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CHAPTER 1 Review Questions

AN OVERVIEW OF FINANCIAL MANAGEMENT

1.

Management’s basic, overriding goal is to create ___________ for _____________

2. The same actions that maximize _____________ also benefits society

3. If businesses are successful and earn above‐normal ___________, this will attract ___________,

which will eventually drive prices down, so the main long‐term beneficiary is the ____________.

4. Free cash flow (FCF) is: ___________ minus ___________ ________ minus ___________ minus

________________.

5. The fundamental value of a firm is the present value of its expected ________________.

6. The weighted average cost of capital is the average return required by ________________ and

________________.

7.

A(n) ________________

relationship arises whenever one or more individuals (the principals)

hire another individual or organization (the agent) to act on their behalf, delegating decision‐

making authority to that agent.

8.

Potential agency

problems

exist

between

a firm’s

shareholders

and

its

________________

and

also between managers and ________________

9. Executive compensation contracts typically have three components, ________________ ,

________________ , and ________________ .

10. ________________ allow managers to purchase stock at some future time at a given price.

11. A(n) ________________ is the acquisition of a company over the opposition of its

management.

12. A relatively new measure of managerial performance, ___________________________ is being

used by more and more firms to tie executive compensation to stock wealth maximization.



13. A potential ________________ arises whenever the manager of a firm owns less than 100

percent of the firm’s common stock.

14. If reliable, accurate information is available to all market participants, then we are said to have

________________

.

15.

The Sarbanes‐Oxyley Act of 2000 was designed to address ___________________________

16. The ________________ is the price paid to borrow debt capital.

17. ________________ risk arises from investing or doing business in a particular country.

18. The value of an investment made overseas will depend on what happens to exchange rates, and

this is known as ________________ risk.

19. Changes in ______________________________ and _______________________ _ can cause

exchange rates to fluctuate.

20. The primary objective of firm is to maximize EPS. True or False

21. The types of actions that help a firm maximize stock price are generally not directly beneficial to

society. True or False.

22.

Which

of

the

following

factors

tend

to

encourage

management

to

pursue

stock

price

maximization as a goal?

a) Shareholders link management’s compensation to company performance

b) Managers’ reactions to the threat of firing and hostile takeovers.

c)

Managers do not have goals other than stock price maximization.

d) Statement a and b are correct.

e)

Statement a,

b and

c are

correct.



Answer: Executive stock options

11.

A(n) ________________ is the acquisition of a company over the opposition of its

management

Answer: hostile takeover

12.

A relatively new measure of managerial performance, ___________________________ is being

used by more and more firms to tie executive compensation to stock wealth maximization.

Answer: economic value added

13.

A potential ________________ arises whenever the manager of a firm owns less than 100

percent of the firm’s common stock.

Answer: agency problem

14.

If reliable, accurate information is available to all market participants, then we are said to

have ________________ .

Answer: market transparency

15.

The Sarbanes-Oxyley Act of 2000 was designed to address ___________________________

Answer: corporate fraud

16.

The ________________ is the price paid to borrow debt capital.

Answer: interest rate

17. ________________ risk arises from investing or doing business in a particular country.

Answer: Country

18.

The value of an investment made overseas will depend on what happens to exchange rates, and

this is known as ________________ risk.

Answer: exchange rate



19.

Changes in ______________________________ and _______________________ _ can cause

exchange rates to fluctuate.

Answer: relative inflation; country risk

20.

The primary objective of firm is to maximize EPS. True or False

Answer: False. An increase in earnings per share will not necessarily increase stock price. For

example if the increase in earnings per share is accompanied by an increase in the riskiness of

the firm, stock price might fall. The primary objective is the maximization of stock price.

21.

The types of actions that help a firm maximize stock price are generally not directly beneficial to

society. True or False.

Answer: False. The actions that maximizes stock price generally also benefit society by

promoting efficient, low cost operations; encouraging the development of new technology,

products, and jobs; and requiring efficient and courteous service.

22.

Which of the following factors tend to encourage management to pursue stock price

maximization as a goal?

a)

Shareholders link management’s compensation to company performance

b)

Managers’ reactions to the threat of firing and hostile takeovers.

c)

Managers do not have goals other than stock price maximization.

d)

Statement a and b are correct.

e)

Statement a, b and c are correct.

Answer: (d). Specific mechanisms which tend to force managers to act in shareholders’ best

interests include: (1) the proper structuring of managerial compensation, (2) direct

intervention by shareholders, (3) the threat of firing, and (4) the threat of takeover.




Risk & Return: Part 1

1. Solve Question 2.1 from test book page 63.

2.

Ripken Iron Works faces the following probability distribution:

State of Probability of Stock's Expected Return

the Economy State Occurring if this State Occurs

Boom 0.25 25%

Normal 0.50 15

Recession 0.25 5

What is the coefficient of variation on the company's stock? (Assume that the standard deviation is

calculated using the probability statistic.)

a. 0.06

b. 0.47c. 0.54

d. 0.67

e. 0.71

3.

The returns of United Railroad Inc. (URI) are listed below, along with the returns on "the

market":

Year URI Market

1 14% 9%

2 16 11

3 22 15

4 7 5

5 2 1

If the risk-free rate is 9 percent and the required return on URI's stock is 15 percent, what is the required

return on the market? Assume the market is in equilibrium. (Hint: Think rise over run.)

a. 4% b. 9% c. 10% d. 13% e. 16%

4.

Historical rates of return for the market and for Stock A are given below:

Year Market Stock A

1 6.0% 8.0%2 8.0 3.0

3 8.0 2.0

4 18.0 12.0

If the required return on the market is 11 percent and the risk-free rate is 6 percent, what is the required

return on Stock A, according to CAPM/SML theory?

a. 6.00% b. 6.57% c. 7.25% d. 7.79% e. 8.27%



5. Assume that the following returns were earned on Stock Y and the market during the last

eight years:

Year rY rM Year rY rM

2009 14% 20% 2005 6 10

2008 9 10 2004

1

5

2007 1 5 2003 11 20

2006 11 15 2002 9 15

Average return 7.5% 10%

Standard deviation 5.18% 10%

a. What is Stock Y's beta coefficient? (Hint: Use a calculator with statistical functions to

determine the least squares line.)

b. If the expected value of r M is 10 percent and r RF is 6 percent, what is the required rate of

return on Stock Y?

c. Suppose that in January, 2010, investors learn that Firm Y will, in the future, face muchgreater competition, and investors conclude that Stock Y will, in the future, be exposed to

much higher nondiversifiable risk. Expected future profits and dividends, however, are

unchanged (although the uncertainty about profits and dividends does increase). What

effect is this knowledge likely to have on Stock Y's market price, on the realized rate of

return on Stock Y during 2009, on the required rate of return on the stock, and on the

expected rate of return on the stock in the future?

d. Suppose that during 2010 Stock Y had a return of minus 5 percent, while the market return

was 20 percent. What would this do to the calculated beta coefficient for Stock Y? (Hint:

Add the new data point and recalculate beta.)

e. Use the CAPM to calculate the required rate of return for Stock Y. Assume r M = 10 percent and r RF = 6 percent.

f. How does this new estimate of r Y compare with the estimate based on data through 2009?

Does this seem reasonable?





1. Solve Question 2.1 from test book page 63.

Stand-alone risk is only a part of total risk and pertains to the risk an investor takes by

holding only one asset. Risk is the chance that some unfavorable event will occur. For

instance, the risk of an asset is essentially the chance that the asset’s cash flows will be

unfavorable or less than expected. A probability distribution is a listing, chart or graph of all

possible outcomes, such as expected rates of return, with a probability assigned to each

outcome. When in graph form, the tighter the probability distribution, the less uncertain the

outcome.

b. The expected rate of return (r̂ ) is the expected value of a probability distribution of expected

returns.

c. A continuous probability distribution contains an infinite number of outcomes and is graphed

from -∞ and +∞.

d. The standard deviation (σ) is a statistical measure of the variability of a set of observations.

The variance (σ2

) of the probability distribution is the sum of the squared deviations about theexpected value adjusted for deviation. The coefficient of variation (CV) is equal to the

standard deviation divided by the expected return; it is a standardized risk measure which

allows comparisons between investments having different expected returns and standard

deviations.

e. A risk averse investor dislikes risk and requires a higher rate of return as an inducement to

buy riskier securities. A realized return is the actual return an investor receives on their

investment. It can be quite different than their expected return.

f. A risk premium is the difference between the rate of return on a risk-free asset and the

expected return on Stock i which has higher risk. The market risk premium is the difference

between the expected return on the market and the risk-free rate.



g. CAPM is a model based upon the proposition that any stock’s required rate of return is equal

to the risk free rate of return plus a risk premium reflecting only the risk re-maining after

diversification.

h. The expected return on a portfolio.∧

r p, is simply the weighted-average expected return of the

individual stocks in the portfolio, with the weights being the fraction of total portfolio value

invested in each stock. The market portfolio is a portfolio consisting of all stocks.

i. Correlation is the tendency of two variables to move together. A correlation coefficient (ρ) of

+1.0 means that the two variables move up and down in perfect synchronization, while a

coefficient of -1.0 means the variables always move in opposite directions. A correlation

coefficient of zero suggests that the two variables are not related to one another; that is, they

are independent.

j. Market risk is that part of a security’s total risk that cannot be eliminated by diversification.

It is measured by the beta coefficient. Diversifiable risk is also known as company specific

risk, that part of a security’s total risk associated with random events not affecting the market

as a whole. This risk can be eliminated by proper diversification. The relevant risk of a stock

is its contribution to the riskiness of a well-diversified portfolio.

k. The beta coefficient is a measure of a stock’s market risk, or the extent to which the returnson a given stock move with the stock market. The average stock’s beta would move on

average with the market so it would have a beta of 1.0.

l. The security market line (SML) represents in a graphical form, the relationship between the

risk of an asset as measured by its beta and the required rates of return for individual

securities. The SML equation is essentially the CAPM, r i = r RF + bi(r M - r RF).

m. The slope of the SML equation is (r M - r RF), the market risk premium. The slope of the SMLreflects the degree of risk aversion in the economy. The greater the average investors

aversion to risk, then the steeper the slope, the higher the risk premium for all stocks, and the

higher the required return.



2. Ripken Iron Works faces the following probability distribution:

State of Probability of Stock's Expected Return

the Economy State Occurring if this State Occurs

Boom 0.25 25% Normal 0.50 15

Recession 0.25 5

What is the coefficient of variation on the company's stock? (Assume that the standard deviation iscalculated using the probability statistic.)a. 0.06

b. 0.47c. 0.54

d. 0.67e. 0.71

Answer:

The expected rate of return will equal 0.25(25%) + 0.5(15%) + 0.25(5%) = 15%. The variance of

the expected return is 0.25(25% 15%)2 + 0.5(15% 15%)

2 + 0.25(5% 15%)

2 = 0.0050. The

standard deviation is the square root of 0.0050 = 0.0707. And, CV = 0.0707/0.15 = 0.47.

3. The returns of United Railroad Inc. (URI) are listed below, along with the returns on "themarket":

Year URI Market

1 −14% −9%2 16 11

3 22 15

4 7 55 −2 −1

If the risk-free rate is 9 percent and the required return on URI's stock is 15 percent, what is the requiredreturn on the market? Assume the market is in equilibrium. (Hint: Think rise over run.)

a. 4% b. 9% c. 10% d. 13% e. 16%

Answer:

b = = 1.5.

rs = 15% = 9% + (rM 9%)1.56% = (r M 9%)1.5

4% = rM 9%

rM = 13%.



4. Historical rates of return for the market and for Stock A are given below:

Year Market Stock A

1 6.0% 8.0%

2 −8.0 3.0

3 −8.0 −2.0

4 18.0 12.0

If the required return on the market is 11 percent and the risk-free rate is 6 percent, what is the required

return on Stock A, according to CAPM/SML theory?a. 6.00% b. 6.57% c. 7.25% d. 7.79% e. 8.27%

Answer:

rA = 6% + (11% 6%)bA.

Calculate bA as follows using a financial calculator:

.

rA = 6% + 5%(0.4534) = 8.2669% 8.27%.

5.

Assume that the following returns were earned on Stock Y and the market during the last

eight years:

Year rY rM Year rY rM

2009 14% 20% 2005 6 10

2008 9 10 2004 −1 −52007 1 −5 2003 11 20

2006 11 15 2002 9 15

Average return 7.5% 10%Standard deviation 5.18% 10%

a. What is Stock Y's beta coefficient? (Hint: Use a calculator with statistical functions todetermine the least squares line.)

b. If the expected value of r M is 10 percent and r RF is 6 percent, what is the required rate ofreturn on Stock Y?

c. Suppose that in January, 2010, investors learn that Firm Y will, in the future, face much

greater competition, and investors conclude that Stock Y will, in the future, be exposed tomuch higher nondiversifiable risk. Expected future profits and dividends, however, areunchanged (although the uncertainty about profits and dividends does increase). Whateffect is this knowledge likely to have on Stock Y's market price, on the realized rate of

return on Stock Y during 2009, on the required rate of return on the stock, and on theexpected rate of return on the stock in the future?

d. Suppose that during 2010 Stock Y had a return of minus 5 percent, while the market returnwas 20 percent. What would this do to the calculated beta coefficient for Stock Y? (Hint:

Add the new data point and recalculate beta.)

e. Use the CAPM to calculate the required rate of return for Stock Y. Assume r M = 10 percent and r RF = 6 percent.



f. How does this new estimate of r Y compare with the estimate based on data through 2009?

Does this seem reasonable?

Answer:

a. The least squares procedure yields the following equation for predicting the rate of

return on Stock Y: rY = a + brM = 2.5 + 0.5rM. Therefore, the beta for Stock Y is 0.50.

The regression line is plotted in the graph.

b. rY = rRF + (rM rRF)bY = 6% + (4%)0.5 = 8%.

c. The stock is now riskier. With greater risk and the same expected earnings and

dividends, the price of the stock would fall. Thus, capital losses would be incurred,and they would offset if not overwhelm the dividend return, with the net result being

a low or even negative realized rate of return during 2010. The required rate of

return would rise. With the same expected dividends and dividend growth rate, but a

lower market price, the expected rate of return on the now lower priced stock would

rise to equal the now higher required rate of return.

d. Adding the point 5, 20 for 2010 to the data set produces this regression equation:

rY = 2.75 + 0.3rM. beta = 0.3.

Thus, the historical beta declines when the 2009 data is added.

e. rY = 6% + (4%)0.3 = 7.2%.

f. This is down from 8% in 2009. Since we know that investors regard Stock Y as being

riskier, the true required rate of return must be higher than 8%, not lower. This

demonstrates one of the problems with using the CAPM. In this case, rising risk

caused a decline in the price of the stock, which caused a low rate of return, which inturn caused the calculated beta to decline. In this example, historical betas do not

reflect risk well at all.





1. If you plotted the returns of Selleck & Company against those of the market and found that

the slope of your line was negative, the CAPM would indicate that the required rate of return

on Selleck’s stock should be less than the risk-free rate for a well-diversified investor,

assuming that the observed relationship is expected to continue in the future.

a. True b. False.

2. If the returns of two firms are negatively correlated, then one of them must have a negative beta.

a. True b. False:

3. It is possible for a firm to have a positive beta, even if the correlation between its returns and

those of another firm are negative.

a. True b. False:

4. The CAPM is a multi‐period model which takes account of differences in securities’ maturities, and

it can

be

used

to

determine

the

required

rate

of

return

for

any

given

level

of

systematic

risk.

a. True b. False

5. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart

from their current levels),

a. The expected rate of return must be equal to the required rate of return; that is, rr̂ .

b. The past realized rate of return must be equal to the expected rate of return; that is, r̂r .

c. The required rate of return must equal the realized rate of return; that is, rr .

d. All three of the above statements must hold for equilibrium to exist; that is, rrr̂ .

e. None of the above statements is correct

6. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true

about these securities? (Assume market equilibrium.)

a. When held in isolation, Stock A has greater risk than Stock B.

b. Stock B must be a more desirable addition to a portfolio than Stock A.

c.

Stock A

must

be

a more

desirable

addition

to

a portfolio

than

Stock

B.

d. The expected return on Stock A should be greater than that on Stock B.

e. The expected return on Stock B should be greater than that on Stock A.



7. Which of the following statements is CORRECT?

a. Tests have shown that the betas of individual stocks are unstable over time, but that the betas

of large portfolios are reasonably stable over time.

b. Richard Roll has argued that it is possible to test the CAPM to see if it is correct.

c. Tests have shown that the risk/return relationship appears to be linear, but the slope of the

relationship is

greater

than

that

predicted

by

the

CAPM.

d. Tests have shown that the betas of individual stocks are stable over time, but that the betas of

large portfolios are much less stable.

e. The most widely cited study of the validity of the CAPM is one performed by Modigliani and

Miller.

8.

Which of the following are the factors for the Fama‐French model?

a. The excess market return, a size factor, and a book‐to‐market factor.

b. The excess market return, a debt factor, and a book‐to‐market factor.

c. The excess market return, a size factor, and a debt.

d. A

debt

factor,

a size

factor,

and

a book

‐to

‐market

factor.

e. The excess market return, an industrial production factor, and a book‐to‐market factor.

9. Assume that you hold a well‐diversified portfolio that has an expected return of 12.0% and a

beta of 1.20. You are in the process of buying 100 shares of Alpha Corp at $10 a share and

adding it to your portfolio. Alpha has an expected return of 15.0% and a beta of 2.00. The total

value of your current portfolio is $9,000. What will the expected return and beta on the

portfolio be after the purchase of the Alpha stock? Hint: Answer choices in the form: [ rp;bp]

a. 11.69%; 1.22 b. 12.30%; 1.28 c. 12.92%; 1.34 d. 13.56%; 1.41 e. 14.24%; 1.48

10.

