Multiple Choice Questions Flashcards
(114 cards)
1
Q
- (LO 1.1) Which of the following is true about finance?
a. Finance is the study of how and under what terms
savings (money) are allocated between lenders and
borrowers.
b. Finance is different from economics because economics
does not study how resources are allocated.
c. All parts of finance are not integrated.
d. Business finance is the only important part of finance.
A
a. Finance is the study of how and under what terms
savings (money) are allocated between lenders and
borrowers.
2
Q
- (LO 1.2) According to Canada’s national balance sheet,
which of the following items is not a real asset?
a. Land
b. Machinery and equipment
c. Stocks
d. Residential structures
A
c. Stocks
3
Q
- (LO 1.3) Which of the following is a correct combination
of primary fund lenders and fund borrowers in the financial
system?
a. Households and government
b. Households and non‐residents
c. Businesses and households
d. Government and non‐residents
A
a. Households and government
4
Q
- (LO 1.3) Which of the following financial intermediaries
does not transform the nature of the underlying financial
securities?
a. Banks
b. Insurance firms
c. Mutual funds
d. Pension funds
A
c. Mutual funds
5
Q
- (LO 1.4) A small investor from New Brunswick has just
purchased 100 common shares of a telecommunications
firm on the Toronto Stock Exchange. This is the first time
the investor has purchased this stock. This transaction is
an example of
a. a primary market transaction because it is the first
time the investor has bought the stock.
b. a primary market transaction because the money the
investor has invested will go directly to the firm.
c. a secondary market transaction because the investor
has bought the stock from other investors.
d. none of the above; this is a large block trade and will
be done using the OTC market (the “third market”).
A
c. a secondary market transaction because the investor
has bought the stock from other investors.
6
Q
- (LO 1.4) What are secondary market transactions? How
do secondary markets facilitate the primary markets?
A
Secondary market transactions are those where ownership of existing shares changes hands, but the corporations or governments who originally issued the securities receive no financing; trading takes place between investors.
This is critical to the functioning of the primary markets, because governments and companies would not be able to raise financing if investors were unable to sell their investments if necessary.
7
Q
- (LO 2.1) Which statement about sole proprietorships is
false?
a . The business has unlimited liability.
b. The business is easy to set up.
c. The business is hard to sell.
d. The income is taxed at a corporate rate.
A
d. The income is taxed at a corporate rate.
8
Q
- (LO 2.2) Which of the following is the goal of a corporation?
a . operate in the legal sense
b . act in the “social interest”
c. maximize the wealth of its shareholders
d . all of the above
A
c. maximize the wealth of its shareholders
9
Q
- (LO 2.4) What is the most important purpose of share
incentive plans?
a . compensate straight salary
b . align the interests of managers and shareholders
c . reward management
d. boost the share price
A
b . align the interests of managers and shareholders
10
Q
- (LO 2.1) Janice borrowed $100,000 from friends and family to start her company (a sole proprietorship). Business has been poor recently, and Janice has decided to cease operations and liquidate the firm. She expects to obtain $108,000 from selling the assets of the company. How much money will the debt holders receive, and how much will be left for Janice? Would these figures be different if the company had been a corporation?
A
When operating as a sole proprietorship, all of the assets of the company belong to the owner; the company’s debts are also the owner’s debts. Janice will have to pay her friends and family (the debtholders) the full $100,000 they are owed. This will leave her with $8,000.
A corporation exists independently from its owners. The $108,000 obtained from selling the assets will first be used to pay the debtholders what they are owed. Any remaining funds will be paid to Janice. Because the value of the assets is greater than the money owed to the debtholders, the payments are the same as they were with the sole proprietorship.
11
Q
- (LO 2.1) Suppose Janice obtains only $93,000 when she sells all the assets of the firm described in Practice Problem 18. How much money would the debt holders receive if the business were a corporation? If it were a sole proprietorship? How much would Janice receive in each case?
A
The debtholders will receive the entire $93,000 obtained from selling the assets. The remaining $7,000 that they were owed will not be paid because the company has no more funds. Furthermore, the limited liability of shareholders in a corporation means that the debtholders have no legal right to expect Janice to pay them the rest of the money. Nonetheless, Janice receives nothing from the asset sale.
If the business were a sole proprietorship, the debtholders would receive the $93,000 from the sale of assets. However, they would also have the right to force Janice to pay them the extra $7,000 they were owed. Janice would not only receive no money from the sale of the assets, she would have to pay the extra $7,000!
12
Q
- (LO 2.4) When you hired Dan to manage your business,
you agreed to pay him a bonus of 10 percent of profits at
the end of each year. The company now has a choice
between two projects (it can take on only one of them).
Project A will generate profits of $50,000 per year, and
detailed financial calculations show that it will increase
the value of the firm by $123,100. Project B will generate
profits of $40,000 per year but will increase the firm’s value by $125,600. Which project is Dan likely to choose and why? Which project would you, the owner of the firm,
prefer?
A
Dan is likely to prefer Project A because it will result in a $5,000 annual bonus for him, whereas Project B would provide only a $4,000 annual bonus. On the other hand, you (the owner) would be better off choosing Project B as it creates more value.
13
Q
- (LO 3.4) Which of the following is not a current asset?
a. cash
b. marketable securities
c. inventories
d. land
A
d. land
14
Q
- (LO 3.2) The balance sheet for a small firm shows total
assets of $529,500 and total liabilities of $379,000. What is the shareholders ’ equity?
A
Assets = Liabilities + Shareholders’ Equity
Assets - Liabilities = Shareholders’ Equity
$529,500 - $379,000 = Shareholders’ Equity
Shareholders’ Equity = 150,500
15
Q
- (LO 3.3) A firm’s net earnings are $85 million and it has 60 million shares outstanding. Determine its earnings per share.
A
Earnings per Share = Net Income / Number of Shares
EPS = $85M / 60M =$1.42
16
Q
What is a firm’s net working capital?
A
Current Assets - Current Liabilities
17
Q
2. (LO 4.2) Which of the following ratios is not in the DuPont system? a . net profit margin b . leverage c . asset turnover d . current ratio
A
d . current ratio
18
Q
- (LO 4.2) To increase return on equity (ROE),
a . increase equity, all else being unchanged.
b . decrease debt outstanding, all else being unchanged.
c . decrease corporate tax rate, all else being unchanged.
d . decrease earnings after tax, all else being unchanged.
A
c . decrease corporate tax rate, all else being unchanged.
To increase return on equity (ROE), we could decrease equity, increase debt level, decrease corporate tax rate (increase NI), or increase earnings after tax (NI), holding all the others unchanged.
