Financial Management - I

(Practice Set)

Dr. Santanu Das

Associate Professor, Finance
International Management Institute, Bhubaneswar
PGDM 2023-25

Cost of Capital
1. Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects
have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following
projects (A, B, and C) should the company accept?
A. Project C, which is of above-average risk and has a return of 11%.
B. Project A, which is of average risk and has a return of 9%.
C. Project B, which is of below-average risk and has a return of 8.5%.
D. All of the projects should be accepted.
2. Adams Inc. has the following data: Rf = 5.00%; Risk Premium = 6.00%; and beta = 1.05. What is the
firm’s cost of common from reinvested earnings based on the CAPM?
A. 12%
B. 11.3%
C. 12.5%
D. 10%
3. To help them estimate the company’s cost of capital, Smithco has hired you as a consultant. You have
been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on
the DCF approach, what is the cost of common from reinvested earnings?
A. 12.94%
B. 13%
C. 11.5%
D. 10.75%
4. Kenny Electric Company’s noncallable bonds were issued several years ago and now have 20 years to
maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and
has a par value of $1,000. If the firm’s tax rate is 40%, what is the component cost of debt for use in
the WACC calculation?
A. 4.4%
B. 5.07%
C. 3.95%
D. 6%

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5. The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years
to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and
the company’s tax rate is 40%. What is the component cost of debt for use in the WACC calculation?
A. 4%
B. 5.5%
C. 4.65%
D. 6.5%
6. To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have
obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF
approach, what is the cost of common from reinvested earnings?
A. 10%
B. 11.65%
C. 10.5%
D. 11.5%
7. As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have
been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on
the DCF approach, what is the cost of common from reinvested earnings?
A. 10.5%
B. 11%
C. 11.5%
D. 11.85%
8. Jack’s Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar
characteristics are yielding 8.5%. The company also has 4 million shares of common stock outstanding.
The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4% and the
market risk premium is 8%. Jack’s tax rate is 35%. What is Jack’s weighted average cost of capital?
A. 10.38%
B. 10%
C. 11.38%
D. 10.5%
9. The Consolidated Transfer Co. is an all-equity financed firm. The beta is 0.75, the market risk premium
is 8% and the risk-free rate is 4%. What is the expected return of Consolidated?
A. 11%
B. 11.34%
C. 10%
D. 10.5%
10. Assuming the CAPM or one-factor model holds, what is the cost of equity for a firm if the firm’s equity
has a beta of 1.2, the risk-free rate of return is 2%, the expected return on the market is 9%, and the
return to the company’s debt is 7%?
A. 11%
B. 11.4%
C. 10%
D. 10.4%

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Valuation of Securities (Bonds & Stocks)

Bonds
1. You are comparing two annuities which offer monthly payments for ten years. Both annuities are identical
with the exception of the payment dates. Annuity A pays on the first of each month while annuity B
pays on the last day of each month. Which one of the following statements is correct concerning these
two annuities?
A. Both annuities are of equal value today
B. Annuity A has a higher future value than annuity B.
C. Annuity B has a higher present value than annuity A.
D. Both annuities have the same future value as of ten years from today
2. A bond that makes no coupon payments and is initially priced at a deep discount is called a
bond.
A. Treasury
B. Municipal
C. Zero Coupon
D. floating rate
3. The principal amount of a bond that is repaid at the end of the loan term is called the bond’s:
A. Face Value or Par Value
B. YTM
C. Coupon
D. Market Value

4. The rate of return required by investors in the market for owning a bond is called the
5. A bond with a face value of $1,000 that sells for $1,000 in the market is called a bond.
6. A bond with a face value of $1,000 that sells for less than $1,000 in the market is called a
bond.

7. A bond with a 6% coupon that pays interest semi-annually and is priced at par will have a market price
of and interest payments in the amount of each.
A. $1,006; $60
B. $1,006; $30
C. $1,060; $60
D. $1,000; $30
8. All else constant, a bond will sell at when the yield to maturity is the coupon
rate.
A. a premium; higher than
B. a premium; equal to
C. at par; higher than
D. a discount; higher than
9. All else constant, a coupon bond that is selling at a premium, must have:
A. a coupon rate that is equal to the yield to maturity.