The returns

on

the

market,

the

returns

on

United

Fund

(UF),

the

risk

‐free

rate,

and

the

required

return on the United Fund are shown below. Assuming the market is in equilibrium and that

beta can be estimated with historical data, what is the required return on the market, rM?

Year Market UF

2003 ‐9% ‐14%

2004 11% 16%

2005 15% 22%

2006 5% 7%

2007 ‐1% ‐2%

rRF: 7.00%; rUnited: 15.00%

a. 10.57% b. 11.13% c. 11.72% d. 12.33% e. 12.95%





1. If you plotted the returns of Selleck & Company against those of the market and found that

the slope of your line was negative, the CAPM would indicate that the required rate of return

on Selleck’s stock should be less than the risk-free rate for a well-diversified investor,

assuming that the observed relationship is expected to continue in the future.

a. True

b. False.

Answer: True

2. If the returns of two firms are negatively correlated, then one of them must have a negative beta.

a. True

b. False:

Answer: True

3. It is possible for a firm to have a positive beta, even if the correlation between its returns and

those of another firm are negative.

a. True

b. False:

Answer: True

4. The CAPM is a multi-period model which takes account of differences in securities’ maturities, and

it can be used to determine the required rate of return for any given level of systematic risk.

a. True

b. False

Answer: False

i.5. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart

from their current levels),

a. The expected rate of return must be equal to the required rate of return; that is, rr̂ = .

b. The past realized rate of return must be equal to the expected rate of return; that is, r̂r = .

c. The required rate of return must equal the realized rate of return; that is, rr = .

d. All three of the above statements must hold for equilibrium to exist; that is, rrr̂ == .

e. None of the above statements is correct

Answer: (a) The expected rate of return must be equal to the required rate of return; that is,

rr̂ = .



6. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true

about these securities? (Assume market equilibrium.)

a. When held in isolation, Stock A has greater risk than Stock B.

b. Stock B must be a more desirable addition to a portfolio than Stock A.

c. Stock A must be a more desirable addition to a portfolio than Stock B.

d. The expected return on Stock A should be greater than that on Stock B.

e. The expected return on Stock B should be greater than that on Stock A.

Answer: (d) The expected return on Stock A should be greater than that on Stock B.

7.

Which of the following statements is CORRECT?a. Tests have shown that the betas of individual stocks are unstable over time, but that the betas

of large portfolios are reasonably stable over time.

b. Richard Roll has argued that it is possible to test the CAPM to see if it is correct.

c. Tests have shown that the risk/return relationship appears to be linear, but the slope of the

relationship is greater than that predicted by the CAPM.

d. Tests have shown that the betas of individual stocks are stable over time, but that the betas of

large portfolios are much less stable.

e. The most widely cited study of the validity of the CAPM is one performed by Modigliani and

Miller.

Answer: (a) Tests have shown that the betas of individual stocks are unstable over time, butthat the betas of large portfolios are reasonably stable over time.

8.

Which of the following are the factors for the Fama-French model?

a. The excess market return, a size factor, and a book-to-market factor.

b. The excess market return, a debt factor, and a book-to-market factor.

c. The excess market return, a size factor, and a debt.

d. A debt factor, a size factor, and a book-to-market factor.

e. The excess market return, an industrial production factor, and a book-to-market factor.

Answer: (a ) The excess market return, a size factor, and a book-to-market factor.



9. Assume that you hold a well-diversified portfolio that has an expected return of 12.0% and a

beta of 1.20. You are in the process of buying 100 shares of Alpha Corp at $10 a share and

adding it to your portfolio. Alpha has an expected return of 15.0% and a beta of 2.00. The total

value of your current portfolio is $9,000. What will the expected return and beta on the

portfolio be after the purchase of the Alpha stock?

rp bp

a. 11.69%; 1.22

b. 12.30%; 1.28

c. 12.92%; 1.34

d. 13.56%; 1.41

e. 14.24%; 1.48

Answer: ( b) 12.30%; 1.28

10. The returns on the market, the returns on United Fund (UF), the risk-free rate, and the required

return on the United Fund are shown below. Assuming the market is in equilibrium and that

beta can be estimated with historical data, what is the required return on the market, rM?

Year Market UF

2003 -9% -14%

2004 11% 16%

2005 15% 22%

2006 5% 7%

2007 -1% -2%

rRF: 7.00%; rUnited: 15.00%

a. 10.57% b. 11.13% c. 11.72% d. 12.33% e. 12.95%

Answer: d . 12.33




Bond Valuation(4.4) Current yieldi. A 12-year bond pays an annual coupon of 8.5 percent. The bond has a yield to maturity of 9.5

percent and a par value of $1,000. What is the bond’s current yield?

a. 6.36% b. 2.15% c. 8.95% d. 9.14% e. 10.21%

(4.4) Current yield and yield to maturity

ii. A bond matures in 12 years, and pays an 8 percent annual coupon. The bond has a face value of

$1,000, and currently sells for $985. What is the bond’s current yield and yield to maturity?

a. Current yield = 8.00%; yield to maturity = 7.92%.

b. Current yield = 8.12%; yield to maturity = 8.20%.

c. Current yield = 8.20%; yield to maturity = 8.37%.

d. Current yield = 8.12%; yield to maturity = 8.37%.

e. Current yield = 8.12%; yield to maturity = 7.92%.

(4.4) Yield to maturityiii. Palmer Products has outstanding bonds with an annual 8 percent coupon. The bonds have a par

value of $1,000 and a price of $865. The bonds will mature in 11 years. What is the yield tomaturity on the bonds?

a. 10.09% b. 11.13% c. 9.25% d. 8.00% e. 9.89%

(4.4) Yield to maturity and bond value--annualiv. A 20-year bond with a par value of $1,000 has a 9 percent annual coupon. The bond currently

sells for $925. If the bond’s yield to maturity remains at its current rate, what will be the price ofthe bond 5 years from now?a. $ 966.79 b. $ 831.35 c. $1,090.00 d. $ 933.09 e. $ 925.00

(4.6) Bond value - semiannual payment

v. A corporate bond with a $1,000 face value pays a $50 coupon every six months. The bond will

mature in ten years, and has a nominal yield to maturity of 9 percent. What is the price of the

bond?

a. $ 634.86 b. $1,064.18 c. $1,065.04 d. $1,078.23 e. $1,094.56




vi. A bond with a $1,000 face value and an 8 percent annual coupon pays interest semiannually. The

bond will mature in 15 years. The nominal yield to maturity is 11 percent. What is the price of

the bond today?

a. $ 784.27 b. $ 781.99 c. $1,259.38 d. $1,000.00 e. $ 739.19

(4.6) YTM and YTCvii. A corporate bond matures in 14 years. The bond has an 8 percent semiannual coupon and a par

value of $1,000. The bond is callable in five years at a call price of $1,050. The price of the bond today is $1,075. What are the bond’s yield to maturity and yield to call?

a. YTM = 14.29%; YTC = 14.09% b. YTM = 3.57%; YTC = 3.52%c. YTM = 7.14%; YTC = 7.34%d. YTM = 6.64%; YTC = 4.78%e. YTM = 7.14%; YTC = 7.05%

(4.6) Yield on semiannual bond

viii. A corporate bond has a face value of $1,000, and pays a $50 coupon every six months (i.e., the

bond has a 10 percent semiannual coupon). The bond matures in 12 years and sells at a price of

$1,080. What is the bond’s nominal yield to maturity?

a. 8.28% b. 8.65% c. 8.90% d. 9.31% e. 10.78%

(4.3) Interest payments remaining

ix. You have just been offered a $1,000 par value bond for $847.88. The coupon rate is 8 percent,

payable annually, and annual interest rates on new issues of the same degree of risk are 10

percent. You want to know how many more interest payments you will receive, but the party

selling the bond cannot remember. Can you determine how many interest payments remain?

a. 14 b. 15 c. 12 d. 20 e. 10

(4.4) Yield to call

x. A corporate bond which matures in 12 years, pays a 9 percent annual coupon, has a face value of

$1,000, and a yield to maturity of 7.5 percent. The bond can first be called four years from now.

The call price is $1,050. What is the bond’s yield to call?

a. 6.73% b. 7.10% c. 7.50% d. 11.86% e. 13.45%




xi. An 8 percent annual coupon, noncallable bond has ten years until it matures and a yield to

maturity of 9.1 percent. What should be the price of a 10-year noncallable bond of equal risk

which pays an 8 percent semiannual coupon? Assume both bonds have a par value of $1,000.

a. $ 898.64 b. $ 736.86 c. $ 854.27 d. $ 941.09 e. $ 964.23

(4.6) Call price Answer: c

xii. Kennedy Gas Works has bonds which mature in 10 years, and have a face value of $1,000. The

bonds have a 10 percent quarterly coupon (i.e., the nominal coupon rate is 10 percent). The

bonds may be called in five years. The bonds have a nominal yield to maturity of 8 percent and a

yield to call of 7.5 percent. What is the call price on the bonds?

a. $ 379.27 b. $1,025.00 c. $1,048.34 d. $1,036.77 e. $1,136.78

i. (4.4) Current yield Answer: d

Current yield = Annual coupon payment/Current price.

Step 1 Find the price of the bond: N = 12, I/YR = 9.5, PMT =85, and FV = 1000. Solve for PV = $930.

Step 2 Calculate the current yield: CY = $85/$930 = 9.14%.

ii. (4.4) Current yield and yield to maturity Answer: b N = 12PV = -985PMT = 80FV = 1,000Solve for I/YR (YTM) = 8.20%.Current yield is calculated as:$80/$985 = 8.12%.

iii

. (4.4) Yield to maturity Answer: a

Enter N = 11, PV = -865, PMT = 80, and FV = 1000. Solve for I/YR

= 10.0868% 10.09%.



iv. (4.4) Yield to maturity and bond value--annual Answer: d

Step 1 Find the YTM. N = 20; PV = -925; PMT = 90; FV = 1000; andsolve for I = YTM. I = 9.8733%.

Step 2 Solve for P5. In 5 years, there will be 15 years leftuntil maturity, so the price at t = 5 is: N = 15; I/YR =9.8733; PMT = 90; FV = 1000; and solve for PV. PV =$933.09.

v. (4.6) Bond value - semiannual payment Answer: c

N = 10 2 = 20I = 9/2 = 4.5PMT = 50FV = 1,000Solve for PV = -$1,065.04.

vi. (4.6) Bond value - semiannual payment Answer: b

N = 15 2 = 30I/YR = 11/2 = 5.5

PMT = 1,000 0.08/2 = 40FV = 1,000Solve for PV = -$781.99.

vii. (4.6) YTM and YTC Answer: e

To calculate YTM: N = 28, PV = -1075, PMT = 40, and FV = 1000.

Solve for I/YR = 3.57% 2 = 7.14%.

To calculate YTC: N = 10, PV = -1075, PMT = 40, and FV = 1050.

Solve for I/YR = 3.52% 2 = 7.05%.

viii. (4.6) Yield on semiannual bond Answer: c

N = 12 2 = 24PV = -1,080PMT = 50FV = 1,000

Solve for I = 4.4508% 2 = 8.9016%.

ix. (4.3) Interest payments remaining Answer: bT me L ne:

0 10% 1 2 n = ? Years

| | |. . .

|

PMT = 80 80 80

VB = 847.88 FV = 1,000



Financial calculator solution:Inputs: I = 10; PV = -$847.88; PMT = 80; FV = 1,000.Output: N = 15 years.

x. (4.4) Yield to call Answer: aFirst get the price based on the YTM: N = 12I = 7.5PMT = 90FV = 1,000Solve for PV = -$1,116.03.

Now solve for the YTC: N = 4PV = -1,116.03PMT = 90

FV = 1,050I = 6.7263% 6.73%.

xi. (4.6) Bond value - semiannual payment Answer: dThe 8% annual coupon bond’s YTM is 9.1%. The effective annual

rate (EAR) is 9.1% because the bond is an annual bond. Now, weneed to find the nominal rate for the semiannual bond which hasthe same EAR, so we can calculate its price.EAR% = 9.1P/YR = 2Solve for NOM% = 8.9019%.

An equally risky 8% semiannual coupon bond has the same EAR.

Now, solve for the semiannual bond’s price. N = 2 10 = 20,I/YR = 8.9019/2 = 4.4510, PMT = 80/2 = 40, FV = 1,000, and solvefor PV = $941.09.

xii. (4.6) Call price Answer: cFirst, solve for the price of the bond today as follows: N = 10

4 = 40, I = 8/4 = 2, PMT = 100/4 = 25, and FV = 1,000; thus,

solve for PV = -$1,136.78. Now, the call price can be solved foras follows: N = 5 4 = 20, I = 7.5/4 = 1.875, PV = -1,136.78,PMT = 25; thus, solve for FV = $1,048.34.




Bond Valuation(4.4) Current yield Answer: di. A 12-year bond pays an annual coupon of 8.5 percent. The bond has a yield to maturity of 9.5

percent and a par value of $1,000. What is the bond’s current yield?

a. 6.36% b. 2.15% c. 8.95% d. 9.14% e. 10.21%

(4.4) Current yield and yield to maturity Answer: b

ii. A bond matures in 12 years, and pays an 8 percent annual coupon. The bond has a face value of

$1,000, and currently sells for $985. What is the bond’s current yield and yield to maturity?

a. Current yield = 8.00%; yield to maturity = 7.92%.

b. Current yield = 8.12%; yield to maturity = 8.20%.

c. Current yield = 8.20%; yield to maturity = 8.37%.

d. Current yield = 8.12%; yield to maturity = 8.37%.

e. Current yield = 8.12%; yield to maturity = 7.92%.

(4.4) Yield to maturity Answer: aiii. Palmer Products has outstanding bonds with an annual 8 percent coupon. The bonds have a par

value of $1,000 and a price of $865. The bonds will mature in 11 years. What is the yield tomaturity on the bonds?

a. 10.09% b. 11.13% c. 9.25% d. 8.00% e. 9.89%

(4.4) Yield to maturity and bond value--annual Answer: div. A 20-year bond with a par value of $1,000 has a 9 percent annual coupon. The bond currently

sells for $925. If the bond’s yield to maturity remains at its current rate, what will be the price ofthe bond 5 years from now?a. $ 966.79 b. $ 831.35 c. $1,090.00 d. $ 933.09 e. $ 925.00

(4.6) Bond value - semiannual payment Answer: c

v. A corporate bond with a $1,000 face value pays a $50 coupon every six months. The bond will

mature in ten years, and has a nominal yield to maturity of 9 percent. What is the price of the

bond?

a. $ 634.86 b. $1,064.18 c. $1,065.04 d. $1,078.23 e. $1,094.56



(4.6) Bond value - semiannual payment Answer: b

vi. A bond with a $1,000 face value and an 8 percent annual coupon pays interest semiannually. The

bond will mature in 15 years. The nominal yield to maturity is 11 percent. What is the price of

the bond today?

a. $ 784.27 b. $ 781.99 c. $1,259.38 d. $1,000.00 e. $ 739.19

(4.6) YTM and YTC Answer: e Diff: Evii. A corporate bond matures in 14 years. The bond has an 8 percent semiannual coupon and a par

value of $1,000. The bond is callable in five years at a call price of $1,050. The price of the bond today is $1,075. What are the bond’s yield to maturity and yield to call?

a. YTM = 14.29%; YTC = 14.09% b. YTM = 3.57%; YTC = 3.52%c. YTM = 7.14%; YTC = 7.34%d. YTM = 6.64%; YTC = 4.78%e. YTM = 7.14%; YTC = 7.05%

(4.6) Yield on semiannual bond Answer: c

viii. A corporate bond has a face value of $1,000, and pays a $50 coupon every six months (i.e., the

bond has a 10 percent semiannual coupon). The bond matures in 12 years and sells at a price of

$1,080. What is the bond’s nominal yield to maturity?

a. 8.28% b. 8.65% c. 8.90% d. 9.31% e. 10.78%

(4.3) Interest payments remaining Answer: b

ix. You have just been offered a $1,000 par value bond for $847.88. The coupon rate is 8 percent,

payable annually, and annual interest rates on new issues of the same degree of risk are 10

percent. You want to know how many more interest payments you will receive, but the party

selling the bond cannot remember. Can you determine how many interest payments remain?

a. 14 b. 15 c. 12 d. 20 e. 10

(4.4) Yield to call Answer: a

x. A corporate bond which matures in 12 years, pays a 9 percent annual coupon, has a face value of

$1,000, and a yield to maturity of 7.5 percent. The bond can first be called four years from now.

The call price is $1,050. What is the bond’s yield to call?

a. 6.73% b. 7.10% c. 7.50% d. 11.86% e. 13.45%



(4.6) Bond value - semiannual payment Answer: d

xi. An 8 percent annual coupon, noncallable bond has ten years until it matures and a yield to

maturity of 9.1 percent. What should be the price of a 10-year noncallable bond of equal risk

which pays an 8 percent semiannual coupon? Assume both bonds have a par value of $1,000.

a. $ 898.64 b. $ 736.86 c. $ 854.27 d. $ 941.09 e. $ 964.23

(4.6) Call price Answer: c

xii. Kennedy Gas Works has bonds which mature in 10 years, and have a face value of $1,000. The

bonds have a 10 percent quarterly coupon (i.e., the nominal coupon rate is 10 percent). The

bonds may be called in five years. The bonds have a nominal yield to maturity of 8 percent and a

yield to call of 7.5 percent. What is the call price on the bonds?

a. $ 379.27 b. $1,025.00 c. $1,048.34 d. $1,036.77 e. $1,136.78

i. (4.4) Current yield Answer: d

Current yield = Annual coupon payment/Current price.