19
Q
How do we calculate a company’s Gross Profit Margin and Operating Margin?
A
Gross Profit Margin = (Revenues - Cost of Goods Sold) / Revenues
Operating Margin = EBIT / Revenues
20
Q
- (LO 4.6) The current ratio is measured as
a. current assets minus current liabilities.
b. current assets divided by current liabilities.
c. cash and cash equivalents divided by current
liabilities.
d. current liabilities divided by current assets.
A
b. current assets divided by current liabilities.
Current ratio indicates how many dollars of current assets are available for one dollar of current liabilities.
21
Q
How do we calculate the ROE ratio, simplified?
A
ROE = Net Income / Shareholders’ Equity
22
Q
How do we calculate the leverage ratio?
A
Leverage Ratio = Total Assets / Shareholders’ Equity
23
Q
How do we calculate the ROA ratio, simplified?
A
ROA = Net Income / Total Assets
24
Q
In the DuPont System, what are the two components of ROA?
A
Net Profit Margin (Operating Efficiency) = Net Income / Revenues
Turnover Ratio (Asset Use Efficiency - Measure of Productivity) = Revenues / Total Assets
25
34. (LO 4.7) The shares of Corine’s Candies Inc. are currently trading at $18.20. There are four million shares outstanding. The company’s 2016 net income was $5.2 million.
Find the market value of equity for the company and the
P/E ratio of the shares.
Market value of equity = Current price per share x Number of shares = $18.20 x 4M = $72.8M
P/E Ratio = Price per share / Earnings per share
Earnings per share = net income / Number of shares
P/E Ratio = $18.20 / ($5.2M / 4M)
P/E Ratio = 14
26
1. (LO 5.2, 5.3) What is the total amount accumulated after
six years if someone invests $ 1,000 today with a simple
annual interest rate of 8 percent? How about with a compound annual interest rate of 8 percent?
a . $ 1,400, $ 1,469
b . $ 1,469, $ 1,400
c . $ 1,480, $ 1,587
d . $ 1,600, $ 1,816
c . $ 1,480, $ 1,587
27
3. (LO 5.2, 5.3) At the end of 2015, Malcolm invested $ 10,000 in two bank accounts. The expected value of each bank account for the years 2015 to 2026 are represented graphically.
A linear graph represents an account paying _______ interest, while a curved graph represents an account paying _______ interest.
simple; compound
28
5. (LO 5.3) Suppose an investor wants to have $15 million to retire 25 years from now. How much would she have to
invest today if her annual rate of return is equal to 5
percent?
a . $ 6,666,667
b . $ 4,429,542
c . $ 600,000
d . $ 21,345
b . $ 4,429,542
29
6. (LO 5.2, 5.3) Which of the following is false?
a. The longer the time period, the smaller the present
value, given a $100 future value and holding the
interest rate constant.
b. The greater the interest rate, the greater the present
value, given a $100 future value and holding the time
period constant.
c. A future dollar is always less valuable than a dollar
today if interest rates are positive.
d. The discount factor is the reciprocal of the compound
factor.
b. The greater the interest rate, the greater the present
value, given a $100 future value and holding the time
period constant.
30
7 . (LO 5.3) Maggie deposits $ 10,000 today and is promised a return of $ 16,000 in eight years. What is the implied annual rate of return?
a. 5.86%
b. 7.16%
c. 6.39%
d. 6.05%
d. 6.05%
31
8. (LO 5.3) How long will it take Mike to triple his investment if he can earn an annual rate of return of 9 percent?
a. 15.5 years
b. 13.9 years
c. 12.7 years
d. 10 years
c. 12.7 years
32
10. (LO 5.4) Jan plans to invest $ 2,000 in an equity fund every year end beginning this year. The expected annual return on the fund is 15 percent. How much would she expect to have at the end of 20 years?
a . $ 237,620
b . $ 176,424
c . $ 204,887
d . $ 178,424
c . $ 204,887
33
11. (LO 5.4) Jan plans to invest $ 2,000 in an equity fund every year end beginning this year. The expected annual return on the fund is 15 percent. She plans to invest for 20 years. What is the present value of Jan’s investments?
a . $ 12,625
b . $ 12,519
c . $ 14,396
d . $ 12,396
b . $ 12,519
34
12. (LO 5.4) What is the present value of a perpetuity with an annual year‐end payment of $ 1,500 and expected annual rate of return equal to 12 percent?
a . $ 14,000
b . $ 13,500
c . $ 11,400
d . $ 12,500
d . $ 12,500
35
24. (LO 5.3) When Jon graduates in three years, he wants to throw a big party, which will cost $800. To have this
amount available, how much does he have to invest
today if he can earn a compound return of 5 percent
per year?
N = 3; FV = 800; I/Y = 5; PMT = 0
PV = 691.07
36
28. (LO 5.6) If Alysha puts $ 50,000 in a savings account paying 6 percent per year, determine how much money she will have in total at the end of the first year if interest is
compounded:
a. annually
b. monthly
c. daily
k = (1 + QR/m)^(m/f) - 1
PV = -50,000; PMT = 0;
a. annually (m = 1): k = 0.06; FV = 53,000
b. monthly (m = 12): k = 0.0617; FV = 53,085
c. daily (m = 365): k = 0.0618; FV = 53,090
37
30. (LO 5.4) Mary‐Beth is planning to live in a university residence for three years while completing her degree. The annual cost for food and lodging is $ 6,500 and must be paid at the start of each school year. What is the total present value of Mary‐Beth ’ s residence fees if the discount rate (interest rate) is 6 percent per year?
N = 3; I/Y = 6; PMT = -6,500
PV = 18,417.05
38
36. (LO 5.4) Grace, a retired librarian, would like to donate
some money to her alma mater to endow a $ 5,000 annual scholarship. The first scholarship will be awarded in five years. The university will manage the funds and expects to earn 3 percent per year. How much will Grace have to donate so that the endowment fund never runs out?
1. Calculate funds needed at the end of four years
```
PV = PMT / k = 5,000 / 0.03
PV = 166,666.67
```
2. Discount this value to today
PV = 166,667/(1.03)^4 = 148,081
39
37. (LO 5.4) Muriel would like to support the education of her favourite grand‐nephew, Stephen, who plans to begin university in three years. How much will Muriel have to invest today, at 5 percent, to be able to give Stephen $ 6,000 at the end of each year for four years?