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B. a yield to maturity that is less than the coupon rate

C. semi-annual interest payments.
D. a coupon rate that is less than the yield to maturity.
10. Consider a bond which pays 8% semiannually and has 8 years to maturity. The market requires an
interest rate of 10% on bonds of this risk. What is this bond’s price? ($891.62)
11. The value of a 25-year, $1000 zero-coupon bond when the market required rate of return is 10% (semi-
annual) is ($87.20).

Stocks
1. Assume that you are using the dividend growth model to value stocks. If you expect the market rate of
return to increase across the board on all equity securities, then you should also expect the:
A. market values of all stocks to increase, all else constant.
B. market values of all stocks to remain constant as the dividend growth will offset the increase
in the market rate.
C. market values of all stocks to decrease, all else constant.
D. stocks that do not pay dividends to decrease in price while the dividend-paying stocks maintain
a constant price.
2. The value of common stock today depends on:
A. the expected future holding period and the discount rate.
B. the expected future dividends and the capital gains.
C. the expected future holding period and capital gains.
D. the expected future dividends, capital gains and the discount rate.

3. Angelina’s made two announcements concerning its common stock today. First, the company announced
that its next annual dividend has been set at $2.16 a share. Secondly, the company announced that
all future dividends will increase by 4% annually. What is the maximum amount you should pay to
purchase a share of Angelina’s stock if your goal is to earn a 10% rate of return?($36)
4. How much are you willing to pay for one share of stock if the company just paid an $.80 annual dividend,
the dividends increase by 4% annually and you require an 8% rate of return?($20.80)
5. Lee Hong Imports paid a $1.00 per share annual dividend last week. Dividends are expected to increase
by 5% annually. What is one share of this stock worth to you today if the appropriate discount rate is
14%? ($11.67)

6. Leslie’s Unique Clothing Stores offers a common stock that pays an annual dividend of $2.00 a share.
The company has promised to maintain a constant dividend. How much are you willing to pay for one
share of this stock if you want to earn a 12% return on your equity investments? ($16.67)
7. The common stock of Eddie’s Engines, Inc. sells for $25.71 a share. The stock is expected to pay $1.80
per share next month when the annual dividend is distributed. Eddie’s has established a pattern of
increasing its dividends by 4% annually and expects to continue doing so. What is the market rate of
return on this stock?
A. 12%
B. 11%
C. 11.5%
D. 12.5%

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8. Martha’s Vineyard recently paid a $3.60 annual dividend on its common stock. This dividend increases
at an average rate of 3.5% per year. The stock is currently selling for $62.10 a share. What is the market
rate of return?
A. 9.5%
B. 9%
C. 10.5%
D. 11%
9. Bet’R Bilt Bikes just announced that its annual dividend for this coming year will be $2.42 a share and
that all future dividends are expected to increase by 2.5% annually. What is the market rate of return
if this stock is currently selling for $22 a share? (13.5%)

10. The common stock of Energizer’s pays an annual dividend that is expected to increase by 10% annually.
The stock commands a market rate of return of 12% and sells for $60.50 a share. What is the expected
amount of the next dividend to be paid on Energizer’s common stock? ($1.21)

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Financial Management - I, International Management Institute, Bhubaneswar

Capital Budgeting Decisions

1. The difference between the present value of an investment and its cost is the
2. Which one of the following statements concerning net present value (NPV) is correct?
A. An investment should be accepted if, and only if, the NPV is exactly equal to zero.
B. An investment should be accepted only if the NPV is equal to the initial cash flow
C. An investment with greater cash inflows than cash outflows, regardless of when the cash flows
occur, will always have a positive NPV and therefore should always be accepted.
D. An investment should be accepted if the NPV is positive and rejected if it is
negative.
3. The length of time required for an investment to generate cash flows sufficient to recover the initial cost
of the investment is called the
4. The discount rate that makes the net present value of an investment exactly equal to zero is called the

5. The present value of an investment’s future cash flows divided by the initial cost of the investment is
called the

6. If you want to review a project from a benefit-cost perspective, you should use the method
of analysis:
A. IRR
B. NPV
C. PI
D. PB Period
7. Matt is analyzing two mutually exclusive projects of similar size and has prepared the following data.
Both projects have 5 year lives.