Step 1 Find the price of the bond: N = 12, I/YR = 9.5, PMT =85, and FV = 1000. Solve for PV = $930.

Step 2 Calculate the current yield: CY = $85/$930 = 9.14%.

ii. (4.4) Current yield and yield to maturity Answer: b N = 12PV = -985PMT = 80FV = 1,000Solve for I/YR (YTM) = 8.20%.Current yield is calculated as:$80/$985 = 8.12%.

iii

. (4.4) Yield to maturity Answer: a

Enter N = 11, PV = -865, PMT = 80, and FV = 1000. Solve for I/YR

= 10.0868% 10.09%.



iv. (4.4) Yield to maturity and bond value--annual Answer: d

Step 1 Find the YTM. N = 20; PV = -925; PMT = 90; FV = 1000; andsolve for I = YTM. I = 9.8733%.

Step 2 Solve for P5. In 5 years, there will be 15 years leftuntil maturity, so the price at t = 5 is: N = 15; I/YR =9.8733; PMT = 90; FV = 1000; and solve for PV. PV =$933.09.

v. (4.6) Bond value - semiannual payment Answer: c

N = 10 2 = 20I = 9/2 = 4.5PMT = 50FV = 1,000Solve for PV = -$1,065.04.

vi. (4.6) Bond value - semiannual payment Answer: b

N = 15 2 = 30I/YR = 11/2 = 5.5

PMT = 1,000 0.08/2 = 40FV = 1,000Solve for PV = -$781.99.

vii. (4.6) YTM and YTC Answer: e

To calculate YTM: N = 28, PV = -1075, PMT = 40, and FV = 1000.

Solve for I/YR = 3.57% 2 = 7.14%.

To calculate YTC: N = 10, PV = -1075, PMT = 40, and FV = 1050.

Solve for I/YR = 3.52% 2 = 7.05%.

viii. (4.6) Yield on semiannual bond Answer: c

N = 12 2 = 24PV = -1,080PMT = 50FV = 1,000

Solve for I = 4.4508% 2 = 8.9016%.

ix. (4.3) Interest payments remaining Answer: bT me L ne:

0 10% 1 2 n = ? Years

| | |. . .

|

PMT = 80 80 80

VB = 847.88 FV = 1,000



Financial calculator solution:Inputs: I = 10; PV = -$847.88; PMT = 80; FV = 1,000.Output: N = 15 years.

x. (4.4) Yield to call Answer: aFirst get the price based on the YTM: N = 12I = 7.5PMT = 90FV = 1,000Solve for PV = -$1,116.03.

Now solve for the YTC: N = 4PV = -1,116.03PMT = 90

FV = 1,050I = 6.7263% 6.73%.

xi. (4.6) Bond value - semiannual payment Answer: dThe 8% annual coupon bond’s YTM is 9.1%. The effective annual

rate (EAR) is 9.1% because the bond is an annual bond. Now, weneed to find the nominal rate for the semiannual bond which hasthe same EAR, so we can calculate its price.EAR% = 9.1P/YR = 2Solve for NOM% = 8.9019%.

An equally risky 8% semiannual coupon bond has the same EAR.

Now, solve for the semiannual bond’s price. N = 2 10 = 20,I/YR = 8.9019/2 = 4.4510, PMT = 80/2 = 40, FV = 1,000, and solvefor PV = $941.09.

xii. (4.6) Call price Answer: cFirst, solve for the price of the bond today as follows: N = 10

4 = 40, I = 8/4 = 2, PMT = 100/4 = 25, and FV = 1,000; thus,

solve for PV = -$1,136.78. Now, the call price can be solved foras follows: N = 5 4 = 20, I = 7.5/4 = 1.875, PV = -1,136.78,PMT = 25; thus, solve for FV = $1,048.34.




Basic Stock Valuation(5.6) Capital gains yield

i. Given the following information, calculate the expected capital gains yield for Chicago Bears

Inc.: beta = 0.6; r M = 15%; r RF = 8%; D1 = $2.00; P0 = $25.00. Assume the stock is in equilibrium

and exhibits constant growth.

a. 3.8% b. 0% c. 8.0% d. 4.2% e. 2.5%

(5.6) Capital gains yield and dividend yield

ii. Conner Corporation has a stock price of $32.35 per share. The last dividend was $3.42 (i.e., D0 =

$3.42). The long-run growth rate for the company is a constant 7 percent. What is the

company’s capital gains yield and dividend yield?

a. Capital gains yield = 7.00%; Dividend yield = 10.57%.

b. Capital gains yield = 10.57%; Dividend yield = 7.00%.

c. Capital gains yield = 7.00%; Dividend yield = 4.31%.

d. Capital gains yield = 11.31%; Dividend yield = 7.00%.

e. Capital gains yield = 7.00%; Dividend yield = 11.31%.

(5.5) Risk and stock value

(5.5) Stock growth rate

iii. Grant Corporation's stock is selling for $40 in the market. The company's beta is 0.8, the market

risk premium is 6 percent, and the risk-free rate is 9 percent. The previous dividend was $2 (i.e.,

D0 = $2) and dividends are expected to grow at a constant rate. What is the growth rate for this

stock?

a. 5.52% b. 5.00% c. 13.80% d. 8.80% e. 8.38%

(5.11) Required return

iv. An increase in a firm's expected growth rate would normally cause the firm's required rate of

return to

a. Increase. b. Decrease. c. Fluctuate. d. Remain constant.

e. Possibly increase, possibly decrease, or possibly remain unchanged.



v. The probability distribution for r M for the coming year is as follows:

Probability r M

0.05 7%

0.30 8

0.30 9

0.30 10

0.05 12

If r RF = 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7 percent, and

D0 = $2, what market price gives the investor a return consistent with the stock's risk?

a. $25.00 b. $37.50 c. $21.72 d. $42.38 e. $56.94

(5.11) Required return

vi. If the expected rate of return on a stock exceeds the required rate,

a. The stock is experiencing supernormal growth.

b. The stock should be sold.

c. The company is probably not trying to maximize price per share.

d. The stock is a good buy.

e. Dividends are not being declared.



(5.12) Efficient markets hypothesis Answer: e Diff: Evii. Which of the following statements is most correct?

a. If a market is strong-form efficient this implies that the returns on bonds and stocks should be

identical. b. If a market is weak-form efficient this implies that all public information is rapidly

incorporated into market prices.c. If your uncle earns a return higher than the overall stock market, this means the stock market

is inefficient.d. Both answers a and b are correct.e. None of the above answers is correct.

(5.12) Market efficiency

viii. Which of the following statements is most correct?

a. Semistrong-form market efficiency implies that all private and public information is rapidly

incorporated into stock prices.

b. Market efficiency implies that all stocks should have the same expected return.

c. Weak-form market efficiency implies that recent trends in stock prices would be of no use in

selecting stocks.

d. All of the answers above are correct.

(5.11) Required returnix. If the expected rate of return on a stock exceeds the required rate,








i. (5.6) Capital gains yield Answer: d Diff: M

Required rate of return, rs = 8% + (15% - 8%)0.6 = 12.2%.

Calculate dividend yield and use to calculate capital gains yield:

Dividend yield =P

D

0

1

=$25.002.00 = 0.08 = 8%.

Capital gains yield = Total yield - Dividend yield = 12.2% - 8% = 4.2%.

Alternative method:

P0 =g-r

D

s

1; $25 =

g-0.122

42

$3.05 - $25g = $2 (Multiply both sides by (0.122 - g))

$25g = $1.05

g = 0.042 = 4.2%.

Since the stock is growing at a constant rate, g = Capital gains yield.

ii. (5.6) Capital gains yield and dividend yield Answer: e Diff: M

Calculate D1 as $3.42 1.07 = $3.66. The dividend yield is $3.66/$32.35 = 11.31%. The capital

gains yield is equal to the long-run growth rate for this stock (since constant growth) or 7%.

iii. (5.5) Stock growth rate Answer: e Diff: M

The required rate of return on the stock is 9% + (6%)0.8 = 13.8%. Using the constant growth

model, we can solve for the growth rate as $40 = [$2(1 + g)]/(13.8% - g) or g = 8.38%.

iv. (5.11) Required return Answer: e Diff: E



v. (5.5) Risk and stock value Answer: d Diff: M

Numerical solution:

Required return on market and stock

rM = 0.05(7%) + 0.30(8%) + 0.30(9%) + 0.30(10%) + 0.05(12%) = 9.05%.

rs = 6.05% + (9.05% - 6.05%)2.0 = 12.05%.

Expected equilibrium stock price

.38.42$07.01205.0

)07.1(2Pö0

vi. (5.11) Required return Answer: d Diff: E

vii. (5.12) Efficient markets hypothesis Answer: e Diff: E

Statements a through d are incorrect; therefore, statement e is

correct. Statement a is incorrect. Strong-form efficiency states that

current market prices reflect all pertinent information, whether

publicly available or privately held. If it holds, even insiders would

find it impossible to earn abnormal returns in the stock market.

Statement b is incorrect; this describes semi-strong form efficiency.

viii. (5.12) Market efficiency Answer: c Diff: E

Statement c is correct; the other statements are false. Semistrong-form market efficiency

implies that only public information, not private, is rapidly incorporated into stock prices.

Markets can be efficient yet still price securities differently depending on their risks.

ix. (5.11) Required return Answer: d Diff: E



v. The probability distribution for r M for the coming year is as follows:

Probability r M

0.05 7%

0.30 8

0.30 9

0.30 10

0.05 12

If r RF = 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7 percent, and

D0 = $2, what market price gives the investor a return consistent with the stock's risk?

a. $25.00 b. $37.50 c. $21.72 d. $42.38 e. $56.94

(5.11) Required return Answer: d Diff: E

vi. If the expected rate of return on a stock exceeds the required rate,








(5.12) Efficient markets hypothesis Answer: e Diff: Evii. Which of the following statements is most correct?

a. If a market is strong-form efficient this implies that the returns on bonds and stocks should be

identical. b. If a market is weak-form efficient this implies that all public information is rapidly

incorporated into market prices.c. If your uncle earns a return higher than the overall stock market, this means the stock market

is inefficient.d. Both answers a and b are correct.e. None of the above answers is correct.

(5.12) Market efficiency Answer: c Diff: E

viii. Which of the following statements is most correct?

a. Semistrong-form market efficiency implies that all private and public information is rapidly

incorporated into stock prices.

b. Market efficiency implies that all stocks should have the same expected return.

c. Weak-form market efficiency implies that recent trends in stock prices would be of no use in

selecting stocks.


(5.11) Required return Answer: d Diff: E ix. If the expected rate of return on a stock exceeds the required rate,








i. (5.6) Capital gains yield Answer: d Diff: M

Required rate of return, rs = 8% + (15% - 8%)0.6 = 12.2%.

Calculate dividend yield and use to calculate capital gains yield:

Dividend yield =P

D

0

1

=$25.002.00 = 0.08 = 8%.

Capital gains yield = Total yield - Dividend yield = 12.2% - 8% = 4.2%.

Alternative method:

P0 =g-r

D

s

1; $25 =

g-0.122

42

$3.05 - $25g = $2 (Multiply both sides by (0.122 - g))

$25g = $1.05

g = 0.042 = 4.2%.

Since the stock is growing at a constant rate, g = Capital gains yield.

ii. (5.6) Capital gains yield and dividend yield Answer: e Diff: M

Calculate D1 as $3.42 1.07 = $3.66. The dividend yield is

$3.66/$32.35 = 11.31%. The capital gains yield is equal to the long-

run growth rate for this stock (since constant growth) or 7%.

iii

. (5.5) Stock growth rate Answer: e Diff: MThe required rate of return on the stock is 9% + (6%)0.8 = 13.8%.

Using the constant growth model, we can solve for the growth rate as

$40 = [$2(1 + g)]/(13.8% - g) or g = 8.38%.

iv. (5.11) Required return Answer: e Diff: E

v. (5.5) Risk and stock value Answer: d Diff: M

Numerical solution:

Required return on market and stock

rM = 0.05(7%) + 0.30(8%) + 0.30(9%) + 0.30(10%) + 0.05(12%) = 9.05%.

rs = 6.05% + (9.05% - 6.05%)2.0 = 12.05%.

Expected equilibrium stock price

.38.42$07.01205.0

)07.1(2Pö0



vi. (5.11) Required return Answer: d Diff: Evii. (5.12) Efficient markets hypothesis Answer: e Diff: E

Statements a through d are incorrect; therefore, statement e is

correct. Statement a is incorrect. Strong-form efficiency states that

current market prices reflect all pertinent information, whether

publicly available or privately held. If it holds, even insiders would

find it impossible to earn abnormal returns in the stock market.

Statement b is incorrect; this describes semi-strong form efficiency.

viii. (5.12) Market efficiency Answer: c Diff: E

Statement c is correct; the other statements are false. Semistrong-

form market efficiency implies that only public information, not

private, is rapidly incorporated into stock prices. Markets can be

efficient yet still price securities differently depending on their

risks.ix. (5.11) Required return Answer: d Diff: E




Accounting for Financial Management

(7.5) Net cash flowi. Last year Aldrin Co. had negative net cash flow, yet its cash on the balance sheet increased.

What could explain these events?

a. Aldrin issued long-term debt. b. Aldrin repurchased some of its common stock.c. Aldrin sold some of its assets.d. Statements a and b are correct.e. Statements a and c are correct.

(7.5) Net cash flowii. Last year, Blanda Brothers had positive net cash flow, yet cash on the balance sheet decreased.

Which of the following could explain the company’s financial performance?

a. The company issued new common stock. b. The company issued new long-term debt.c. The company sold off some of its assets.d. The company purchased a lot of new fixed assets.e. The company eliminated its dividend.

(7.5) Net cash flow and net income

iii. Holmes Aircraft recently announced an increase in its net income, yet its net cash flow declinedrelative to last year. Which of the following could explain this performance?a. The company’s interest expense increased. b. The company’s depreciation expense declined.c. The company’s operating income declined.

d. All of the statements above are correct.e. None of the statements above is correct.

(7.5) Net cash flow and net incomeiv. Kramer Corporation recently announced that its net income was lower than last year. However,

analysts estimate that the company’s net cash flow increased. What factors could explain thisdiscrepancy?a. The company’s depreciation expense increased. b. The company’s interest expense declined.c. The company had an increase in its noncash revenues.d. Answers a and b are correct.e. Answers b and c are correct.

(7.7) EVA, cash flow, and net incomev. Which of the following statements is most correct?

a. Actions which increase net income will always increase net cash flow. b. One way to increase EVA is to maintain the same operating income with less capital.c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity

capital is free.d. Answers a and b are correct.e. Answers a and c are correct.



(7.7) Net operating working capital

vi. Which of the following would not cause an increase in net operating working capital?

a. Inventory increases. b. Accounts receivable increases.

c. Short-term investments increase.d. Accounts payables decrease.e. Accruals decrease.

(7.7) Net operating profit after taxes (NOPAT)vii. Harmeling Enterprises experienced a decline in net operating profit after taxes (NOPAT). Which

of the following definitely cannot help explain this decline?

a. Sales revenues decreased. b. Costs of goods sold increased.c. Depreciation increased.d. Interest expense increased.

e. Taxes increased.

(7.7) Free cash flowviii. Which of the following best describes free cash flow?

a. Free cash flow is the amount of cash flow available for distribution to all investors after allnecessary investments in operating capital have been made.

b. Free cash flow is the amount of cash flow available for distribution to shareholders after allnecessary investments in operating capital have been made.

c. Free cash flow is the net change in the cash account on the balance sheet.d. Free cash flow is equal to net income plus depreciation.e. Free cash flow is equal to the cash flow from non-taxable transactions.

(7.9) Taxes and financingix. Which of the following statements is most correct?

a. Indexing tax brackets reduces the extent of "bracket creep." b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate

than bonds with the same risk and maturity issued by a private corporation such as FloridaPower & Light.

c. Our federal tax laws tend to encourage corporations to finance with debt rather than withequity securities.

d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it instocks rather than in bonds. However, other factors may offset tax considerations.

e. All of the statements above are true.



(7.9) Taxesx. Which of the following statements is most correct?

a. Corporations are allowed to exclude 70 percent of their interest income from corporate taxes. b. Corporations are allowed to exclude 70 percent of their dividend income from corporate

taxes.

c. Individuals pay taxes on only 30 percent of the income realized from municipal bonds.d. Answers a and b are correct.e. None of the answers above is correct.

(7.9) Taxesxi. Which of the following statements is most correct?

a. 70 percent of a corporation’s interest income is excluded from corporate income taxes. b. 70 percent of a corporation’s dividend income is excluded from corporate income taxes.c. A municipal bond will generally trade at a higher yield than a corporate bond of equal risk.d. All of the answers above are correct.e. Answers b and c are correct.

(7.9) Carry back, carry forwardxii. A loss incurred by a corporation

a. Must be carried forward unless the company has had 2 loss years in a row. b. Can be carried back 2 years, then carried forward up to 20 years following the loss.c. Can be carried back 5 years and forward 3 years.d. Cannot be used to reduce taxes in other years except with special permission from the IRS.e. Can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm.