1. Calculate funds needed at year 3
```
N = 4; I/Y = 5; PMT = -6,000
PV = 21,275.70
```
2. Discount this value to today
```
N = 3; I/Y = 5; PMT = 0; FV = 21,275.70
PV = 18,378.75
```
40
39. (LO 5.6) A bank is currently offering a savings account
paying an interest rate of 9 percent compounded quarterly. It would like to offer another account, with the same effective annual rate, but compounded monthly. What is the equivalent rate compounded monthly?
k = (1 + QR/m)^(m/f) - 1
```
k = (1 + 0.09/4)^(4/12) - 1
k = 0.00744 = 0.744%
```
k = 12 * 0.744% = 8.933%
41
43. (LO 5.4) Felix will need $ 10,000 per year for four years to pay for tuition. How much will Felix ’ s parents have to invest at the end of each year for the eight years before he begins his studies if their savings earn compound interest at 7 percent per year? Assume the tuition payments occur at the end of each year.
1. Calculate funds needed at year 8
```
N = 4; I/Y = 7; PMT = -10,000
PV = 33,872.11
```
2. Find the tuition payment amount.
```
N = 8; I/Y = 7; FV = 33,872.11
PMT = 3,301.44
```
42
58. (LO 5.4) Two friends, Abe and Betty, are planning for their retirement. Both are 20 years old and plan on retiring in 40 years with $1 million each. Betty plans on making annual deposits beginning in one year (total of 40 deposits) while Abe plans on waiting and then depositing twice as much as Betty deposits. If both can earn 5 percent per year, how long can Abe wait before he has to start making his deposits?
1. Calculate Betty's annual deposits.
```
N = 40; I/Y = 5; PV = 0; FV = 1,000,000
PMT = -8,278.16
```
2. Calculate Abe's annual deposits.
```
PMT = -8,278.16 * 2
PMT = -16,556.32
```
3. Calculate Abe's number of deposit years.
```
I/Y = 5; PV = 0; PMT = -16,556.32; FV = 1,000,000
N = 28.52 = 29 years
```
Abe can wait 11 years before he has to start making his deposits.
43
60. (LO 5.4, 5.6) Amanda would like to borrow $ 50,000 to pay one year ’ s tuition at a private U.S. university. She would like to make quarterly payments and finish repaying the loan in five years. If the bank is quoting her a rate of 6 percent compounded monthly, determine her quarterly payment.
1. Calculate the quarterly effective rate
```
k = (1 + QR/m)^(m/f) - 1
k = (1 + 0.06/12)^(12/4) - 1
k = 1.5075%
```
2. Calculate her quarterly payment
```
N = 20; I/Y = 1.5075; PV = -50,000; FV = 0
PMT = 2,914.44
```
44
61. (LO 5.4, 5.6) Wilma would like to borrow $ 250,000 to start her own business. She would like to make monthly payments to repay the loan in 10 years. If the bank is quoting her a rate of 6 percent compounded quarterly, determine her monthly payment.
1. Calculate the monthly effective rate
```
k = (1 + QR/m)^(m/f) - 1
k = (1 + 0.06/4)^(4/12) - 1
k = 0.4975%
```
2. Calculate her monthly payment
```
N = 120; I/Y = 0.4975%; PV = -250,000; FV = 0
PMT = 2,771.75
```
45
64. (LO 5.4) Céline has just won a lottery. She will receive a payment of $ 6,000 at the end of each year for nine years. As an alternative, she can choose an immediate payment of $ 50,000.
a. Which alternative should she pick if the interest rate is
5 percent?
b. What would the interest rate have to be for Céline to
be indifferent about the two alternatives?
a. Which alternative should she pick if the interest rate is
5 percent?
Option 1: N = 9; I/Y = 5; FV=0; PMT = -6,000
PV = 42,646.93
Option 2: 50,000
Option B is better!
b. What would the interest rate have to be for Céline to
be indifferent about the two alternatives?
Option 1: N = 9; PV = 0; PMT = 6,000; PV = 50,000; FV = 0
I/Y = 1.5675%
46
67. (LO 5.6, 5.7) Jimmie wishes to buy a new car that will cost $29,000.
a. How much will his monthly car payments be if he
obtains a loan that is amortized over 60 months, and
the nominal interest rate is 8.5 percent per year with
monthly compounding?
b. Create an amortization schedule.
```
k = (1 + QR/m)^(m/f) - 1
k = (1 + 0.085/12)^12/12 - 1
k = 0.7083%
```
```
N = 60; I/Y = 0.7083; PV = -29,000; FV = 0
PMT = 594.97
```
47
69. (LO 5.7) Five years ago, Franklin borrowed $ 250,000 to purchase a house in Sandy Lake. At the time, the quoted rate on the mortgage was 6 percent, the amortization period was 25 years, the term was five years, and the payments were made monthly. Now that the term of the mortgage is complete, Franklin must renegotiate his mortgage. If the current market rate for mortgages is 8 percent, what is Franklin ’ s new monthly payment?
1. Calculate the previous monthly payment amount.
```
k = (1 + QR/m)^(m/f) - 1
k = (1 + 0.06/2)^(2/12) - 1
k = 0.4938%
```
```
N = 300; I/Y = 0.4938; PV = -250,000; FV = 0
PMT = -1,599.5162
```
2. Calculate PV of remaining payments on the mortgage.
```
N = 240; I/Y = 0.4938; PMT = -1,599.5162; FV = 0
PV = 224,591.7542
```
3. Calculate the new monthly payment amount.
```
k = (1 + QR/m)^(m/f) - 1
k = (1 + 0.08/2)^(2/12) - 1
k = 0.6558%
```
```
N = 240; I/Y = 0.6558; PV = -224,591.7542; FV = 0
PMT = 1,860.4231
```
48
3 . (LO 6.2) What is the price of a 10‐year, 8‐percent, annual coupon bond when the market rate is 6 percent? The face value is $100.
a. $114.72
b. $110.57
c. $107.71
d. $113.42
a. $114.72
```
N = 10; I/Y = 6; PMT = 8; FV = 100
PV = -114.72
```
49
4 . (LO 6.2) Which of the following bond prices is most sensitive to market rate changes? The par value is $100 for all.
a. 5‐year, 5‐percent coupon rate, yield 5.5 percent
b. 3‐year, 8‐percent coupon rate, yield 5.6 percent
c. 7.5‐year, 4.5‐percent coupon rate, yield 5.5 percent
d. 10‐year, 4.5‐percent coupon rate, yield 5.5 percent
d. 10‐year, 4.5‐percent coupon rate, yield 5.5 percent
All else being equal, interest rate risk is positively related to term to maturity, but negatively related to coupon rate and market yields. The bond in choice D has the lowest yield, lowest coupon rate and the longest term to maturity relative to the other bonds. Therefore it has the highest interest rate risk.
