. -$14,000

b. -$13,000

c. -$12,000

d. -$11,000

e. -$10,000

24. For this project, Topsider s cash flows in Year 2 for this project are

closest to:

a. $2,000

b. $3,000

c. $4,000

d. $5,000

e. $6,000

25. For this project, Topsider s cash flows in Year 3 for this project are

closest to:

a. $2,000

b. $3,000

c. $4,000

d. $5,000

e. $6,000

MBA 8622

page - 8 -

1. B

2. E

3. C

4. D

5. A Currently beta (b) = 1.2 from: 16 = 4 + b (14 - 4).

For k to equal 14, b must decrease to 1. The beta of a portfolio of assets is

the weighted average of the betas that make up that portfolio. This firm will

have two divisions, each with a beta. The beta of the existing division is 1.2

(since the current required rate of return is 16%). With the addition of the new

division, the firm will have two divisions (each with a separate beta) that are

equally weighted in size.

Thus, for the answer solve: (.5)(1.2) + (.5)(b-new) = 1; and beta of the new

division = .8.

6. E.

7. B

8. C

9. C

10. B

11.B

12. E

14.D

15. A First solve for current k = D1/P0 + g = (4.00)(.40)(1.06)/30 + .06 =

.1165 or 11.65%.

Then find current beta from: 11.65 = 8% + b (5%); b = .73.

Next increase beta by 50% : .73(1.50) = 1.095.

Now solve for new k = 8% + (1.095)(5%) = 13.475%.

Finally, solve for new price = P0 = (1.60)(1.06)/ (.13475-.06) = 22.68.

Reduction in price = 30 - 22.68.

16. A Want to solve: K = (D/A)(kd)(1-T) + (S/A)(ks)

where, D/A = (18.9/31.5), S/A = (12.6/31.5), kd = 8%, and (1-T) = .6.

To get ks, must either solve the CAPM equation of the DCF equation. Since

we do not have a beta, we cannot solve the CAPM equation. The DCF

equation is:

k = D1/P0 + g. Here, D0 = (Net income x Dividend payout ratio) divided by

the number of shares outstanding = (10,000,000)(.1)/1,000,000 = 1.00 and

D1 = D0(1+g) = 1.00(1.04) = $1.04.

P0 can be found from the market value of equity and the number of shares

outstanding. Specifically, P0 = Market value of equity divided by the number

of shares outstanding = 12,600,000/1,000,000 = 12.60.

g = 4% = .04. Thus, ks = 1.04/12.60 + .04.

Plug this into the above equation to solve for WACC.

17. C Solve k = D0(1+g)/P0 + g; k = 2.00(1.06)/50 + .06 = .1024 =

10.24%.

19. A

20. D

21. C

22. E

23. C 24. E

25. E

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