(7.9) Miscellaneous concepts

xiii. Which of the following statements is most correct?

a. Retained earnings, as reported on the balance sheet, represents the amount of cash a companyhas available to pay out as dividends to shareholders.

b. 70 percent of the interest received by corporations is excluded from taxable income.c. 70 percent of the dividends received by corporations is excluded from taxable income.d. None of the answers above is correct.e. Answers a and c are correct.

(7.7) MVAxiv. Hayes Corporation has $300 million worth of common equity on its balance sheet, and 6 million

shares of stock outstanding. The company’s Market Value Added (MVA) is $162 million. What

is the company’s stock price?

a. $ 23 b. $ 32 c. $ 50 d. $ 77 e. $138



(7.7) MVAxv. Byrd Lumber has 2 million shares of stock outstanding. On the balance sheet the company has

$40 million worth of common equity. The company’s stock price is $15 a share. What is the

company’s Market Value Added (MVA)?

a. ($80 million) b. ($20 million) c. ($10 million) d. $20 million e. $80 million

(7.9) Corporate taxes

xvi. Your corporation has the following cash flows:

Operating income $250,000

Interest received 10,000

Interest paid 45,000

Dividends received 20,000

Dividends paid 50,000

If the applicable income tax rate is 40 percent (federal and state combined), and if 70 percent of

dividends received are exempt from taxes, what is the corporation's tax liability?

a. $ 74,000 b. $ 88,400 c. $ 91,600 d. $100,000 e. $106,500

(7.9) After-tax returns

xvii. A corporation with a marginal tax rate of 35 percent would receive what after-tax dividend yield

on a 12 percent coupon rate preferred stock bought at par, assuming a 70 percent dividend

exclusion?

a. 11.03% b. 10.74% c. 6.48% d. 7.31% e. 5.52%



i. (7.5) Net cash flow Answer: e Diff: E

Long-term debt is a source of cash. Companies issue debt to get more cash. Therefore,

statement a is true. If the company repurchases common stock, it must use cash to pay for

the repurchases. So, cash on the balance sheet would decrease. Therefore, statement b is

false. If the company sold assets total assets would be unchanged, but there would be anincrease in cash and a decrease in other assets. Therefore, statement c is true. Since

statements a and c are true, the correct choice is statement e.

ii. (7.5) Net cash flow Answer: d Diff: E

If the company issued new stock, cash on the balance sheet would increase. Therefore,

statement a is false. If it issued long-term debt, cash on the balance sheet would increase.

Consequently, statement b is also false. If it sold assets, cash on the balance sheet would

increase. So, statement c is also false. If it bought assets, cash would decrease and net

cash flow would not be affected. (So, if cash flow were positive before, it would stay positive.) Therefore, statement d is true. If the company eliminated its dividend, cash on

the balance sheet would increase. So, statement e is also false.

iii. (7.5) Net cash flow and net income Answer: b Diff: E

Statement b is correct. Statement a is false, since it would reduce net income. Statement b is true; a decline in depreciation expense would increase net income but decrease netcash flow. Statement c is false; since a decline in operating income would cause netincome to decline. The remaining statements are false.

iv

. (7.5) Net cash flow and net income Answer: a Diff: E

v. EVA, cash flow, and net income Answer: b Diff: E

EVA = EBIT(1 - T) - (After-tax cost of capital)(Total capital). Therefore, if less

capital is used with the same operating income, EVA will be increased.

vi.(7.7)

Net operating working capital Answer: c Diff: E

vii.(7.7)

Net operating profit after taxes (NOPAT) Answer: d Diff: E

viii.(7.7)

Free cash flow Answer: a Diff: E

ix. (7.9) Taxes and financing Answer: e Diff: E

x. (7.9) Taxes Answer: b Diff: EStatement b is correct. The other statements are false. Corporations cannot exclude

interest income from corporate taxes and individuals pay no taxes on municipal bond

income.



xi. (7.9) Taxes Answer: b Diff: EStatement b is correct. The other statements are false. Corporations cannot exclude

interest income from corporate taxes. Recall that municipal bonds are not taxed.

)T1(

munonY eld

bondtaxableon

yieldtax-preEquivalent

or

T1bondtaxableon

y eldtax-Pre

munion

y eldtax-preEqu valent

.

Munis trade at lower yields than equivalent corporate bonds because investors do nothave to pay taxes on munis.

xii. (7.9) Carry back, carry forward Answer: b Diff: E

xiii. (7.9) Miscellaneous concepts Answer: c Diff: EStatement c is correct. The other statements are false. Retained earnings do not represent

cash and all of the firm’s interest income is taxed.

xiv. (7.7) MVA Answer: d Diff: EMVA = (Shares outstanding)(Stock Price) - Total common equity.

$162,000,000 = (6,000,000)P0 - $300,000,000

$462,000,000 = (6,000,000)P0

P0 = $77.00.

xv. (7.7) MVA Answer: c Diff: EMVA = (Shares outstanding)(Stock Price) - Total common equity.

MVA = (2,000,000)($15) - $40,000,000

MVA = -$10,000,000.



xvi. (7.9) Corporate taxes Answer: b Diff: EOperating income $250,000


Interest paid (45,000)

Dividends received (taxable) 6,000*

Taxable income $221,000

*$20,000(0.30) = $6,000.

Taxes = 0.4($221,000) = $88,400.

xvii. (7.9) After-tax returns Answer: b Diff: E12%[1 - 0.30(0.35)] = 10.74%.




Accounting for Financial Management

(7.5) Net cash flow Answer: e Diff: Ei. Last year Aldrin Co. had negative net cash flow, yet its cash on the balance sheet increased.

What could explain these events?

a. Aldrin issued long-term debt. b. Aldrin repurchased some of its common stock.c. Aldrin sold some of its assets.d. Statements a and b are correct.e. Statements a and c are correct.

(7.5) Net cash flow Answer: d Diff: Eii. Last year, Blanda Brothers had positive net cash flow, yet cash on the balance sheet decreased.

Which of the following could explain the company’s financial performance?

a. The company issued new common stock. b. The company issued new long-term debt.c. The company sold off some of its assets.d. The company purchased a lot of new fixed assets.e. The company eliminated its dividend.

(7.5) Net cash flow and net income Answer: b Diff: E

iii. Holmes Aircraft recently announced an increase in its net income, yet its net cash flow declinedrelative to last year. Which of the following could explain this performance?a. The company’s interest expense increased. b. The company’s depreciation expense declined.c. The company’s operating income declined.

d. All of the statements above are correct.e. None of the statements above is correct.

(7.5) Net cash flow and net income Answer: a Diff: E iv. Kramer Corporation recently announced that its net income was lower than last year. However,

analysts estimate that the company’s net cash flow increased. What factors could explain thisdiscrepancy?a. The company’s depreciation expense increased. b. The company’s interest expense declined.c. The company had an increase in its noncash revenues.d. Answers a and b are correct.e. Answers b and c are correct.

(7.7) EVA, cash flow, and net income Answer: b Diff: E v. Which of the following statements is most correct?

a. Actions which increase net income will always increase net cash flow. b. One way to increase EVA is to maintain the same operating income with less capital.c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity

capital is free.d. Answers a and b are correct.e. Answers a and c are correct.



(7.7) Net operating working capital Answer: c Diff: E

vi. Which of the following would not cause an increase in net operating working capital?

a. Inventory increases. b. Accounts receivable increases.

c. Short-term investments increase.d. Accounts payables decrease.e. Accruals decrease.

(7.7) Net operating profit after taxes (NOPAT) Answer: d Diff: Evii. Harmeling Enterprises experienced a decline in net operating profit after taxes (NOPAT). Which

of the following definitely cannot help explain this decline?

a. Sales revenues decreased. b. Costs of goods sold increased.c. Depreciation increased.d. Interest expense increased.

e. Taxes increased.

(7.7) Free cash flow Answer: a Diff: Eviii. Which of the following best describes free cash flow?

a. Free cash flow is the amount of cash flow available for distribution to all investors after allnecessary investments in operating capital have been made.

b. Free cash flow is the amount of cash flow available for distribution to shareholders after allnecessary investments in operating capital have been made.

c. Free cash flow is the net change in the cash account on the balance sheet.d. Free cash flow is equal to net income plus depreciation.e. Free cash flow is equal to the cash flow from non-taxable transactions.

(7.9) Taxes and financing Answer: e Diff: Eix. Which of the following statements is most correct?

a. Indexing tax brackets reduces the extent of "bracket creep." b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate

than bonds with the same risk and maturity issued by a private corporation such as FloridaPower & Light.

c. Our federal tax laws tend to encourage corporations to finance with debt rather than withequity securities.

d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it instocks rather than in bonds. However, other factors may offset tax considerations.




(7.9) Taxes Answer: b Diff: E x. Which of the following statements is most correct?

a. Corporations are allowed to exclude 70 percent of their interest income from corporate taxes. b. Corporations are allowed to exclude 70 percent of their dividend income from corporate

taxes.

c. Individuals pay taxes on only 30 percent of the income realized from municipal bonds.d. Answers a and b are correct.e. None of the answers above is correct.

(7.9) Taxes Answer: b Diff: E xi. Which of the following statements is most correct?

a. 70 percent of a corporation’s interest income is excluded from corporate income taxes. b. 70 percent of a corporation’s dividend income is excluded from corporate income taxes.c. A municipal bond will generally trade at a higher yield than a corporate bond of equal risk.d. All of the answers above are correct.e. Answers b and c are correct.

(7.9) Carry back, carry forward Answer: b Diff: Exii. A loss incurred by a corporation

a. Must be carried forward unless the company has had 2 loss years in a row. b. Can be carried back 2 years, then carried forward up to 20 years following the loss.c. Can be carried back 5 years and forward 3 years.d. Cannot be used to reduce taxes in other years except with special permission from the IRS.e. Can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm.

(7.9) Miscellaneous concepts Answer: c Diff: E xiii. Which of the following statements is most correct?

a. Retained earnings, as reported on the balance sheet, represents the amount of cash a companyhas available to pay out as dividends to shareholders.

b. 70 percent of the interest received by corporations is excluded from taxable income.c. 70 percent of the dividends received by corporations is excluded from taxable income.d. None of the answers above is correct.e. Answers a and c are correct.

(7.7) MVA Answer: d Diff: Exiv. Hayes Corporation has $300 million worth of common equity on its balance sheet, and 6 million

shares of stock outstanding. The company’s Market Value Added (MVA) is $162 million. What

is the company’s stock price?

a. $ 23 b. $ 32 c. $ 50 d. $ 77 e. $138



(7.7) MVA Answer: c Diff: Exv. Byrd Lumber has 2 million shares of stock outstanding. On the balance sheet the company has

$40 million worth of common equity. The company’s stock price is $15 a share. What is the

company’s Market Value Added (MVA)?

a. ($80 million) b. ($20 million) c. ($10 million) d. $20 million e. $80 million

(7.9) Corporate taxes Answer: b Diff: E

xvi. Your corporation has the following cash flows:

Operating income $250,000


Interest paid 45,000

Dividends received 20,000

Dividends paid 50,000

If the applicable income tax rate is 40 percent (federal and state combined), and if 70 percent of

dividends received are exempt from taxes, what is the corporation's tax liability?

a. $ 74,000 b. $ 88,400 c. $ 91,600 d. $100,000 e. $106,500

(7.9) After-tax returns Answer: b Diff: E

xvii. A corporation with a marginal tax rate of 35 percent would receive what after-tax dividend yield

on a 12 percent coupon rate preferred stock bought at par, assuming a 70 percent dividend

exclusion?

a. 11.03% b. 10.74% c. 6.48% d. 7.31% e. 5.52%



i. (7.5) Net cash flow Answer: e Diff: E

Long-term debt is a source of cash. Companies issue debt to get more cash. Therefore,

statement a is true. If the company repurchases common stock, it must use cash to pay for

the repurchases. So, cash on the balance sheet would decrease. Therefore, statement b is

false. If the company sold assets total assets would be unchanged, but there would be anincrease in cash and a decrease in other assets. Therefore, statement c is true. Since

statements a and c are true, the correct choice is statement e.

ii. (7.5) Net cash flow Answer: d Diff: E

If the company issued new stock, cash on the balance sheet would increase. Therefore,

statement a is false. If it issued long-term debt, cash on the balance sheet would increase.

Consequently, statement b is also false. If it sold assets, cash on the balance sheet would

increase. So, statement c is also false. If it bought assets, cash would decrease and net

cash flow would not be affected. (So, if cash flow were positive before, it would stay positive.) Therefore, statement d is true. If the company eliminated its dividend, cash on

the balance sheet would increase. So, statement e is also false.

iii. (7.5) Net cash flow and net income Answer: b Diff: E

Statement b is correct. Statement a is false, since it would reduce net income. Statement b is true; a decline in depreciation expense would increase net income but decrease netcash flow. Statement c is false; since a decline in operating income would cause netincome to decline. The remaining statements are false.

iv

. (7.5) Net cash flow and net income Answer: a Diff: E

v. EVA, cash flow, and net income Answer: b Diff: E

EVA = EBIT(1 - T) - (After-tax cost of capital)(Total capital). Therefore, if less

capital is used with the same operating income, EVA will be increased.

vi.(7.7)

Net operating working capital Answer: c Diff: E

vii.(7.7)

Net operating profit after taxes (NOPAT) Answer: d Diff: E

viii.(7.7)

Free cash flow Answer: a Diff: E

ix. (7.9) Taxes and financing Answer: e Diff: E

x. (7.9) Taxes Answer: b Diff: EStatement b is correct. The other statements are false. Corporations cannot exclude

interest income from corporate taxes and individuals pay no taxes on municipal bond

income.



xi. (7.9) Taxes Answer: b Diff: EStatement b is correct. The other statements are false. Corporations cannot exclude

interest income from corporate taxes. Recall that municipal bonds are not taxed.

)T1(

munonY eld

bondtaxableon

yieldtax-preEquivalent

or

T1bondtaxableon

y eldtax-Pre

munion

y eldtax-preEqu valent

.

Munis trade at lower yields than equivalent corporate bonds because investors do nothave to pay taxes on munis.

xii. (7.9) Carry back, carry forward Answer: b Diff: E

xiii. (7.9) Miscellaneous concepts Answer: c Diff: EStatement c is correct. The other statements are false. Retained earnings do not represent

cash and all of the firm’s interest income is taxed.

xiv. (7.7) MVA Answer: d Diff: EMVA = (Shares outstanding)(Stock Price) - Total common equity.

$162,000,000 = (6,000,000)P0 - $300,000,000

$462,000,000 = (6,000,000)P0

P0 = $77.00.

xv. (7.7) MVA Answer: c Diff: EMVA = (Shares outstanding)(Stock Price) - Total common equity.

MVA = (2,000,000)($15) - $40,000,000

MVA = -$10,000,000.



xvi. (7.9) Corporate taxes Answer: b Diff: EOperating income $250,000


Interest paid (45,000)

Dividends received (taxable) 6,000*

Taxable income $221,000

*$20,000(0.30) = $6,000.

Taxes = 0.4($221,000) = $88,400.

xvii. (7.9) After-tax returns Answer: b Diff: E12%[1 - 0.30(0.35)] = 10.74%.




Analysis of Financial Statements

(8.2) Current ratio

i. Pepsi Corporation's current ratio is 0.5, while Coke Company's current ratio is 1.5. Both

firms want to "window dress" their coming end-of-year financial statements. As part of

their window dressing strategy, each firm will double its current liabilities by adding

short-term debt and placing the funds obtained in the cash account. Which of the

statements below best describes the actual results of these transactions?

a. The transactions will have no effect on the current ratios.

b. The current ratios of both firms will be increased.

c. The current ratios of both firms will be decreased.

d. Only Pepsi Corporation's current ratio will be increased.

e. Only Coke Company's current ratio will be increased.

(8.2) Current ratio

ii

. Other things held constant, which of the following will not affect the current ratio,assuming an initial current ratio greater than 1.0?

a. Fixed assets are sold for cash.

b. Long-term debt is issued to pay off current liabilities.

c. Accounts receivable are collected.

d. Cash is used to pay off accounts payable.

e. A bank loan is obtained, and the proceeds are credited to the firm's checking account.



(8.2) Quick ratio

iii. Other things held constant, which of the following will not affect the quick ratio?

(Assume that current assets equal current liabilities.)


b. Cash is used to purchase inventories.

c. Cash is used to pay off accounts payable.

d. Accounts receivable are collected.

e. Long-term debt is issued to pay off a short-term bank loan.

(8.2) Quick ratioiv. Which of the following actions will increase a company’s quick ratio?

a. Reduce inventories and use the proceeds to reduce long-term debt. b. Reduce inventories and use the proceeds to reduce current liabilities.c. Issue short-term debt and use the proceeds to purchase inventory.d. Issue long-term debt and use the proceeds to purchase fixed assets.e. Issue equity and use the proceeds to purchase inventory.

(Comp: 8.3, 8.5) Free cash flow

v. Which of the following alternatives could potentially result in a net increase in a

company's free cash flow for the current year?

a. Reducing the days-sales-outstanding ratio.

b. Increasing the number of years over which fixed assets are depreciated.

c. Decreasing the accounts payable balance.


e. Answers a and b are correct.



(Comp: 8.4, 8.5) Miscellaneous ratiosvi

. Company R and Company S each have the same operating income (EBIT) and basicearning power (BEP) ratio. Company S, however, has a lower times-interest-earned(TIE) ratio. Which of the following statements is most correct?

a. Company S has a higher ROA. b. Company S has a higher net income.c. Company S has a higher interest expense.d. Statements a and b are correct.e. Statements a, b, and c are correct.