50
5 . (LO 6.3) What is the yield to maturity on an eight‐year, 9‐percent bond that pays interest semi-annually, which is
now priced at $980? Use a financial calculator.
a. 9.05 percent
b. 9 percent
c . 4.68 percent
d. 9.36 percent
d. 9.36 percent
```
N = 16; PV = -980; FV = 1000; PMT = 45
I/Y = 4.68
YTM = 2 x 4.68 = 9.36
```
51
6 . (LO 6.3) Which of the following statements is correct?
a . Current yield is the ratio of annual coupon payment
divided by the par value.
b . When the coupon rate is higher than the market rate,
the bond is priced at a discount.
c. When the market rate is higher than the coupon rate,
the bond is priced at a premium.
d. If a bond is at a discount, the coupon rate is less than
the current yield, which is less than YTM.
d. If a bond is at a discount, the coupon rate is less than
the current yield, which is less than YTM.
Current yield is the ratio of the annual coupon divided by the current market price. Coupon rate is the ratio of annual coupon divided by the face value. When a bond is at discount, the price is less than the face value. Therefore, the coupon rate is less than the current yield.
52
7 . (LO 6.4) Which statement is incorrect?
a. The liquidity preference theory states that investors
prefer short‐term debt.
b. According to the expectations theory, a downward-sloping yield curve implies that interest rates are
expected to decline in the future.
c. The risk premium in the bond yield reflects default
risk, liquidity risk, and issue‐specific features.
d. A debt rating of AAA is a worse rating than BB for S&P.
d. A debt rating of AAA is a worse rating than BB for S&P.
53
8 . (LO 6.5) What is the quoted price of a 182‐day Canadian T‐bill that has a face value of $10,000 and a quoted yield of 3 percent?
a. $9,778.67
b. $9,852.62
c. $97.7867
d. $98.5262
d. $98.5262
```
P = F / ( 1 + k x (n/365))
P = 10,000 / (1 + 0.03(182/365))
P = 9,852.62
```
Because it is quoted on a basis of $100, the quoted price is $98.5262
54
12 . (LO 6.2) State the relationship between market rates and bond prices.
Inversely proportional, meaning...
When market interest rates increase, prices of bonds decrease. When market interest rates decrease, prices of bonds increase.
55
24 . (LO 6.2) Suppose that, several years ago, the Canadian government issued three very similar bonds; each has a $1,000 face value and a 10‐percent coupon rate and will mature in five years. The only difference between the bonds is the frequency of the coupon payments. If the market yield is now 5.5 percent, determine the price of the bond that pays coupons:
a . annually.
b . semi‐annually.
c . monthly.
a . annually.
N = 5; I/Y = 5.5; PMT = 100; FV = 1,000
PV = -1,192.16
b . semi‐annually.
N = 10; I/Y = 2.75; PMT = 50; FV = 1,000
PV = -1,194.40
c . monthly.
N = 60; I/Y = 0.4583; PMT = 8.33; FV = 1,000
PV = -1,196.17
Notice that the value of the bond increases with more frequent coupon payments.
56
25 . (LO 6.2) The following is data for two bonds at a time
when the market yield is 7 percent.
Bond A: Coupon rate = 6%, Price = $958.42
Bond B: Coupon rate = 8%, Price = $1,041.58
These bonds are otherwise identical (FV = $1,000, five
years to maturity, semi‐annual coupon payments). Which
bond ’ s price will change more, and by how much, if the
market yield increases by 100 basis points?
100 basis points = 1%
Bond A: N = 10; I/Y = 4; PMT = 30; FV = 1,000
PV = -918.8910
This represents a decrease in price of (958.42-918.89) = $39.53 or ($39.53/958.42) = 4.12%
Bond B: N = 10; I/Y = 8; PMT = 40; FV = 1,000
PV = -1,000
Bond B decreases in price by (1,041.58-1,000) = $41.58 or ($41.58/1,041.58) = 3.99%
In general, lower coupon bonds will be impacted more (in percentage terms) than higher coupon bonds.
57
16 . (LO 6.2) A bond is currently trading at $841.70. It has 15 years to maturity. If you require a rate of return of 12 percent, what should be the bond ’ s coupon rate if the bond pays semi‐annual coupons?
N = 30; I/Y = 6; PV = 841.70; FV = 1,000
PMT = 48.4997 = 48.5
Coupon rate = 9.7%
58
26 . (LO 6.2) The following two bonds are identical (FV =
$1,000, 8‐ percent coupon rate paid semi‐annually), except
that they mature at different times.
Bond C: 3 years to maturity, Price = $1,026.64
Bond D: 8 years to maturity, Price = $1,060.47
If the market yield, currently 7 percent, increases by 100
basis points, which bond ’ s price will change more and by
how much?
Bond C: N = 6; I/Y = 4; PMT = 40; FV = 1,000
PV = -1,000
This is a decrease in price of (1,026.64–1,000) = $26.64 or (26.64/1,026.64) = 2.59%
Bond D: N = 16; I/Y = 4; PMT = 40; FV = 1,000
PV = -1,000
Bond D decreases in price by (1,060.47-1000) = $60.47 or (60.47/1,060.47) = 5.7%
Longer maturity bonds will be impacted more by changes in the market yield.
59
35 . (LO 6.5) At maturity, each of the following zero coupon
bonds (pure discount bonds) will be worth $1,000. For
each bond, fill in the missing quantity in the following
table. Assume semi‐annual compounding.
Bond A: Price = $450, 10 years to maturity, YTM?
Bond B: Price = $400, _____, YTM = 6%
Bond C: Price = ?, 15 years to maturity, YTM = 12%
Bond A: YTM = 4.0733 x 2 = 8.1466
Bond B: 30.9989/2 = 15.5 years to maturity
Bond C: Price = 174.11
60
45 . (LO 6.2) A 20‐year semi-annual bond has just been issued with its coupon rate set at the current market yield of 6 percent. How much would the price of the bond change (in percentage terms) if the market yield suddenly fell by 50 basis points? How much would the price change if the yield rose by 50 basis points?
N = 40; I/Y= 2.75; PMT = 30; FV = 1,000;
PV = –1,060.20
This is an increase in price of $60.20 or 6.02%.
An increase of 50bp results in a market yield of 6.5%
N = 40; I/Y= 3.25; PMT = 30; FV = 1,000;
PV = –944.48
This is a price decrease of $55.52 or 5.55%
Falling market yields cause larger price impacts than increasing market yields.