Matt has been asked for his best recommendation given this information. His recommendation should
be to accept:
A. project B because it has the shortest payback period
B. both projects as they both have positive net present values.
C. project A and reject project B based on their net present values.
D. project B and reject project A based on other criteria not mentioned in the problem.
8. What is the net present value of a project that has an initial cash outflow of $12,670 and the following
cash inflows? The required return is 11.5%.($218.68)

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9. A project will produce cash inflows of $1,750 a year for four years. The project initially costs $10,600
to get started. In year five, the project will be closed and as a result should produce a cash inflow of
$8,500. What is the net present value of this project if the required rate of return is 13.75%? ($1011.4)
10. You are considering two mutually exclusive projects with the following cash flows. Will your choice
between the two projects differ if the required rate of return is 8% rather than 11%? If so, what should
you do?

A. yes; Select A at 8% and B at 11% .

B. yes; Select B at 8% and A at 11%.
C. yes; Select A at 8% and select neither at 11%.
D. no; Regardless of the required rate, project A always has the higher NPV.
11. What is the profitability index for an investment with the following cash flows given a 9% required
return?

12. You are considering two independent projects both of which have been assigned a discount rate of 8%.
Based on the profitability index, what is your recommendation concerning these projects?

13. You are considering a project with an initial cost of $4,300. What is the payback period for this project
if the cash inflows are $550, $970, $2,600, and $500 a year over the next four years?
14. Jack is considering adding toys to his general store. He estimates that the cost of inventory will be
$4,200. The remodeling and shelving costs are estimated at $1,500. Toy sales are expected to produce
net cash inflows of $1,200, $1,500, $1,600, and $1,750 over the next four years, respectively. Should Jack
add toys to his store if he assigns a three-year payback period to this project?
A. Yes; because the payback period is 2.94 years.
B. Yes; because the payback period is 2.02 years
C. No; because the payback period is 3.80 years
D. Yes; because the payback period is 3.80 years.

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15. You are analyzing a project and have prepared the following data:

Required payback period 2.5 years Required return 8.50

Based on the internal rate of return of for this project, you should the project.
A. 8.95%; accept
B. 10.75%; accept
C. 10.33%; reject
D. 10.75%; reject
16. Conducting scenario analysis helps managers see the:
A. potential range of outcomes from a proposed project
B. impact of an individual variable on the outcome of a project.
C. changes in long-term debt over the course of a proposed project
D. possible range of market prices for their firm’s stock over the life of a project.
17. Sensitivity analysis helps you determine the:
A. range of possible outcomes given possible ranges for every variable.
B. net present value given the best and the worst possible situations.
C. degree to which the net present value reacts to changes in a single variable
D. degree to which a project is reliant upon the fixed costs
18. Sensitivity analysis provides information on:
A. whether the NPV should be trusted and may provide a false sense of security if all NPVs are
positive.
B. the need for additional information as it tests each variable in isolation.
C. the degree of difficulty in changing multiple variables together.
D. Both whether the NPV should be trusted and may provide a false sense of security
if all NPVs are positive; and the need for additional information as it tests each
variable in isolation
19. Taylor Inc., the company you work for, is considering a new project whose data are shown below. What
is the project’s Year 1 cash flow?
Sales revenues, each year $62,500; Depreciation $8,000; Other operating costs $25,000; Interest expense
$8,000; Tax rate 35.0%.($27,175)

20. Erickson Inc. is considering a capital budgeting project that has an expected return of 25% and a
standard deviation of 30%. What is the project’s coefficient of variation? (1.20)
21. McLeod Inc. is considering an investment that has an expected return of 15% and a standard deviation
of 10%. What is the investment’s coefficient of variation? (0.67)

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22. Century Roofing is thinking of opening a new warehouse, and the key data are shown below. The
company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides
not to open the new warehouse. The equipment for the project would be depreciated by the straight-line
method over the project’s 3-year life, after which it would be worth nothing and thus it would have a
zero salvage value. No new working capital would be required, and revenues and other operating costs
would be constant over the project’s 3-year life. What is the project’s NPV? (Hint: Cash flows are
constant in Years 1-3.) ($12,271)