(Comp: 8.4, 8.5) Leverage and financial ratios

vii. Stennett Corp.'s CFO has proposed that the company issue new debt and use the proceeds

to buy back common stock. Which of the following are likely to occur if this proposal is

adopted? (Assume that the proposal would have no effect on the company's operatingearnings.)

a. Return on assets (ROA) will decline.

b. The times interest earned ratio (TIE) will increase.

c. Taxes paid will decline.

d. None of the statements above is correct.

e. Statements a and c are correct.

(8.4) TIE ratio

viii. Culver Inc. has earnings after interest but before taxes of $300. The company's before-

tax times-interest-earned ratio is 7.00. Calculate the company's interest charges.

a. $42.86

b. $50.00

c. $40.00

d. $60.00

e. $57.93



(8.5) Financial statement analysisix. Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent.

The company recently reported that its basic earning power (BEP) ratio was 15 percent

and that its return on assets (ROA) was 9 percent. What was the company’s interestexpense?

a. $ 0 b. $ 2,000,000c. $ 6,000,000d. $15,000,000e. $18,000,000

(8.5) ROA

x. A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has debt of

$7,500,000, total assets of $22,500,000, and an after-tax interest cost on total debt of 5

percent, what is the firm's ROA?

a. 8.4%

b. 10.9%

c. 12.0%

d. 13.3%

e. 15.1%



(8.5) Profit margin

xi. Your company had the following balance sheet and income statement information for

2008:

Balance sheet:

Cash $ 20

A/R 1,000

Inventories 5,000

Total C.A. $ 6,020 Debt $ 4,000

Net F.A. 2,980 Equity 5,000

Total Assets $ 9,000 Total claims $ 9,000

Income statement:

Sales $10,000

Cost of goods sold 9,200

EBIT $ 800

Interest (10%) 400

EBT $ 400

Taxes (40%) 160

Net Income $ 240

The industry average inventory turnover is 5. You think you can change your inventorycontrol system so as to cause your turnover to equal the industry average, and this change

is expected to have no effect on either sales or cost of goods sold. The cash generatedfrom reducing inventories will be used to buy tax-exempt securities which have a 7 percent rate of return. What will your profit margin be after the change in inventories isreflected in the income statement?

a. 2.1% b. 2.4% c. 4.5% d. 5.3% e. 6.7%



(8.5) ROE

xii. Tapley Dental Supply Company has the following data:

Net income: $240 Sales: $10,000 Total assets: $6,000

Debt ratio: 75% TIE ratio: 2.0 Current ratio: 1.2

BEP ratio: 13.33%

If Tapley could streamline operations, cut operating costs, and raise net income to $300,without affecting sales or the balance sheet (the additional profits will be paid out asdividends), by how much would its ROE increase?

a. 3.00%

b. 3.50%

c. 4.00%

d. 4.25%

e. 5.50%



(8.6) Market price per share

xiii. The Charleston Company is a relatively small, privately owned firm. Last year the

company had after-tax income of $15,000, and 10,000 shares were outstanding. The

owners were trying to determine the equilibrium market value for the stock, prior to

taking the company public. A similar firm which is publicly traded had a price/earningsratio of 5.0. Using only the information given, estimate the market value of one share of

Charleston's stock.

a. $10.00

b. $ 7.50

c. $ 5.00

d. $ 2.50

e. $ 1.50

(8.6) P/E ratio and stock price

xiv. Cleveland Corporation has 100,000 shares of common stock outstanding. The company’s

net income is $750,000 and its P/E is 8. What is the company’s stock price?

a. $20.00

b. $30.00

c. $40.00

d. $50.00

e. $60.00



(8.6) Market price per share

xv. You are given the following information: Stockholders' equity = $1,250; price/earnings

ratio = 5; shares outstanding = 25; market/book ratio = 1.5. Calculate the market price of

a share of the company's stock.

a. $ 33.33

b. $ 75.00

c. $ 10.00

d. $166.67

e. $133.32

(8.8) Du Pont equation

xvi. The Wilson Corporation has the following relationships:

Sales/Total assets 2.0

Return on assets (ROA) 4%

Return on equity (ROE) 6%

What is Wilson’s profit margin and debt ratio?

a. 2% and 0.33

b. 4% and 0.33

c. 4% and 0.67

d. 2% and 0.67

e. 4% and 0.50



Medium:

(8.2) Liquidity ratios

xvii. Oliver Incorporated has a current ratio = 1.6, and a quick ratio equal to 1.2. The

company has $2 million in sales and its current liabilities are $1 million. What is the

company’s inventory turnover ratio?

a. 5.0

b. 5.2

c. 5.5

d. 6.0

e. 6.3

(8.2) Quick ratioxviii

. Last year, Quayle Energy had sales of $200 million, and its inventory turnover ratio was5.0. The company’s current assets totaled $100 million, and its current ratio was 1.2.What was the company’s quick ratio?

a. 1.20 b. 1.39c. 0.72d. 0.55e. 2.49

(8.2) Quick ratio

xix. Thomas Corp. has the following simplified balance sheet:

Cash $ 50,000 Current liabilities $125,000

Inventory 150,000

Accounts receivable 100,000 Long-term debt 175,000

Net fixed assets 200,000 Common equity 200,000

Total $500,000 Total $500,000



Sales for the year totaled $600,000. The company president believes the company carries

excess inventory. She would like the inventory turnover ratio to be 8 and would use the

freed up cash to reduce current liabilities. If the company follows the president's

recommendation and sales remain the same, the new quick ratio would be:

a. 2.4

b. 4.0

c. 4.5

d. 1.2

e. 3.0



(8.2) Quick ratioxx

. Stallworth Industries recently reported the following balance sheet:

Assets:

Cash $ 300,000

Accounts receivable 700,000

Inventories 500,000

Current assets $1,500,000

Net fixed assets 3,500,000

Total assets $5,000,000

Liabilities and Equity:

Current liabilities $1,000,000

Long-term debt 2,000,000

Common equity 2,000,000

Total liabilities and equity $5,000,000

The company’s current inventory turnover ratio is 4. The company wishes to maintain itscurrent level of sales, but lower its inventory so that its inventory turnover ratio equalsthe industry average, which is 6. Half of the cash freed up by the inventory decreasewould be used to purchase additional fixed assets, while the remainder would be used toreduce current liabilities. What would be the company’s quick ratio, if it were able toreduce inventory as planned?

a. 1.091 b. 1.273c. 1.342d. 1.454e. 1.761




Analysis of Financial Statements

(8.2) Current ratio Answer: d Diff: E

i. Pepsi Corporation's current ratio is 0.5, while Coke Company's current ratio is 1.5. Both

firms want to "window dress" their coming end-of-year financial statements. As part of

their window dressing strategy, each firm will double its current liabilities by adding

short-term debt and placing the funds obtained in the cash account. Which of the

statements below best describes the actual results of these transactions?

a. The transactions will have no effect on the current ratios.

b. The current ratios of both firms will be increased.

c. The current ratios of both firms will be decreased.

d. Only Pepsi Corporation's current ratio will be increased.

e. Only Coke Company's current ratio will be increased.

(8.2) Current ratio Answer: c Diff: E

ii

. Other things held constant, which of the following will not affect the current ratio,assuming an initial current ratio greater than 1.0?


b. Long-term debt is issued to pay off current liabilities.

c. Accounts receivable are collected.

d. Cash is used to pay off accounts payable.

e. A bank loan is obtained, and the proceeds are credited to the firm's checking account.



(8.2) Quick ratio Answer: d Diff: E

iii. Other things held constant, which of the following will not affect the quick ratio?

(Assume that current assets equal current liabilities.)


b. Cash is used to purchase inventories.

c. Cash is used to pay off accounts payable.

d. Accounts receivable are collected.

e. Long-term debt is issued to pay off a short-term bank loan.

(8.2) Quick ratio Answer: b Diff: Eiv. Which of the following actions will increase a company’s quick ratio?

a. Reduce inventories and use the proceeds to reduce long-term debt. b. Reduce inventories and use the proceeds to reduce current liabilities.c. Issue short-term debt and use the proceeds to purchase inventory.d. Issue long-term debt and use the proceeds to purchase fixed assets.e. Issue equity and use the proceeds to purchase inventory.

(Comp: 8.3, 8.5) Free cash flow Answer: a Diff: E

v. Which of the following alternatives could potentially result in a net increase in a

company's free cash flow for the current year?

a. Reducing the days-sales-outstanding ratio.

b. Increasing the number of years over which fixed assets are depreciated.

c. Decreasing the accounts payable balance.





(Comp: 8.4, 8.5) Miscellaneous ratios Answer: c Diff: Evi. Company R and Company S each have the same operating income (EBIT) and basic

earning power (BEP) ratio. Company S, however, has a lower times-interest-earned(TIE) ratio. Which of the following statements is most correct?

a. Company S has a higher ROA. b. Company S has a higher net income.c. Company S has a higher interest expense.d. Statements a and b are correct.e. Statements a, b, and c are correct.

(Comp: 8.4, 8.5) Leverage and financial ratios Answer: e Diff: E

vii. Stennett Corp.'s CFO has proposed that the company issue new debt and use the proceeds

to buy back common stock. Which of the following are likely to occur if this proposal is

adopted? (Assume that the proposal would have no effect on the company's operatingearnings.)

a. Return on assets (ROA) will decline.

b. The times interest earned ratio (TIE) will increase.

c. Taxes paid will decline.

d. None of the statements above is correct.


(8.4) TIE ratio Answer: b Diff: E

viii. Culver Inc. has earnings after interest but before taxes of $300. The company's before-

tax times-interest-earned ratio is 7.00. Calculate the company's interest charges.

a. $42.86

b. $50.00

c. $40.00

d. $60.00

e. $57.93



(8.5) Financial statement analysis Answer: a Diff: Eix. Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent.

The company recently reported that its basic earning power (BEP) ratio was 15 percentand that its return on assets (ROA) was 9 percent. What was the company’s interestexpense?

a. $ 0 b. $ 2,000,000c. $ 6,000,000d. $15,000,000e. $18,000,000

(8.5) ROA Answer: d Diff: E

x. A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has debt of

$7,500,000, total assets of $22,500,000, and an after-tax interest cost on total debt of 5

percent, what is the firm's ROA?

a. 8.4%

b. 10.9%

c. 12.0%

d. 13.3%

e. 15.1%



(8.5) ROE Answer: c Diff: E

xii. Tapley Dental Supply Company has the following data:

Net income: $240 Sales: $10,000 Total assets: $6,000

Debt ratio: 75% TIE ratio: 2.0 Current ratio: 1.2

BEP ratio: 13.33%

If Tapley could streamline operations, cut operating costs, and raise net income to $300,without affecting sales or the balance sheet (the additional profits will be paid out asdividends), by how much would its ROE increase?

a. 3.00%

b. 3.50%

c. 4.00%

d. 4.25%

e. 5.50%



(8.6) Market price per share Answer: b Diff: E

xiii. The Charleston Company is a relatively small, privately owned firm. Last year the

company had after-tax income of $15,000, and 10,000 shares were outstanding. The

owners were trying to determine the equilibrium market value for the stock, prior to

taking the company public. A similar firm which is publicly traded had a price/earningsratio of 5.0. Using only the information given, estimate the market value of one share of

Charleston's stock.

a. $10.00

b. $ 7.50

c. $ 5.00

d. $ 2.50

e. $ 1.50

(8.6) P/E ratio and stock price Answer: e Diff: E

xiv. Cleveland Corporation has 100,000 shares of common stock outstanding. The company’s

net income is $750,000 and its P/E is 8. What is the company’s stock price?

a. $20.00

b. $30.00

c. $40.00

d. $50.00

e. $60.00



(8.6) Market price per share Answer: b Diff: E

xv. You are given the following information: Stockholders' equity = $1,250; price/earnings

ratio = 5; shares outstanding = 25; market/book ratio = 1.5. Calculate the market price of

a share of the company's stock.

a. $ 33.33

b. $ 75.00

c. $ 10.00

d. $166.67

e. $133.32

(8.8) Du Pont equation Answer: a Diff: E

xvi. The Wilson Corporation has the following relationships:

Sales/Total assets 2.0

Return on assets (ROA) 4%

Return on equity (ROE) 6%

What is Wilson’s profit margin and debt ratio?

a. 2% and 0.33

b. 4% and 0.33

c. 4% and 0.67

d. 2% and 0.67

e. 4% and 0.50



Medium:

(8.2) Liquidity ratios Answer: a Diff: M

xvii. Oliver Incorporated has a current ratio = 1.6, and a quick ratio equal to 1.2. The

company has $2 million in sales and its current liabilities are $1 million. What is the

company’s inventory turnover ratio?

a. 5.0

b. 5.2

c. 5.5

d. 6.0

e. 6.3

(8.2) Quick ratio Answer: c Diff: Mxviii. Last year, Quayle Energy had sales of $200 million, and its inventory turnover ratio was

5.0. The company’s current assets totaled $100 million, and its current ratio was 1.2.What was the company’s quick ratio?

a. 1.20 b. 1.39c. 0.72d. 0.55e. 2.49

(8.2) Quick ratio Answer: e Diff: M

xix. Thomas Corp. has the following simplified balance sheet:

Cash $ 50,000 Current liabilities $125,000

Inventory 150,000

Accounts receivable 100,000 Long-term debt 175,000

Net fixed assets 200,000 Common equity 200,000

Total $500,000 Total $500,000



Sales for the year totaled $600,000. The company president believes the company carries

excess inventory. She would like the inventory turnover ratio to be 8

freed up cash to reduce current liabilities. If the company follows the president's

recommendation and sales remain the same, the new quick ratio would be:

a. 2.4

b. 4.0

c. 4.5

d. 1.2

e. 3.0



(8.2) Quick ratio Answer: a Diff: Mxx. Stallworth Industries recently reported the following balance sheet:

Assets:

Cash $ 300,000

Accounts receivable 700,000

Inventories 500,000

Current assets $1,500,000

Net fixed assets 3,500,000

Total assets $5,000,000

Liabilities and Equity:

Current liabilities $1,000,000

Long-term debt 2,000,000

Common equity 2,000,000

Total liabilities and equity $5,000,000

The company’s current inventory turnover ratio is 4. The company wishes to maintain itscurrent level of sales, but lower its inventory so that its inventory turnover ratio equalsthe industry average, which is 6. Half of the cash freed up by the inventory decreasewould be used to purchase additional fixed assets, while the remainder would be used toreduce current liabilities. What would be the company’s quick ratio, if it were able toreduce inventory as planned?

a. 1.091 b. 1.273c. 1.342d. 1.454e. 1.761



i. (8.2) Current ratio Answer: d Diff: E

Pepsi Corporation:

Before: Current ratio = 50/100 = 0.50.

After: Current ratio = 150/200 = 0.75.

Coke Company:

Before: Current ratio = 150/100 = 1.50.

After: Current ratio = 250/200 = 1.25.

ii. (8.2) Current ratio Answer: c Diff: E

iii. (8.2) Quick ratio Answer: d Diff: E

The quick ratio is calculated as follows:

Current Assets – Inventories .

Current Liabilities

The only action that doesn't affect the quick ratio is statement d. While this action decreases

receivables (a current asset), it increases cash (also a current asset). The net effect is no change

in the quick ratio.

iv. (8.2) Quick ratio Answer: b Diff: E

Statement b is correct. Statement a is false, since these actions

would have no effect on the quick ratio, as the numerator and

denominator of the quick ratio would remain the same. Statement b is

true, since reducing current liabilities would decrease the denominator

of the quick ratio thus increasing the ratio. Statement c is false,

since these actions would increase the denominator of the quick ratio,

but have no effect on the numerator, thus decreasing the quick ratio.

Statement d is false, since these actions would have no effect on the

quick ratio. Statement e is false, since these actions would have no

effect on the quick ratio.



v. (Comp: 8.3, 8.5) Free cash flows Answer: a Diff: E

Statement a is correct. The other statements are false. Increasing the years over which fixed

assets are depreciated results in smaller amounts being depreciated each year. Given that

depreciation is a non-cash expense and is used to reduce taxable income, the change would

result in less depreciation expense and higher taxes for the year. Since taxes are paid with cash,the company's free cash flow would decrease. In addition, decreasing accounts payable results

in a use of cash.

vi. (Comp: 8.4, 8.5) Miscellaneous ratios Answer: c Diff: E

Both companies have the same operating income and level of assets. If

S has a lower TIE ratio than R this means that S has more interest

expense and consequently, lower net income. Therefore, S has a lower

ROA (NI/A) than R. From this, only statement c is correct.

vii. (Comp: 8.4, 8.5) Leverage and financial ratios Answer: e Diff: E

Statements a and c are correct. The increase in debt payments will reduce net income and

hence reduce ROA. Also, higher debt payments will result in lower taxable income and less tax.

Therefore, statement e is the best choice.

viii. (8.4) TIE ratio Answer: b Diff: E

TIE = EBIT/I

7 = ($300 + I)/I

7I = $300 + I

6I = $300

I = $50.

ix. (8.5) Financial statement analysis Answer: a Diff: E

BEP = EBIT/TA

0.15 = EBIT/$100,000,000

EBIT = $15,000,000.

ROA = NI/TA

0.09 = NI/$100,000,000

NI = $9,000,000.

EBT = NI/(1 - T)

EBT = $9,000,000/0.6

EBT = $15,000,000.

Therefore interest expense = $0.



x. (8.5) ROA Answer: d Diff: E

Net income = 0.15($20,000,000) = $3,000,000.

ROA = $3,000,000/$22,500,000 = 13.3%.

xi. (8.5) Profit margin Answer: c Diff: E

Current inventory turnover =Inv

S =

$5,000

10,000 = 2.