61
1 . (LO 7. 1 ) Jason bought 46,000 shares of CTB Inc. on January 12, 2015. At that time, CTB Inc. had 2 million common shares outstanding. Calculate the portion of CTB Inc. that Jason owns.
a. 2.3 percent
b . 1.4 percent
c . 6.0 percent
d . 1.5 percent
a. 2.3 percent
46,000 / 2,000,000 = 0.023 = 2.3%
62
2 . (LO 7. 1 ) You bought 100 shares at $20 each. At the end of the year, you received a total of $250 in dividends, and your stock was worth $2,250 total. What was your total return?
a . 45 percent
b . 50 percent
c. 90 percent
d . 25 percent
d . 25 percent
Shares Purchased = 100 x 20 = $2,000
Dividends Received = $250
Update Share Value = $2,250
Total Return = 2,250 + 250 - 2,000 = 500
500/2,000 = 25%
63
3 . (LO 7. 1 ) Which of the following is not a difference between equity securities and debt securities?
a . Incur a tax‐deductible expense
b . Have a fixed maturity date
c . Always involve fixed periodic payments
d . Represent ownership of the security
d . Represent ownership of the security
Both debt and equity represent ownership of the security. Equity represents ownership of the firm.
64
5. (LO 7. 3 ) Which of the following statements about equities is correct?
a . Every firm pays dividends to common shareholders
each year.
b . Preferred dividends are usually paid annually in
practice.
c . Common shareholders are entitled to a firm ’ s
earnings before preferred shareholders.
d . Common shareholders can vote on issues, such as
mergers, election of board members, and so on.
d . Common shareholders can vote on issues, such as
| mergers, election of board members, and so on.
65
7 . (LO 7. 3 ) Grace Holdings recently paid an annual dividend of $1.50 per share, and its estimated long‐term growth rate in dividends is 4 percent. The current market price of each share is $26. The implied rate of return on the share is
a. 9.77 percent.
b . 10 percent.
c . 12.5 percent.
d . 13.33 percent.
b . 10 percent.
```
D1 = D0 (1 + g) = 1.50 (1 + 0.04) = $1.56
k = (D1/P0) + g = (1.56 / 26) + 0.04 = 10%
```
66
8 . (LO 7. 2 ) Park Recreational Vehicles Ltd. shares are currently selling for $37.50 each. You bought 200 shares one year ago at $34 and received dividend payments of
$1.50 per share. What was your total dollar capital gain this
year?
a . $400
b . $300
c . $700
d . None of the above
c . $700
Total Dollar Capital Gain = (Current Share Price - Purchase Share Price) x Number of Shares = (37.50 - 34) x 200 = $700
67
21 . (LO 7. 3 ) FinCorp Inc. purchased a stock for $48. It expects to receive a dividend of $4 in one year and to sell the stock immediately afterwards.
a . If the sale price is $65, what is the expected one‐year
holding period return?
b . If the sale price is $38, what is the expected one‐year
holding period return?
c . If the actual return was − 5 percent, what was the sale
price?
d . If the actual return was 18 percent, what was the sale
price?
ER = k = (D1 + P1 - P0) / P0
a. ER = (4 + 65 - 48) / 48 = 0.4375 = 43.75%
b. ER = (4 + 38 - 48) / 48 = -0.125 = -12.5%
c. P1 = (-0.05 x 48) - 4 + 48 = 41.6
d. P1 = (0.18 x 48) - 4 + 48 = 52.64
68
22. (LO 7. 3 ) Fill in the missing information for these companies' common shares.
Company A:
Price = ___, Required Return = 15%, Dividend Growth = ___, Current Dividend = $4.50, Dividend Expected in 1 Year = $5.00
Company D:
Price = $55, Required Return = ___%, Dividend Growth = ___, Current Dividend = $10, Dividend Expected in 1 Year = $11
Company A:
Price = $128.57
Dividend Growth = 11.11%
Company D:
Dividend Growth = 0.1 = 10%
Required Return = 30%
69
23. (LO 7. 3 ) ToolWerks Company is expected to earn
$12 million next year. There are 4 million shares outstanding and the company uses a dividend payout ratio of 30 percent. The required rate of return for companies like ToolWerks is 10 percent. The current share price of ToolWerks is $45.
a . What are the expected earnings per share for
ToolWerks?
b . What are the expected dividends per share for
ToolWerks?
c . What is the dividend growth rate expected for
ToolWerks?
a. EPS = 12M / 4M = $3
b. DPS = (0.3 x 12,000,000) / 4,000,000 = $0.9
c. g = 0.08
70
25 . (LO 7. 3 ) Oak Furniture Company ’ s most recent earnings were $300,000. From these earnings, it paid dividends on common equity totalling $175,000. There are 50,000 common shares outstanding. The ROE for Oak Furniture is 12 percent. Determine the following:
```
a .
i) Earnings per share
ii) Which can you calculate: leading or lagging EPS?
b . Dividends per share
c . Earnings retention ratio
d . Sustainable growth rate
```
a. EPS = 300,000 / 50,000 = $6.
b. DPS = 175,000 / 50,000 = $3.5
c. Earnings Retention Ratio = 1 - Dividend Payout Ratio = 1 - (175,000/300,000) = 41.67%
d. g = b x ROE = 0.4167 x 0.12 = 4.99%
71
27 . (LO 7. 3 ) FinCorp Inc. purchased a stock for $50. It expects to hold the stock for two years, receive a dividend of $1.50 at the end of each year, and sell the stock immediately after receiving the second dividend. Assume dividends are held in a zero‐interest savings account.
a . If the sale price is $75, what is the expected annual
return?
b . If the sale price is $35, what is the expected annual
return?
c . If the actual return was −4 percent, what was the sale
price?
d . If the actual return was 15 percent, what was the sale
price?
a. PV = -50; FV = 75; PMT = 1.5; N = 2
I/Y = 25.2023
b. FV = 35
I/Y = -13.0468
c. PV = -50; PMT = 1.5; N = 2; I/Y = -4
FV = 43.14
d. PV = -50; PMT = 1.5; N = 2; I/Y = 15
FV = 62.90
72
29 . (LO 7. 2 ) Star Corporation has issued $1 million in preferred shares to investors with a 6.75 percent annual dividend rate on a par value of $100. Assuming the firm pays dividends indefinitely and the required rate is 11.5 percent, calculate the price of the preferred shares.
P = D / k = 6.75 / 0.115 = 58.70
73
34 . (LO 7. 3 ) Spinnaker Supplies Ltd. currently doesn ’ t pay any dividends but is expected to start paying dividends in five years. The first dividend is expected to be $1.80 and is expected to grow at 4.5 percent thereafter. The required rate of return for the firm is 10.5 percent. What is Spinnaker ’ s current stock price?
1. Find the price of the stock at Year 4
P4 = 1.8 / (0.105 - 0.045) = $30
2. Discount this price back to Year 0
P0 = 30 / (1.105)^4 = $20.12
74
37 . (LO 7. 3 ) Peak ’ s Organic Foods ’ current dividend is $4. You expect the growth rate to be 10 percent for years 1 to 5, and 3 percent from years 6 to infinity. The required rate of return on this firm ’ s equity is 12.5 percent. Determine the following:
a . The expected dividend at the end of year 5
b . The expected dividend at the end of year 6
c . The expected price of the stock at the end of year 5
(immediately after the year 5 dividend)
d . The price of the stock today
a. D5 = 4 x (1.1)^5 = $6.44
b. D6 = 6.44 x 1.03 = $6.6353
c. P5 = 6.6353 / (0.125 - 0.03) = $69.8453
d. P0 = $57.46
75
38 . (LO 7. 3 ) Peele Clothiers Ltd. ’ s current dividend is $3.60. Dividends are expected to grow by 9 percent for years 1 to 3, 6 percent for years 4 to 7, and 2 percent thereafter. The required rate of return on the stock is 12 percent. What is the current stock price for Peele?
The price of the stock today is $48.98.
76
55 . (LO 7. 3 ) Larch Foods Inc. ’ s current dividend is $5.
Dividends are expected to decline by 4 percent per year for the next three years, and then remain constant thereafter. The required rate of return for this type of company is 12 percent. What is the current stock price for Larch Foods?
$37.347
77
12 . (LO 8.5) State three of the most important assumptions
| underlying Markowitz’ s notion of efficient portfolios.
1. Investors are rational decision-makers.
2. Investors are risk averse. They like expected returns, dislike risk, and require compensation to assume additional risk.
3. Investor preferences are based on a portfolio’s expected return and risk, as measured by variance or standard deviation.
78
13 . (LO 8.2) FinCorp Inc. conducted an extensive analysis of the economy and concluded that the probability of a
recession next year is 30 percent, the probability of a boom is 45 percent, and the probability of a stable economy is 25 percent. Your boss has estimated that the price of PakCom Ltd. will be $60 if there is a recession, $110 if there is a boom, and $85 if the economy is stable. Currently, PakCom is trading for $83. Calculate the ex ante expected return on PakCom.
```
ER = (0.3)(60) + (0.45)(110) + (0.25)(85) = $88.75
ER = (88.75/83) - 1 = 6.93%
```
79
16 . (LO 8.1) At the beginning of the year you bought 300 shares of Lycel Ltd. at $84 each. During the year you received dividends of $780. At the end of the year the stock is trading for $87 and you decide to sell all your shares. Calculate your capital gain, total dollar return, and percentage return.
Capital gain = 3 x 300 = $900
Total dollar return = 780 + (3 x 300) = $1,680
Percentage return = 1,680 / (84 x 300) = 6.67%
80
17 . (LO 8.1) At the beginning of last year you invested $24,000 in 1,500 shares of Goran Products Inc. During the year you received $3,750 as a dividend. At the end of the year you sold the shares for $15 each. Calculate your total dollar return, capital gain, percentage return, and dividend yield.
Capital loss = 1 x 1,500 = $1,500
Total dollar return = 3,750 - 1,500 = $2,250
Percentage return = 2,250 / 24,000 = 9.375%
Dividend yield = 3,750 / 24,000 = 15.625%
81
32 . (LO 8.4) You wish to combine two stocks, Peledon and
Mexcor, into a portfolio with a standard deviation of 6 percent.
The expected return of Peledon is 2 percent with a
standard deviation of 1 percent. The expected return of
Mexcor is 25 percent with a standard deviation of 10 percent.
The correlation between the two stocks is 0.4.
a . What is the composition (weights) of the portfolio?
b . What is the expected return on the portfolio?
a . w = 0.41794
b. ER = 25 + 0.41794 (2 - 25) = 15.3874%
82
33 . (LO 8.4) Calculate the covariance and correlation coefficient between the two securities of a portfolio that has 60 percent in stock X (with an expected return of 40 percent and a standard deviation of 12 percent) and 40 percent in stock Y (with an expected return of 30 percent and a standard deviation of 15 percent). The portfolio standard deviation is 6 percent.
Covariance = –108
Correlation coefficient = -0.6
83
44 . (LO 8.4) The expected return of ABC is 15 percent, and the expected return of DEF is 23 percent. Their standard deviations are 10 percent and 23 percent, respectively, and the correlation coefficient between them is zero.
a . What is the expected return and standard deviation of
a portfolio composed of 25 percent ABC and 75
percent DEF?
b . What is the expected return and standard deviation of
a portfolio composed of 75 percent ABC and 25
percent DEF?
c . Would a risk‐averse investor hold a portfolio made up
of 100 percent of ABC?
a. ER = 21%; SD = 17.43%
b. ER = 17%; SD = 9.45%
c. No, because by trading some ABC for DEF the investor will have a higher expected return and a lower standard deviation compared to 100 percent in ABC.
84
5 . (LO 9.3) If portfolio A lies above the SML, portfolio A is
a. overvalued.
b. undervalued.
c . properly valued.
d . undetermined.
b. undervalued.
Because Portfolio A lies above the SML it provides investors with an expected return that is higher than the return that is required to provide adequate compensation for risk. Therefore, its price must be below that which investors would be willing to pay; it is undervalued.
85
7 . (LO 9.3) A portfolio with a beta greater than one is
a . more volatile than the market.
b. less volatile than the market.
c . as volatile as the market.
d. not volatile.
a . more volatile than the market.
The market beta equals 1. A portfolio with a beta greater than 1 is more volatile than the market.
86
8 . (LO 9.3) Which of the following statements is false?
a . Systematic risk cannot be diversified away.
b. The market portfolio includes all risky assets including
stocks, bonds, real estate, derivatives, and so on.
c . The market portfolio is observable.
d . The y ‐intercept of both the SML and the CML is RF .
c . The market portfolio is observable.
The market portfolio is unobservable in reality. Therefore we use a market index as a proxy.
87
12 . (LO 9.2) State three of the assumptions underlying the
| capital asset pricing model (CAPM).