New inventory turnover =Inv

S = 5; Inv =

5

S =

5

10,000 = $2,000.

Freed cash = $5,000 - $2,000 = $3,000.

Increase in NI = 0.07($3,000) = $210.

New Profit margin =Sales

NI =

$10,000

210+240 = 0.0450 = 4.5%.

xii. (8.5) ROE Answer: c Diff: E

Equity = 0.25($6,000) = $1,500.

Current ROE =E

NI =

$1,500

240 = 16%.

New ROE = $1,500

300

= 0.20 = 20%.

ROE = 20% - 16% = 4%.



xiii

. (8.6) Market price per share Answer: b Diff: E

EPS = $15,000/10,000 = $1.50.

P/E = 5.0 = P/$1.50.

P = $7.50.

xiv. (8.6) P/E ratio and stock price Answer: e Diff: E

EPS = $750,000/100,000 = $7.50.

P/E = Price/EPS = 8.

Thus Price = 8 $7.50 = $60.00.

xv. (8.6) Market price per share Answer: b Diff: E

Total market value = $1,250(1.5) = $1,875.

Market value per share = $1,875/25 = $75.

Alternative solution:

Book value per share = $1,250/25 = $50.

Market value per share = $50(1.5) = $75.



xvi

. (8.8) Du Pont equation Answer: a Diff: E

First, calculate the profit margin, which equals NI/Sales:

ROA = NI/TA = 0.04. [TA is Total assets.]

Sales/Total assets = S/TA = 2.

PM = (NI/TA)(TA/S) = 0.04(0.5) = 0.02. [TA/S = 1/2 = 0.5.]

Next, find the debt ratio by finding the equity ratio:

E/TA = (E/NI)(NI/TA). [ROE = NI/E and ROA = NI/TA.]

E/TA = (1/ROE)(ROA) = (1/0.06)(0.04) = 0.667, or 66.7% equity.

Therefore, D/TA must be 0.333 = 33.3%.

xvii. (8.2) Liquidity ratios Answer: a Diff: M

QR = (Current assets - Inventory)/Current liabilities

1.2 = (CA - I)/$1,000,000

CA - I = $1,200,000.

CR = (Current assets - Inventory + Inventory)/Current liabilities

1.6 = ($1,200,000 + Inventory)/$1,000,000

$1,600,000 = $1,200,000 + Inventory

Inventory = $400,000.

Inventory turnover = Sales/Inventory

= $2,000,000/$400,000

= 5.



xviii. (8.2) Quick ratio Answer: c Diff: M

Step 1 Calculate inventory:

Quayle Energy has $40 million in inventory because the

inventory turnover ratio is equal to 5.

S/Inv = 5; Inv =5

000,000,200 = $40,000,000.

Step 2 Calculate current liabilities:

From the current ratio, we can conclude that they have $83.33

million in current liabilities.

CR =CL

000,000,100 = 1.2; CL = $83.33 million.

Step 3 Find quick ratio:

CL

InvCA

=333,333,83$

000,000,40$000,000,100$

= 0.72.

xix. (8.2) Quick ratio Answer: e Diff: M

If sales remain at $600,000, then for the inventory turnover ratio to be 8x inventory must be

$600,000/8 = $75,000. Current inventory minus the new level of inventory reflects the amount

of cash freed up or $150,000 - $75,000 = $75,000. Current liabilities will be reduced to $125,000

- $75,000 = $50,000. Thus, new current assets are $50,000 + $75,000 + $100,000 = $225,000.

The new quick ratio is then: ($225,000 - $75,000)/$50,000 = 3.

xx. (8.2) Quick ratio Answer: a Diff: M

Old inventory turnover = 4 = Sales/$500,000Sales = $2,000,000.

New inventory = $2,000,000/6 = $333,333.33.

Cash saved = $500,000 - $333,333 = $166,667.

New current assets = $300,000 + $700,000 + $333,333 = $1,333,333.

New current liabilities = $1,000,000 - $166,667/2 = $916,667.

CA – Inv. = $1,000,000.

New quick ratio = $1,000,000/$916,667 = 1.0909 or 1.091.




Determining the Cost of Capital

(10.1) Capital components

i. Which of the following is not considered a capital component for the purpose of calculating the

weighted average cost of capital as it applies to capital budgeting?

a. Long-term debt.

b. Common stock.

c. Accounts payable.

d. Preferred stock.

e. All of the above are considered capital components for WACC and capital budgeting

purposes.


ii. Which of the following is not considered a capital component?

a. Long-term debt.

b. Common stock.

c. Permanent short-term debt.

d. Preferred stock.

e. All of the above are considered capital components.


iii. Which of the following is not considered a capital component for the purpose of calculating the


a. Long-term debt.

b. Common stock.

c. Short-term debt used to finance seasonal current assets.

d. Preferred stock.


purposes.



(10.6) DCF cost of equity estimation

iv. Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost

of common equity is the least difficult to estimate?

a. Expected growth rate, g.

b. Dividend yield, D1/P0.

c. Required return, r s.

d. Expected rate of return,

r s.

e. All of the above are equally difficult to estimate.


v. For a typical firm with a given capital structure, which of the following is correct? (Note: Allrates are after taxes.)

a. r d > r s > WACC.

b. r s > r d > WACC.

c. WACC > r s > r d .

d. r s > WACC > r d .

e. None of the statements above is correct.


vi. Which of the following statements is most correct?

a. If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the

same, the company's marginal cost of debt capital used to calculate its weighted average cost

of capital will fall.

b. All else equal, an increase in a company's stock price will increase the marginal cost of

common stock, r s.

c. All else equal, an increase in interest rates will decrease the marginal cost of common stock,

r s.

d. Answers a and b are correct.

e. Answers b and c are correct.



(10.10) Cost of capital components and WACCvii. Which of the following statements is most correct?

a. The WACC is a measure of the before-tax cost of capital.

b. Typically the after-tax cost of debt financing exceeds the after-tax cost of equity financing.c. The WACC measures the marginal after-tax cost of capital.d. Statements a and b are correct.e. Statements b and c are correct.

(10.10) WACC and capital componentsviii. A company has a capital structure which consists of 50 percent debt and 50 percent equity.

Which of the following statements is most correct?

a. The cost of equity financing is greater than or equal to the cost of debt financing. b. The WACC exceeds the cost of equity financing.

c. The WACC is calculated on a before-tax basis.d. The WACC represents the cost of capital based on historical averages. In that sense, it does

not represent the marginal cost of capital.e. The cost of retained earnings exceeds the cost of issuing new common stock.

(10.11) Factors influencing WACC

ix. Wyden Brothers uses the CAPM to calculate the cost of equity capital. The company’s capital

structure consists of common stock, preferred stock, and debt. Which of the following events will

reduce the company’s WACC?

a. A reduction in the market risk premium.

b. An increase in the risk-free rate.

c. An increase in the company’s beta.

d. An increase in expected inflation.

e. An increase in the flotation costs associated with issuing preferred stock.



Medium:

(10.5) CAPM cost of equity estimation

x

. In applying the CAPM to estimate the cost of equity capital, which of the following elements isnot subject to dispute or controversy?

a. The expected rate of return on the market, r M.

b. The stock's beta coefficient, bi.

c. The risk-free rate, r RF.

d. The market risk premium (RPM).

e. All of the above are subject to dispute.

(10.6) CAPM and DCF estimation

xi. Which of the following statements is most correct?

a. Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not

accurately measure stand-alone risk.

b. If the calculated beta underestimates the firm's true investment risk, then the CAPM method

will overestimate r s.

c. The discounted cash flow method of estimating the cost of equity can't be used unless the

growth component, g, is constant during the analysis period.

d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity

capital, is that they yield precise estimates and require little or no judgement.

e. All of the statements above are false.



(10.8) Cost of equity estimation

xii. Which of the following statements is most correct?

a. Although some methods of estimating the cost of equity capital encounter severe difficulties,the CAPM is a simple and reliable model that provides great accuracy and consistency in

estimating the cost of equity capital.

b. The DCF model is preferred over other models to estimate the cost of equity because of the

ease with which a firm's growth rate is obtained.

c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always

accurate but its advantages are that it is a standardized and objective model.

d. Depreciation-generated funds are an additional source of capital and, in fact, represent the

largest single source of funds for some firms.


(10.8) CAPM cost of equity estimation


a. The CAPM approach to estimating a firm's cost of common stock never gives a better

estimate than the DCF approach.

b. The CAPM approach is typically used to estimate a firm's cost of preferred stock.

c. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one

used in the CAPM method.

d. In practice (as opposed to in theory), the DCF method and the CAPM method usually

produce exactly the same estimate for r s.

e. The statements above are all false.




xiv. Which of the following statements is most correct?

a. Suppose a firm is losing money and thus, is not paying taxes, and that this situation isexpected to persist for a few years whether or not the firm uses debt financing. Then the

firm's after-tax cost of debt will equal its before-tax cost of debt.

b. The component cost of preferred stock is expressed as r ps(1 - T), because preferred stock

dividends are treated as fixed charges, similar to the treatment of debt interest.

c. The reason that a cost is assigned to retained earnings is because these funds are already

earning a return in the business; the reason does not involve the opportunity cost principle.

d. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity

involves adding a subjectively determined risk-premium to the market risk-free bond rate.



xv. Which of the following statements is most correct?

a. The before-tax cost of preferred stock may be lower than the before-tax cost of debt, even

though preferred stock is riskier than debt.

b. If a company's stock price increases, this increases its cost of common stock.

c. If the cost of equity capital increases, it must be due to an increase in the firm's beta.

d. Statements a and b are correct.

e. Answers a, b, and c are correct.




xvi. Which of the following statements is most correct?

a. Capital components are the types of capital used by firms to raise money. All capital comesfrom one of three components: long-term debt, preferred stock, and equity.

b. Preferred stock does not involve any adjustment for flotation cost since the dividend and

price are fixed.

c. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt

and of outstanding debt.

d. The opportunity cost principle implies that if the firm cannot invest retained earnings and

earn at least r s, it should pay these funds to its stockholders and let them invest directly in

other assets that do provide this return.

e. The cost of common stock, r s, is usually less than the cost of preferred stock.


xvii. Which of the following statements is most correct?

a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock

for the tax exclusion of 70 percent of dividend income.

b. We ideally would like to use historical measures of the component costs from prior

financings in estimating the appropriate weighted average cost of capital.

c. The cost of common stock (r s) will increase if the market risk premium and risk-free rate

decline by a substantial amount.

d. Statements b and c are correct.




(10.10) Cost of capital estimation

xviii. Which of the following statements is most correct?

a. The cost of capital used to evaluate a project should be the cost of the specific type offinancing used to fund that project.

b. The cost of debt used to calculate the weighted average cost of capital is based on an average

of the cost of debt already issued by the firm and the cost of new debt.

c. One problem with the CAPM approach to estimating the cost of equity capital is that if a

firm's stockholders are, in fact, not well diversified, beta may be a poor measure of the firm's

true investment risk.

d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method

of estimating a firm's cost of equity capital.

e. The cost of equity capital is generally easier to measure than the cost of debt, which varies

daily with interest rates, or the cost of preferred stock since preferred stock is issued

infrequently.

(10.10) WACC

xix. Which of the following statements is most correct?

a. The weighted average cost of capital for a given capital budget level is a weighted average of

the marginal cost of each relevant capital component which makes up the firm's target capital

structure.

b. The weighted average cost of capital is calculated on a before-tax basis.

c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and

equity financing.

d. Answers a and c are correct.

e. All of the answers above are correct.



(10.11) WACC concepts

xx. Which of the following statements about the cost of capital is incorrect ?

a. A company's target capital structure affects its weighted average cost of capital.

b. Weighted average cost of capital calculations should be based on the after-tax-costs of all the

individual capital components.

c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will

increase.

d. The cost of retained earnings is equal to the return stockholders could earn on alternative

investments of equal risk.

e. Flotation costs can increase the cost of preferred stock.

(10.12) Risk treatment

xxi. Which of the following methods of estimating the cost of common equity for a firm treats risk

explicitly?

a. DCF method.

b. CAPM method.

c. Composite method.

d. Bond-yield-plus-risk-premium method.

e. Answers b and d are correct.



(10.14) WACC concepts

xxii. Which of the following statements is most correct?

a. Since stockholders do not generally pay corporate taxes, corporations should focus on before-tax cash flows when calculating the weighted average cost of capital (WACC).

b. When calculating the weighted average cost of capital, firms should include the cost of

accounts payable.

c. When calculating the weighted average cost of capital, firms should rely on historical costs

rather than marginal costs of capital.


e. None of the answers above is correct.

Multiple Choice: Problems

Easy:

(10.6) Cost of common stock

xxiii. Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, and its

growth rate is a constant 6 percent. What is its cost of common stock, r s?

a. 5.0%

b. 5.3%

c. 11.0%

d. 11.3%

e. 11.6%




xxiv. Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, and its growth rate

is a constant 5 percent. What is the cost of common stock, r s?

a. 9.0%

b. 9.2%

c. 9.6%

d. 9.8%

e. 10.0%


xxv. The Global Advertising Company has a marginal tax rate of 40 percent. The last dividend paid by

Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth

rate in earnings and dividends is 5 percent. What is Global's cost of common stock?

a. 12.22%

b. 17.22%

c. 10.33%

d. 9.66%

e. 16.00%



(10.9) WACC with Flotation Costs

xxvi. An analyst has collected the following information regarding Christopher Co.:

The company’s capital structure is 70 percent equity, 30 percent debt.

The yield to maturity on the company’s bonds is 9 percent.

The company’s year-end dividend is forecasted to be $0.80 a share. The company expects that its dividend will grow at a constant rate of 9 percent a year.

The company’s stock price is $25.

The company’s tax rate is 40 percent.

The company anticipates that it will need to raise new common stock this year. Itsinvestment bankers anticipate that the total flotation cost will equal 10 percent of theamount issued. Assume the company accounts for flotation costs by adjusting the cost ofcapital. Given this information, calculate the company’s WACC.

a. 10.41% b. 12.56%c. 10.78%d. 13.55%e. 9.29%

Medium:


xxvii. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and themarket risk premium (r M - r RF) is 6 percent. What is the company’s cost of common stock, r s?

a. 7.0%

b. 7.2%

c. 11.0%

d. 12.2%

e. 12.4%




xxviii. 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, then what is the firm's

cost of common stock?

a. 10.0%

b. 10.2%

c. 10.6%

d. 10.8%

e. 11.0%

(10.6) WACC and dividend growth rate

xxix. Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is

55 percent equity and 45 percent debt. The company has sufficient retained earnings to fund the

equity portion of its capital budget. The before-tax cost of debt is 9 percent, and the company’s

tax rate is 30 percent. If the expected dividend next period (D1) and current stock price are $5 and

$45, respectively, what is the company’s growth rate?

a. 2.68%

b. 3.44%

c. 4.64%

d. 6.75%

e. 8.16%



(10.10) WACC

xxx. A company’s balance sheets show a total of $30 million long-term debt with a coupon rate of 9

percent. The yield to maturity on this debt is 11.11 percent, and the debt has a total current

market value of $25 million. The balance sheets also show that that the company has 10 million

shares of stock; the total of common stock and retained earnings is $30 million. The current stock

price is $7.5 per share. The current return required by stockholders, r S, is 12 percent. The

company has a target capital structure of 40 percent debt and 60 percent equity. The tax rate is

40%. What weighted average cost of capital should you use to evaluate potential projects?

a. 8.55%

b. 9.33%

c. 9.36%

d. 9.87%

e. 10.67%




Determining the Cost of Capital

(10.1) Capital components Answer: c Diff: E

i. Which of the following is not considered a capital component for the purpose of calculating the


a. Long-term debt.

b. Common stock.

c. Accounts payable.

d. Preferred stock.


purposes.

(10.1) Capital components Answer: e Diff: E

ii. Which of the following is not considered a capital component?

a. Long-term debt.

b. Common stock.

c. Permanent short-term debt.

d. Preferred stock.

e. All of the above are considered capital components.

(10.1) Capital components Answer: c Diff: E

iii. Which of the following is not considered a capital component for the purpose of calculating the


a. Long-term debt.

b. Common stock.

c. Short-term debt used to finance seasonal current assets.

d. Preferred stock.


purposes.



(10.6) DCF cost of equity estimation Answer: b Diff: E

iv. Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost

of common equity is the least difficult to estimate?

a. Expected growth rate, g.

b. Dividend yield, D1/P0.

c. Required return, r s.

d. Expected rate of return,

r s.

e. All of the above are equally difficult to estimate.

(10.10) Capital components Answer: d Diff: E

v. For a typical firm with a given capital structure, which of the following is correct? (Note: Allrates are after taxes.)

a. r d > r s > WACC.

b. r s > r d > WACC.

c. WACC > r s > r d.

d. r s > WACC > r d.


(10.10) Capital components Answer: a Diff: E

vi. Which of the following statements is most correct?

a. If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the

same, the company's marginal cost of debt capital used to calculate its weighted average cost

of capital will fall.

b. All else equal, an increase in a company's stock price will increase the marginal cost of

common stock, r s.

c. All else equal, an increase in interest rates will decrease the marginal cost of common stock,

r s.





(10.10) Cost of capital components and WACC Answer: c Diff: Evii. Which of the following statements is most correct?

a. The WACC is a measure of the before-tax cost of capital.

b. Typically the after-tax cost of debt financing exceeds the after-tax cost of equity financing.c. The WACC measures the marginal after-tax cost of capital.d. Statements a and b are correct.e. Statements b and c are correct.

(10.10) WACC and capital components Answer: a Diff: Eviii. A company has a capital structure which consists of 50 percent debt and 50 percent equity.


a. The cost of equity financing is greater than or equal to the cost of debt financing. b. The WACC exceeds the cost of equity financing.

c. The WACC is calculated on a before-tax basis.d. The WACC represents the cost of capital based on historical averages. In that sense, it does

not represent the marginal cost of capital.e. The cost of retained earnings exceeds the cost of issuing new common stock.

(10.11) Factors influencing WACC Answer: a Diff: E

ix. Wyden Brothers uses the CAPM to calculate the cost of equity capital. The company’s capital

structure consists of common stock, preferred stock, and debt. Which of the following events will

reduce the company’s WACC?

a. A reduction in the market risk premium.

b. An increase in the risk-free rate.

c. An increase in the company’s beta.

d. An increase in expected inflation.

e. An increase in the flotation costs associated with issuing preferred stock.



Medium:

(10.5) CAPM cost of equity estimation Answer: e Diff: M

x

. In applying the CAPM to estimate the cost of equity capital, which of the following elements isnot subject to dispute or controversy?

a. The expected rate of return on the market, r M.

b. The stock's beta coefficient, bi.

c. The risk-free rate, r RF.

d. The market risk premium (RPM).

e. All of the above are subject to dispute.

(10.6) CAPM and DCF estimation Answer: a Diff: M


a. Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not

accurately measure stand-alone risk.

b. If the calculated beta underestimates the firm's true investment risk, then the CAPM method

will overestimate r s.

c. The discounted cash flow method of estimating the cost of equity can't be used unless the

growth component, g, is constant during the analysis period.

d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity

capital, is that they yield precise estimates and require little or no judgement.




(10.8) Cost of equity estimation Answer: d Diff: M


a. Although some methods of estimating the cost of equity capital encounter severe difficulties,the CAPM is a simple and reliable model that provides great accuracy and consistency in

estimating the cost of equity capital.

b. The DCF model is preferred over other models to estimate the cost of equity because of the

ease with which a firm's growth rate is obtained.

c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always

accurate but its advantages are that it is a standardized and objective model.

d. Depreciation-generated funds are an additional source of capital and, in fact, represent the

largest single source of funds for some firms.


(10.8) CAPM cost of equity estimation Answer: e Diff: M


a. The CAPM approach to estimating a firm's cost of common stock never gives a better

estimate than the DCF approach.

b. The CAPM approach is typically used to estimate a firm's cost of preferred stock.

c. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one

used in the CAPM method.

d. In practice (as opposed to in theory), the DCF method and the CAPM method usually

produce exactly the same estimate for r s.




(10.10) Capital components Answer: d Diff: M


a. Capital components are the types of capital used by firms to raise money. All capital comesfrom one of three components: long-term debt, preferred stock, and equity.

b. Preferred stock does not involve any adjustment for flotation cost since the dividend and

price are fixed.

c. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt

and of outstanding debt.

d. The opportunity cost principle implies that if the firm cannot invest retained earnings and

earn at least r s, it should pay these funds to its stockholders and let them invest directly in

other assets that do provide this return.

e. The cost of common stock, r s, is usually less than the cost of preferred stock.

(10.10) Capital components Answer: e Diff: M

xvii. Which of the following statements is most correct?

a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock

for the tax exclusion of 70 percent of dividend income.

b. We ideally would like to use historical measures of the component costs from prior

financings in estimating the appropriate weighted average cost of capital.

c. The cost of common stock (r s) will increase if the market risk premium and risk-free rate

decline by a substantial amount.





(10.10) Cost of capital estimation Answer: c Diff: M


a. The cost of capital used to evaluate a project should be the cost of the specific type offinancing used to fund that project.

b. The cost of debt used to calculate the weighted average cost of capital is based on an average

of the cost of debt already issued by the firm and the cost of new debt.

c. One problem with the CAPM approach to estimating the cost of equity capital is that if a

firm's stockholders are, in fact, not well diversified, beta may be a poor measure of the firm's

true investment risk.

d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method

of estimating a firm's cost of equity capital.

e. The cost of equity capital is generally easier to measure than the cost of debt, which varies

daily with interest rates, or the cost of preferred stock since preferred stock is issued

infrequently.

(10.10) WACC Answer: d Diff: M


a. The weighted average cost of capital for a given capital budget level is a weighted average of

the marginal cost of each relevant capital component which makes up the firm's target capital

structure.

b. The weighted average cost of capital is calculated on a before-tax basis.

c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and

equity financing.


e. All of the answers above are correct.



(10.11) WACC concepts Answer: c Diff: M

xx. Which of the following statements about the cost of capital is incorrect ?

a. A company's target capital structure affects its weighted average cost of capital.

b. Weighted average cost of capital calculations should be based on the after-tax-costs of all the

individual capital components.

c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will

increase.

d. The cost of retained earnings is equal to the return stockholders could earn on alternative

investments of equal risk.

e. Flotation costs can increase the cost of preferred stock.

(10.12) Risk treatment Answer: e Diff: M

xxi. Which of the following methods of estimating the cost of common equity for a firm treats risk

explicitly?

a. DCF method.

b. CAPM method.

c. Composite method.

d. Bond-yield-plus-risk-premium method.

e. Answers b and d are correct.



(10.14) WACC concepts Answer: e Diff: M


a. Since stockholders do not generally pay corporate taxes, corporations should focus on before-tax cash flows when calculating the weighted average cost of capital (WACC).

b. When calculating the weighted average cost of capital, firms should include the cost of

accounts payable.

c. When calculating the weighted average cost of capital, firms should rely on historical costs

rather than marginal costs of capital.




Easy:

(10.6) Cost of common stock Answer: d Diff: E

xxiii. Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, and its

growth rate is a constant 6 percent. What is its cost of common stock, r s?

a. 5.0%

b. 5.3%

c. 11.0%

d. 11.3%

e. 11.6%



(10.6) Cost of common stock Answer: b Diff: E

xxiv. Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, and its growth rate

is a constant 5 percent. What is the cost of common stock, r s?

a. 9.0%

b. 9.2%

c. 9.6%

d. 9.8%

e. 10.0%

(10.6) Cost of common stock Answer: e Diff: E

xxv. The Global Advertising Company has a marginal tax rate of 40 percent. The last dividend paid by

Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth

rate in earnings and dividends is 5 percent. What is Global's cost of common stock?

a. 12.22%

b. 17.22%

c. 10.33%

d. 9.66%

e. 16.00%



(10.6) Cost of common stock Answer: b Diff: M

xxviii. 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, then what is the firm's

cost of common stock?

a. 10.0%

b. 10.2%

c. 10.6%

d. 10.8%

e. 11.0%

(10.6) WACC and dividend growth rate Answer: c Diff: M

xxix. Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is

55 percent equity and 45 percent debt. The company has sufficient retained earnings to fund the

equity portion of its capital budget. The before-tax cost of debt is 9 percent, and the company’s

tax rate is 30 percent. If the expected dividend next period (D1) and current stock price are $5 and

$45, respectively, what is the company’s growth rate?

a. 2.68%

b. 3.44%

c. 4.64%

d. 6.75%

e. 8.16%



(10.10) WACC Answer: c Diff: M

xxxii. Johnson Industries finances its projects with 40 percent debt, 10 percent preferred stock, and 50

percent common stock.

The company can issue bonds at a yield to maturity of 8.4 percent.

The cost of preferred stock is 9 percent.

The company's common stock currently sells for $30 a share.

The company's dividend is currently $2.00 a share (D 0 = $2.00), and is expected to grow at aconstant rate of 6 percent per year.

Assume that the flotation cost on debt and preferred stock is zero, and no new stock will beissued.


What is the company’s weighted average cost of capital (WACC)?

a. 8.33%

b. 9.32%

c. 9.79%

d. 9.99%

e. 13.15%

(10.10) WACC Answer: e Diff: Mxxxiii. Dobson Dairies has a capital structure which consists of 60 percent long-term debt and 40 percent

common stock. The company’s CFO has obtained the following information:

The before-tax yield to maturity on the company’s bonds is 8 percent.

The company’s common stock is expected to pay a $3.00 dividend at year end (D1 = $3.00),and the dividend is expected to grow at a constant rate of 7 percent a year. The common stock

currently sells for $60 a share. Assume the firm will be able to use retained earnings to fund the equity portion of its capital

budget.




What is the company’s weighted average cost of capital (WACC)?

a. 12.00% b. 8.03%c. 9.34%d. 8.00%

e. 7.68%

Multiple part:

(The following information applies to the next six problems.)

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent

preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, acurrent maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which

pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2,

the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth

firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent.

The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-

premium method to find r s. The firm's marginal tax rate is 40 percent.

(10.2) Cost of debt Answer: e Diff: M

xxxiv. What is Rollins' component cost of debt?

a. 10.0%

b. 9.1%

c. 8.6%

d. 8.0%

e. 7.2%



(10.3) Cost of preferred stock Answer: d Diff: E

xxxv. What is Rollins' cost of preferred stock?

a. 10.0%

b. 11.0%

c. 12.0%

d. 12.6%

e. 13.2%

(10.5) Cost of common stock: CAPM Answer: c Diff: E

xxxvi. What is Rollins' cost of common stock (r s) using the CAPM approach?

a. 13.6%

b. 14.1%

c. 16.0%

d. 16.6%

e. 16.9%

(10.6) Cost of common stock: DCF Answer: c Diff: E

xxxvii. What is the firm's cost of common stock (r s) using the DCF approach?

a. 13.6%

b. 14.1%

c. 16.0%

d. 16.6%

e. 16.9%



(10.7) Cost of common stock: Risk premium Answer: c Diff: E

xxxviii. What is Rollins' cost of common stock using the bond-yield-plus-risk-premium approach?

a. 13.6%

b. 14.1%

c. 16.0%

d. 16.6%

e. 16.9%

(10.10) WACC Answer: a Diff: E

xxxix. What is Rollins' WACC?

a. 13.6%

b. 14.1%

c. 16.0%

d. 16.6%

e. 16.9%



(10.10) WACC Answer: d Diff: E

xlii. What is the firm's weighted average cost of capital (WACC)?

a. 9.5%

b. 10.3%

c. 10.8%

d. 11.4%

e. 11.9%

(10.6) Cost of equity Answer: a Diff: M

xliii. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60

percent common equity. The firm expects to earn $600 in after-tax income during the coming

year, and it will retain 40 percent of those earnings. The current market price of the firm's stock

is P0 = $28; its last dividend was D0 = $2.20, and its expected growth rate is 6 percent. Allison

can issue new common stock at a 15 percent flotation cost. What will Allison's marginal cost

of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new

capital?

a. 15.8%

b. 13.9%

c. 7.9%

d. 14.3%

e. 9.7%



i. (10.1) Capital components Answer: c Diff: Eii. (10.1) Capital components Answer: e Diff: E

iii. (10.1) Capital components Answer: c Diff: E

iv. (10.6) DCF cost of equity estimation Answer: b Diff: E

v. (10.10) Capital components Answer: d Diff: E

vi. (10.10) Capital components Answer: a Diff: E

The debt cost used to calculate a firm's WACC is rd(1 - T). If rd remains constant but T increases,

then the term (1 - T) decreases and the value of the entire equation, rd(1 - T), decreases.

Statement b is false; if a company's stock price increases, and all else remains constant, then the

dividend yield decreases and rs decreases. This can be seen from the equation rs = D1/P0 + g.

Statement c is false, since an increase in interest rates will cause an increase in the cost of

common stock, rs. Consequently, statements d and e are false too.

vii. (10.10) Cost of capital components and WACC Answer: c Diff: E

WACC measures the marginal after-tax cost of capital; therefore,

statement a is false. The after-tax cost of debt financing is less

than the after-tax cost of equity financing; therefore, statement b is

false. The correct choice is statement c.

viii. (10.10) WACC and capital components Answer: a Diff: E

Statement a is correct; the other statements are false. Statement b is

incorrect; WACC is an average of debt and equity financing. Since debt

financing is cheaper and is adjusted downward for taxes, it should,

when averaged with equity, cause the WACC to be less than the cost of

equity financing. Statement c is incorrect; WACC is calculated on an

after-tax basis. Statement d is incorrect; the WACC is based on

marginal, not embedded, costs. Statement e is incorrect; the cost of

issuing new common stock is greater than the cost of retained earnings.

ix. (10.11) Factors influencing WACC Answer: a Diff: E

Statement a is correct; the other statements are false. If RPM decreases, the cost of equity will

be reduced. Answers b through e will all increase the company’s WACC.

x. (10.5) CAPM cost of equity estimation Answer: e Diff: Mxi. (10.6) CAPM and DCF estimation Answer: a Diff: M

xii. (10.8) Cost of equity estimation Answer: d Diff: M

xiii. (10.8) CAPM cost of equity estimation Answer: e Diff: M

xiv. (10.8) Miscellaneous concepts Answer: a Diff: M



xv

. (10.8) Miscellaneous concepts Answer: a Diff: M

Statement a is correct. Most preferred stock is owned by corporations which receive a 70

percent exclusion of dividends. Consequently, the before-tax coupons on preferred stock are

often lower than the before-tax coupons on debt, despite the fact that preferred stock is riskier

than debt. All the other statements are false.

xvi. (10.10) Capital components Answer: d Diff: M

xvii. (10.10) Capital components Answer: e Diff: M

Statement e is correct. Unlike interest expense on debt, preferred dividends are not deductible,

hence there are no tax savings associated with the use of preferred stock. The component costs

of WACC should reflect the costs of new financing, not historical measures. The cost of common

stock would decline, not increase, if the market risk premium and risk-free rate decline.

xviii. (10.10) Cost of capital estimation Answer: c Diff: M

xix. (10.10) WACC Answer: d Diff: M

Statements a and c are both correct; therefore, statement d is the correct choice. Statement a

recites the definition of the weighted average cost of capital. Statement c is correct because rd =

rRF + LP + MRP + DRP while rs = rRF + (rM - rRF)b. If rRF increases then the values for rd and rs will

increase.

xx

. (10.10) WACC concepts Answer: c Diff: MStatement c is the correct choice. A tax rate increase would lead to a decrease in the after-tax

cost of debt and, consequently, the firm's WACC would decrease.

xxi. (10.12) Risk treatment Answer: e Diff: M

xxii. (10.14) WACC concepts Answer: e Diff: M

Statement e is correct. After-tax cash flows must be considered in order to account for the tax

deductibility of interest payments on corporate debt. The impact of accounts payable is

reflected in cash flows, not WACC. The marginal, not the embedded, cost of capital is the

relevant cost of capital.

xxiii. (10.6) Cost of common stock Answer: d Diff: E

The cost of common stock is:



rs = $1(1.06)/$20 + 0.06 = 0.053 + 0.06 = 0.113 = 11.3%.

xxiv. (10.6) Cost of common stock Answer: b Diff: E

rs =$50

)2.00(1.05 + 5% = 9.2%.

xxv. (10.6) Cost of common stock Answer: e Diff: E

rs =$8.59

)0.90(1.05 + 0.05 = 0.1600 = 16.00%.

xxvi. (10.9) WACC with Flotation Costs Answer: a Diff: E

WACC = wdrd(1 - T) + wcere. rd is given = 9%. Find re:re = D1/[P0(1 - F)] + g

= $0.8/[$25(1 - 0.1)] + 0.09

= 0.125556.

Now you can calculate WACC:

WACC = (0.3)(0.09)(0.6) + (0.7)(0.125556) = 10.41%.

xxvii. (10.5) Cost of common stock Answer: d Diff: M

The cost of common equity as calculated from the CAPM is

rs = rRF + (rM - rRF)b

= 5% + (6%)1.2

= 12.2%.

xxviii. (10.6) Cost of common stock Answer: b Diff: M

rs =0$5

)60(1.00.2 + 0.06% = 10.24% 10.2%.



xxix

. (10.6) WACC and dividend growth rate Answer: c Diff: M

Solve for rs: WACC = 11.5% = wdrd(1 - T) + wcers

11.5% = 0.45(0.09)(0.70) + 0.55rs

rs = 15.75%.

Solve for g: 15.75% = D1/P0 + g

15.75% = $5/$45 + g

g = 4.64%.

xxx. (10.10) WACC Answer: d Diff: MWeights should be based on the target capital structure: wd = 40% and we = 60%. The cost of

debt should be based on the yield of 11.11%.

WACC = 0.60 (12%) + 0.4 (1-.4) (11.11%) = 9.87%.

xxxi. (10.10) WACC Answer: b Diff: M

Find the cost of common stock:

rs = D1/P0 + g = $2(1.0)/$25 + 0%; rs = 0.08 = 8%.

Finally, calculate WACC, using rs = 0.08, and rd = 0.06, so

WACC = (D/A)(1 - Tax rate)rd + (E/A)rs

= 0.4(1 - 0.4)(0.06) + 0.6(0.08) = 0.0624 6.2%.



xxxii

. (10.10) WACC Answer: c Diff: M

The cost of common stock is: rs = D1/P0 + g = $2.12/$30 + 0.06 = 13.07%.

The cost to the company of the bonds is the YTM multiplied by 1 minus the tax rate:

rd = YTM(1 - T) = 8.4%(0.7) = 5.88%.

The cost of the preferred is given as 9%.

The weighted average cost of capital is then

WACC = wd(rd) + wps(rps) + wce(rs)

WACC = 0.4(5.88%) + 0.1(9%) + 0.5(13.07%) = 9.79%.

xxxiii. (10.10) WACC Answer: e Diff: M

The firm will not be issuing new equity because there are adequate

retained earnings available to fund available projects. Therefore,

WACC should be calculated using rs.

rs = D1/P0 + g

= $3.00/$60.00 + 0.07

= 0.12 = 12%.