1. All investors have identical expectations about ER, SD and the correlation coefficient for all securities
2. All investors have the same one-period time horizon
3. All investors can borrow/lend at the risk-free rate
4. There are no transaction costs
5. There are no personal income taxes, thus investors are indifferent whether they receive capital gains or dividends
6. There are many investors, meaning that no single investor can affect the stock price through their buying/selling decisions. Investors are price-takers.
7. Capital markets are in equilibrium.
88
14 . (LO 9.3) What is the beta of the following?
a . Risk‐free asset
b . Market portfolio
a. Beta = 0
By definition, the return on the risk-free asset is constant and therefore, the covariance between the risk-free asset and any other asset must be zero.
b. B = 1
The covariance of an asset with itself equals the variance of the asset. Therefore, the beta of the market must be one.
89
15 . (LO 9.3) If a security ’ s total risk (variance) increases, does that mean the beta must have increased? Explain.
No, the total risk has two components – systematic (or market) and unique (non-systematic). If the total has increased, it doesn’t mean that the market risk (measured by beta) component has necessarily increased.
90
17 . (LO 9.3) The current price of a stock is $20. It is expected to rise to $22 in one year and pay an annual dividend of $1 during the year. The RF is 4 percent, the ER of M is 10 percent, and the stock ’ s beta is 1.6. Determine whether the stock is overvalued, undervalued, or properly valued. Is the stock above, below, or on the SML?
```
k = RF + (ER of M - RF) Beta
k = 4 + (10 - 4)(1.6)
k = 13.6%
```
```
Expected return (15%) > Required return (13.6%), so the stock lies above the SML.
It is under-valued.
```
91
18 . (LO 9.3) The idea behind CAPM is that investors should not be compensated for diversifiable risk. Why not?
By having a portfolio of stocks, we can potentially eliminate diversifiable risk.
92
24 . (LO 9.3) Stock FM has a standard deviation of 28 percent and a correlation coefficient of 0.7 with market returns.
The standard deviation of market return is 16 percent, and
the expected return is 13.5 percent. The risk‐free rate is 4.5 percent.
a . What is the beta of stock FM?
b . What is the required rate of return of stock FM by the
CAPM model?
c . Compare FM ’ s required return to the expected market
return. What causes the difference?
a. Beta = ((0.7)(0.28)) / (0.16) = 1.225
b. k = 4.5 + (13.5 - 4.5)(1.225) = 15.53
c. Stock FM has a required rate of return (15.525%), which is higher than the market return (13.5%) because its beta is higher than the market beta of 1.
93
27 . (LO 9.3) You are valuing the Vancouver Rain‐Making
Company (VRM) and need to calculate the following:
a . Required rate of return (assume the market risk
premium is 8 percent, the risk‐free rate is 3 percent,
and the beta is 1.28)
b . Price of VRM based on the current dividend of $1.5
and a dividend growth rate of 5 percent
a. k = 3 + (8)(1.28) = 13.24%
| b. P = ((1.5)(1.05)) / (0.1324 - 0.05) = $19.11
94
30 . (LO 9.3) Portfolio A has a beta of 0.82. Portfolio B has a beta of 1.05. RF is 3 percent and the market risk premium is 6 percent. Calculate the required rate of return of A and B. If the expected rate of return for both portfolio A and B is 8.5 percent, what investment strategy should
apply?
k of A = 3 + (0.82)(6) = 7.92
k of B = 3 + (1.05)(6) = 9.30
Therefore Portfolio A lies above the SML and is under-valued, while Portfolio B lies below the SML and is over-valued. If the market is efficient, Portfolios A and B will both adjust to the required rate of return according to the SML; they will fall on the SML. Portfolio A’s price will rise and Portfolio B’s price will fall. Thus, you should buy the under-valued Portfolio A and sell the over-valued Portfolio B.
95
35 . (LO 9.3) The variance of the market returns is 0.0576, and the covariance of the returns on ABC stock and the market is 0.09504. If the risk‐free rate is 5 percent and the market risk premium is 8 percent, what is the required rate of return of ABC?
Beta = 0.09504 / 0.0576 = 1.65
k = 5 + (8)(1.65) = 18.2%
96
44 . (LO 9.3) You are forecasting the returns for PVC Company, a plumbing supply company, which pays a current dividend of $10. The dividend is expected to grow at a rate of 3 percent. You have identified two public companies, ABC and VJK, which appear to be comparable to PVC. ABC has the same total risk as PVC and a beta of 1.2. VJK, in contrast, has a very different total risk but the same market risk as PVC. VJK ’ s beta is 0.75. The market risk premium is 5 percent and the risk‐free rate is 1 percent.
a . Determine the required return for PVC using the
appropriate beta.
b . Determine the price of PVC.
a. k = 1 + (5)(0.75) = 4.75%
b. P = (10 x 1.03) / (0.0475 - 0.03) = 588.57
To value PVC, find a comparable firm. ABC, while having the same total risk, is not necessarily appropriate because we do not know if the market risk is similar. Remember, we are only rewarded for holding market risk, and if PVC has very different market risk than ABC, we will get an incorrect valuation.
VJK, in contrast, has the same market risk as PVC, so we will use it to determine the required rate of return for PVC. Note, here we are assuming that PVC will be part of a well-diversified portfolio and therefore its unsystematic or unique risk will be diversified away.
97
1 . (LO 13.1) What will probably happen if a firm does not
invest effectively?
a. The firm could still maintain its competitive
advantage.
b. The cost of capital of the firm will be unchanged.
c. The long‐term survival of the firm will be affected.
d. The short‐term performance will be unaffected.
c. The long‐term survival of the firm will be affected.
98
5 . (LO 13.2) Which project(s) should a firm choose when the projects are independent? When they are mutually exclusive?
Suppose both are within the capital budget and k is
12 percent for both projects.
Project A: CF0 -$5,000; CF1 $1,500;
CF2 $4,000; CF3 $2,000
Project B: CF0 -$5,000; CF1 $1,500;
CF2 $1,500; CF3 $4,500
a. Both projects; project A
b. Both projects; project B
c. Project B; project B
d. Neither project; neither project
NPV of Project A = 951.62
NPV of Project B = 738.09
a. Both projects; project A
99
6 . (LO 13.2) What is the IRR of the following project? Aftertax initial investment $8,000; CF1 $2,000; CF2 $3,000; CF3 $4,000; CF4 $5,000. If k = 18%, should you accept the project?
a. 16.25%; no
b. 20.50%; yes
c. 22.66%; yes
d. 25.33%; yes
c. 22.66%; yes
100
7 . (LO 13.2) We should reject a project if:
a. NPV > 0.
b. IRR > required rate of return.
c. discounted payback period < required period.
d. PI < 1.
d. PI < 1
101
8 . (LO 13.3) Which of the following statements about IRR
and NPV is incorrect?
a. NPV and IRR yield the same ranking when evaluating
projects.
b. NPV assumes that cash flows are reinvested at the
cost of capital of the firm.
c. A project may have multiple IRRs when the sign of the
cash flow changes more than once.
d. IRR is the discount rate that makes the NPV equal
zero.
a. NPV and IRR yield the same ranking when evaluating
projects.
NPV and IRR yield the same ranking when evaluating independent projects. They may have different rankings when evaluating mutually exclusive projects.
102
29 . (LO 13.2) Cutler Compacts will generate cash flows of
$30,000 in year 1 and $65,000 in year 2. However, if it makes an immediate investment of $20,000, it can instead expect to have cash streams of $55,000 in total in year 1 and $63,000 in year 2. The appropriate discount rate is 9 percent.
a . Calculate the NPV of the proposed project.
b . Why would IRR be a poor choice in this situation?
a. NPV = 1,252.42
b. The IRR is a poor choice due to the change in the signs of the incremental cash flows. This may result in multiple IRRs.
103
58 . (LO 13.3) MedCo, a large manufacturing company, currently uses a large printing press in its operations and is considering two replacements: the PDX341 and PDW581. The PDX costs $400,000 and has annual maintenance costs of $10,000 for the first 5 years and $15,000 for the next 10 years. After 15 years, the PDX will be scrapped (salvage value is zero). In contrast, the PDW can be acquired for $100,000 and requires maintenance of $30,000 a year for its 10‐year life. The salvage value of the PDW is expected to be zero in 10 years. Assuming that MedCo must replace its current printing press (it has stopped functioning), has an 8‐percent cost of capital, and all cash flows are after tax, which replacement press is the most appropriate?
PDX341:
NPV = -508,428.6301
EANPV: PV = -508,428.63; FV = 0; I/Y = 8; N = 15
PMT = -$59,399.49
PDW581:
NPV = –301,302.44
EANPV: PV = -301,302.44; FV = 0; I/Y = 8; N = 10
PMT = -$44,902.95
104
2 . (LO 20.1) If an all‐equity firm is expected to earn and pay
out a $2.25 dividend forever (in perpetuity), what is the value of the firm ’ s stock given a cost of equity of 10 percent?
a. $25.00
b. $25.50
c. $12.50
d. $22.50
d. $22.50
105
6 . (LO 20.2) Which of the following is not an input in the calculation of WACC?
a. Book values of equity and debt
b. Market values of equity and debt
c. Cost of equity
d. Corporate tax rate
a. Book values of equity and debt
106
11. (LO 20.6) What is the cost of equity given RF=3%,
| beta=1.4, expected market return=10%?
```
k = RF + (ER - RF)(beta)
k = 3 + (10 - 3)(1.4)
k = 12.8%
```
107
15 . (LO 20.2) A firm ’ s market values of equity and debt are
$750,000 and $250,000, respectively. The before-tax cost of debt = 6%; RF = 3%; beta = 1.08; the market risk premium = 8%; and the tax rate = 25%. Calculate the WACC
(weighted average cost of capital).
E = 750,000
D = 250,000
k of debt = 6%
k of equity = 3 + (8)(1.08) = 11.64
WAAC = (0.75)(11.64) + (0.25)(6)(1-0.25)
WAAC = 9.855%
108
25 . (LO 20.7) Suppose a firm uses a constant WACC to calculate the NPV of all of its capital budgeting projects, rather than adjusting for the risk of the individual projects. What
errors will the firm make in its capital budgeting decisions?
The firm will make both type 1 and type 2 errors. In the first case, it will tend to accept high-risk projects that it should have rejected. Since the project has high risk, using the WACC (which is too low a discount rate given the risk of the project) will overestimate the NPV and will lead management to accept projects that should be rejected. In the second case, the firm may reject low-risk projects that it should have accepted. Again, using the WACC (in this case a discount rate that is too high given the risk) will underestimate the NPV and lead management to reject projects it should have accepted.
109
8 . (LO 21.4) In the M&M irrelevance world, which of the following is false ?
a. The cost of equity increases as the debt‐equity ratio
increases.
b. If the expected ROI of a project is greater than the
WACC, the share price will go up.
c. The firm ’ s objective is to increase the market value of
the share price, not EPS.
d. The WACC always increases as the debt‐equity ratio
increases.
d. The WACC always increases as the debt‐equity ratio
| increases.
110
9 . (LO 21.4) What is the cost of equity for a levered firm given the following?
K(U) = 10%; K(D) = 6%; T = 25%; and D/SL = 0.5.
a. 11.5%
b. 10.6%
c. 12.4%
d. 14.8%
a. 11.5%
Cost of equity = 10 + (10 - 6)(1 - 0.25)(0.5)
Cost of equity = 11.5%
111
10 . (LO 21.7) Which of the firms below is the most likely to raise debt in the capital market?
a. A profitable firm that has a risky underlying business
b. A large and profitable firm with stable earnings and
cash from operations
c. A less profitable firm that has a non‐risky business
and cyclical cash flows
d. A small firm that has seen its share price decrease
in the past
b. A large and profitable firm with stable earnings and
| cash from operations
112
25 . (LO 21.3) In the M&M no‐tax world, calculate the value of the levered firm (V L ). Cost of unlevered equity (KU) = 16%; cost of debt (KD) = 8%; debt (D) = $500,000; and NI = $480,000.
What is the cost of levered equity?
VL = VU = EBIT/KU = (480,000 + 0.08*500,000)/0.16 = 3,250,000
SL = VL – D = 3,250,000 – 500,000 = 2,750,000
KE = 17.45%
113
28 . (LO 21.4) In the M&M tax world, calculate the value of the unlevered firm (U) and the identical risk-levered firm (L).
Corporate tax rate = 30%; perpetual EBIT for U and L =
$3 million; cost of capital of U = 16%; L’s outstanding debt =
$5 million; pre-tax cost of debt = 8%.
What is the WACC of L?
14.36%
114
1. (LO 23.1) Which of the following is not a warning sign of potential liquidity problems?
a. Declines in working capital and daily cash flows
b. Increases in accounts receivable and longer collection
periods
c. Decreases in debt and debt ratios
d. A buildup of inventory and declining inventory
turnover
c. Decreases in debt and debt ratios