WACC = wdrd(1 - T) + wcers

= (0.6)(0.08)(1 - 0.4) + (0.4)(0.12)

= 0.0768 = 7.68%.



xxxvii

. (10.6) Cost of common stock: DCF Answer: c Diff: E

Cost of common stock (DCF approach):

rs =$27

)2.00(1.08 + 8% = 16.0%.

xxxviii. (10.7) Cost of common stock: Risk premium Answer: c Diff: E

Cost of common stock (Bond yield-plus-risk-premium approach):

rs = 12.0% + 4.0% = 16.0%.

xxxix. (10.10) WACC Answer: a Diff: E

WACC = wdrd(1 - T) + wpsrps + wcers

= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.0%) = 13.56% 13.6%.

xl. (10.3) Cost of preferred stock Answer: b Diff: E

rps =$80

10 = 12.5%.

xli. (10.6) Cost of common stock Answer: c Diff: E

rs =$40.00

)2.00(1.10 + 0.10 = 15.5%.

xlii. (10.10) WACC Answer: d Diff: E

xliii. (10.6) Cost of equity Answer: a Diff: M

Calculate the retained earnings break point:

Given:

Net income = $600; Debt = 0.4; Equity = 0.6; Dividend payout = 0.6.

Break pointRE = $600(1 - 0.6)/0.6 = $400.

Allison will need new equity capital; capital budget exceeds Break pointRE.

Use the dividend growth model to calculate r e:



re = F1P

g1D

0

0

+ g =

15.0128$

06.120.2$

+ 0.06

= 0.0979 + 0.06 = 0.1579 15.8%.




CAPITAL BUDGETING: DECISION CRITERIA

(12.3) IRRi. Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the

same risk. Which of the following statements is most correct?

a. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project Bwill exceed the NPV of Project A.

b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A.c. If the WACC is less than 18 percent, Project B will always have a shorter payback than

Project A.d. If the WACC is greater than 18 percent, Project B will always have a shorter payback than

Project A.e. If the WACC increases, the IRR of both projects will decline.

(12.4) Ranking conflictsii. Which of the following statements is most correct?

a. The NPV method assumes that cash flows will be reinvested at the cost of capital while the

IRR method assumes reinvestment at the IRR.

b. The NPV method assumes that cash flows will be reinvested at the risk free rate while the


c. The NPV method assumes that cash flows will be reinvested at the cost of capital while the

IRR method assumes reinvestment at the risk-free rate.

d. The NPV method does not consider the inflation premium.

e. The IRR method does not consider all relevant cash flows, and particularly cash flows

beyond the payback period.

(12.4) NPV and IRRiii. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent.

Both projects have a cost of capital of 12 percent. Which of the following statements is mostcorrect?

a. Both projects have a positive net present value (NPV). b. Project A must have a higher NPV than Project B.c. If the cost of capital were less than 12 percent, Project B would have a higher IRR than

Project A.d. Statements a and c are correct.e. Statements a, b, and c are correct.



(12.4) NPV profiles

iv. Projects A and B have the same expected lives and initial cash outflows. However, one project's

cash flows are larger in the early years, while the other project has larger cash flows in the later

years. The two NPV profiles are given below:


a. Project A has the smaller cash flows in the later years.

b. Project A has the larger cash flows in the later years.

c. We require information on the cost of capital in order to determine which project has larger

early cash flows.

d. The NPV profile graph is inconsistent with the statement made in the problem.


(12.4) NPV and IRR

v. Which of the following statements is most correct?

a. If a project’s internal rate of return (IRR) exceeds the cost of capital, then the project’s net

present value (NPV) must be positive.

b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.

c. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return

equal to the cost of capital.



NPV

A

B

r



(12.8) Payback period

vi. A major disadvantage of the payback period method is that it

a. Is useless as a risk indicator.

b. Ignores cash flows beyond the payback period.

c. Does not directly account for the time value of money.


e. Only answers b and c are correct.

(12.10) Post-audit

vii. The post-audit is used to

a. Improve cash flow forecasts. b. Stimulate management to improve operations and bring results into line with forecasts.

c. Eliminate potentially profitable but risky projects.



(12.12) Project selection

viii. Your company has a cost of capital equal to 10%. If the following projects are mutually

exclusive, and you only have the information that is provided, which should you accept?

A B C E

Payback (years) 1 5 2 5

IRR 18% 20% 20% 12%

NPV (Millions) $40 $75 $35 $100

a. A

b. B

c. C

d. B and C

e. E



(12.3) IRR

xii. The internal rate of return of a capital investment

a. Changes when the cost of capital changes.

b. Is equal to the annual net cash flows divided by one half of the project's cost when the cashflows are an annuity.

c. Must exceed the cost of capital in order for the firm to accept the investment.

d. Is similar to the yield to maturity on a bond.

e. Answers c and d are correct.

(12.4) NPV profiles

xiii. Projects L and S each have an initial cost of $10,000, followed by a series of positive cash

inflows. Project L has total, undiscounted cash inflows of $16,000, while S has totalundiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have

identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate?

(Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.)

a. Project S.

b. Project L.

c. Both projects are equally sensitive to changes in the discount rate since their NPVs are equal

at all costs of capital.

d. Neither project is sensitive to changes in the discount rate, since both have NPV profileswhich are horizontal.

e. The solution cannot be determined unless the timing of the cash flows is known.

(12.4) NPV profiles

xiv. Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash flows

from Project L are $15,000, while the undiscounted cash flows from Project S total $13,000.

Their NPV profiles cross at a discount rate of 10 percent. Which of the following statements best

describes this situation?

a. The NPV and IRR methods will select the same project if the cost of capital is greater than

10 percent; for example, 18 percent.

b. The NPV and IRR methods will select the same project if the cost of capital is less than 10

percent; for example, 8 percent.

c. To determine if a ranking conflict will occur between the two projects the cost of capital is

needed as well as an additional piece of information.



d. Project L should be selected at any cost of capital, because it has a higher IRR.

e. Project S should be selected at any cost of capital, because it has a higher IRR.

(12.4) NPV and IRR

xv. Assume that you are comparing two mutually exclusive projects. Which of the following

statements is most correct?

a. The NPV and IRR rules will always lead to the same decision unless one or both of the

projects are "non-normal" in the sense of having only one change of sign in the cash flow

stream, i.e., one or more initial cash outflows (the investment) followed by a series of cash

inflows.

b. If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by

dropping the IRR and replacing it with the MIRR.

c. There will be a meaningful (as opposed to irrelevant) conflict only if the projects' NPV

profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the

discount rate at which the crossover occurs.

d. Statements a, b, and c are true.

(12.4) NPV and IRR

xvi. Which of the following statements is incorrect ?

a. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than

the cost of capital.

b. If the multiple IRR problem does not exist, any independent project acceptable by the NPV

method will also be acceptable by the IRR method.

c. If IRR = r (the cost of capital), then NPV = 0.

d. NPV can be negative if the IRR is positive.

e. The NPV method is not affected by the multiple IRR problem.



(12.4) Ranking methods

xvii. Which of the following statements is correct?

a. Because discounted payback takes account of the cost of capital, a project's discounted

payback is normally shorter than its regular payback.

b. The NPV and IRR methods use the same basic equation, but in the NPV method the discount

rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set

equal to zero and the discount rate is found.

c. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV

profiles, a NPV/IRR conflict will not occur.

d. If you are choosing between two projects which have the same life, and if their NPV profiles

cross, then the smaller project will probably be the one with the steeper NPV profile.

e. If the cost of capital is relatively high, this will favor larger, longer-term projects oversmaller, shorter-term alternatives because it is good to earn high rates on larger amounts overlonger periods.

(12.4) Ranking methods

xviii. In comparing two mutually exclusive projects of equal size and equal life, which of the following


a. The project with the higher NPV may not always be the project with the higher IRR.

b. The project with the higher NPV may not always be the project with the higher MIRR.

c. The project with the higher IRR may not always be the project with the higher MIRR.


e. Answers a and c are correct.




xix. Which of the following is most correct?

a. The NPV and IRR rules will always lead to the same decision in choosing between mutually

exclusive projects, unless one or both of the projects are “non-normal” in the sense of having

only one change of sign in the cash flow stream.

b. The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of

capital.

c. Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive

projects (that each have normal cash flows) when the cost of capital exceeds the crossover

point (that is, the point at which the NPV profiles cross).

d. The discounted payback method overcomes the problems that the payback method has with

cash flows occurring after the payback period.



xx. Normal projects C and D are mutually exclusive. Project C has a higher net present value if the

WACC is less than 12 percent, whereas Project D has a higher net present value if the WACC

exceeds 12 percent. Both projects have a positive NPV if the WACC is 12 percent. Which of the

following statements is most correct?

a. Project D has a higher internal rate of return.

b. Project D is probably larger in scale than Project C.

c. Project C probably has a faster payback.

d. All of the statements above are correct.


(12.6) Modified IRR

xxi. Which of the following statements is most correct? The modified IRR (MIRR) method:

a. Always leads to the same ranking decision as NPV for independent projects.

b. Overcomes the problem of multiple rates of return.

c. Compounds cash flows at the cost of capital.

d. Overcomes the problems of cash flow timing and project size that lead to criticism of the

regular IRR method.




(Comp.) Miscellaneous concepts


a. The IRR method is appealing to some managers because it produces a rate of return uponwhich to base decisions rather than a dollar amount like the NPV method.

b. The discounted payback method solves all the problems associated with the payback method.

c. For independent projects, the decision to accept or reject will always be the same using either

the IRR method or the NPV method.




xxiii. Which of the following statements is most correct?

a. One of the disadvantages of choosing between mutually exclusive projects on the basis of the

discounted payback method is that you might choose the project with the faster payback

period but with the lower total return.

b. Multiple IRRs can occur in cases when project cash flows are normal, but they are more

common in cases where project cash flows are nonnormal.

c. When choosing between mutually exclusive projects, managers should accept all projects

with IRRs greater than the weighted average cost of capital.


e. Two of the statements above are correct.

(Comp.) NPV, IRR, and MIRR

xxiv. Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other

cash flows are positive). Which of the following statements is most correct?

a. All else equal, a project's IRR increases as the cost of capital declines.

b. All else equal, a project's NPV increases as the cost of capital declines.

c. All else equal, a project's MIRR is unaffected by changes in the cost of capital.





(Comp.) NPV, IRR, and paybackxxv. Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of

15 percent. Both projects have a positive net present value. Which of the following statements ismost correct?a. Project X must have a higher net present value than Project Y. b. If the two projects have the same WACC, Project X must have a higher net present value.

c. Project X must have a shorter payback than Project Y.d. Both answers b and c are correct.e. None of the above answers is correct.


xxvi. Which of the following statements is most correct?

a. If a project with normal cash flows has an IRR which exceeds the cost of capital, then the

project must have a positive NPV.

b. If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a higher

NPV.

c. The modified internal rate of return (MIRR) can never exceed the IRR.




xxvii

. Which of the following statements is most correct?

a. The MIRR method will always arrive at the same conclusion as the NPV method.

b. The MIRR method can overcome the multiple IRR problem, while the NPV method cannot.

c. The MIRR method uses a more reasonable assumption about reinvestment rates than the IRR

method.

d. Statements a and c are correct.

e. All of the above statements are correct.



Easy:

(12.3) IRRxxviii. The capital budgeting director of Sparrow Corporation is evaluating a project which costs

$200,000, is expected to last for 10 years and produce after-tax cash flows, including

depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40

percent, what is the project's IRR?

a. 8%

b. 14%

c. 18%

d. -5%

e. 12%

(12.3) IRR

xxix. An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100

per year at the end of each year for 20 years. Find the internal rate of return to the nearest whole

percentage point.

a. 9%

b. 7%

c. 5%

d. 3%

e. 11%



(12.4) IRR and mutually exclusive projectsxxx. A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown

below:

Years 0 r = 12% 1 2 3

| | | |

S -1,100 1,000 350 50

L -1,100 0 300 1,500

The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that

cost. What is the regular IRR (not MIRR) of the better project, i.e., the project which the

company should choose if it wants to maximize its stock price?

a. 12.00% b. 15.53% c. 18.62% d. 19.08% e. 20.46%

12.4) NPV and IRR

xxxi. Your company is choosing between the following non-repeatable, equally risky, mutually

exclusive projects with the cash flows shown below. Your cost of capital is 10 percent. How

much value will your firm sacrifice if it selects the project with the higher IRR?

Project S: 0 r = 10% 1 2 3

| | | |

-1,000 500 500 500

Project L: 0 r = 10% 1 2 3 4 5

| | | | | |

-2,000 668.76 668.76 668.76 668.76 668.76

a. $243.43 b. $291.70 c. $332.50 d. $481.15 e. $535.13



(12.4) NPV and IRR

xxxii. Green Grocers is deciding among two mutually exclusive projects. The two projects have the

following cash flows:

Project A Project B

Year Cash Flow Cash Flow

0 -$50,000 -$30,000

1 10,000 6,000

2 15,000 12,000

3 40,000 18,000

4 20,000 12,000

The company’s cost of capital is 10 percent (WACC = 10%). What is the net present value

(NPV) of the project with the highest internal rate of return (IRR)?

a. $ 7,090 b. $ 8,360 c. $11,450 d. $12,510 e. $15,200

(12.11) Replacement chain

xxxiii. Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo

shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2

years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years.

The company has a contract that requires it to produce the shirts for 4 years, but the patent will

expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be

zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's

cost of capital is 10 percent, by what amount will the better project increase Vanderheiden's

value?

a. $ 677.69

b. $1,098.89

c. $1,179.46

d. $1,237.76

e. $1,312.31



(Comp.) NPV, IRR, and paybackxxxiv. Braun Industries is considering an investment project which has the following cash flows:

Year Cash Flow

0 -$1,000

1 400

2 300

3 500

4 400

The company’s WACC is 10 percent. What is the project’s payback, internal rate of return, and

net present value?

a. Payback = 2.4, IRR = 10.00%, NPV = $600.

b. Payback = 2.4, IRR = 21.22%, NPV = $260.

c. Payback = 2.6, IRR = 21.22%, NPV = $300.

d. Payback = 2.6, IRR = 21.22%, NPV = $260.

e. Payback = 2.6, IRR = 24.12%, NPV = $300.




CAPITAL BUDGETING: DECISION CRITERIA

(12.3) IRR Answer: b Diff: Ei. Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the

same risk. Which of the following statements is most correct?

a. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project Bwill exceed the NPV of Project A.

b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A.c. If the WACC is less than 18 percent, Project B will always have a shorter payback than

Project A.d. If the WACC is greater than 18 percent, Project B will always have a shorter payback than

Project A.e. If the WACC increases, the IRR of both projects will decline.

(12.4) Ranking conflicts Answer: a Diff: Eii. Which of the following statements is most correct?

a. The NPV method assumes that cash flows will be reinvested at the cost of capital while the


b. The NPV method assumes that cash flows will be reinvested at the risk free rate while the


c. The NPV method assumes that cash flows will be reinvested at the cost of capital while the

IRR method assumes reinvestment at the risk-free rate.

d. The NPV method does not consider the inflation premium.

e. The IRR method does not consider all relevant cash flows, and particularly cash flows

beyond the payback period.

(12.4) NPV and IRR Answer: a Diff: Eiii. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent.

Both projects have a cost of capital of 12 percent. Which of the following statements is mostcorrect?

a. Both projects have a positive net present value (NPV). b. Project A must have a higher NPV than Project B.c. If the cost of capital were less than 12 percent, Project B would have a higher IRR than

Project A.d. Statements a and c are correct.e. Statements a, b, and c are correct.



(Comp.) NPV, IRR, and MIRR Answer: b Diff: Eix. A project has an up-front cost of $100,000. The project’s WACC is 12 percent and its net present

value is $10,000. Which of the following statements is most correct?

a. The project should be rejected since its return is less than the WACC.

b. The project’s internal rate of return is greater than 12 percent.c. The project’s modified internal rate of return is less than 12 percent.d. All of the above answers are correct.e. None of the above answers is correct.

(Comp.) Ranking methods Answer: b Diff: E

x. Assume a project has normal cash flows (i.e., the initial cash flow is negative, and all other cash

flows are positive). Which of the following statements is most correct?






Medium:

(12.2) Project selection Answer: a Diff: M

xi. A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of

the following independent projects should the company accept?

a. Project A requires an up-front expenditure of $1,000,000 and generates a net present value of

$3,200.

b. Project B has a modified internal rate of return of 9.5 percent.

c. Project C requires an up-front expenditure of $1,000,000 and generates a positive internal rate

of return of 9.7 percent.

d. Project D has an internal rate of return of 9.5 percent.

e. None of the projects above should be accepted.



(12.3) IRR Answer: e Diff: M

xii. The internal rate of return of a capital investment

a. Changes when the cost of capital changes.

b. Is equal to the annual net cash flows divided by one half of the project's cost when the cashflows are an annuity.

c. Must exceed the cost of capital in order for the firm to accept the investment.

d. Is similar to the yield to maturity on a bond.


(12.4) NPV profiles Answer: b Diff: M

xiii. Projects L and S each have an initial cost of $10,000, followed by a series of positive cash

inflows. Project L has total, undiscounted cash inflows of $16,000, while S has totalundiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have

identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate?

(Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.)

a. Project S.

b. Project L.

c. Both projects are equally sensitive to changes in the discount rate since their NPVs are equal

at all costs of capital.

d. Neither project is sensitive to changes in the discount rate, since both have NPV profileswhich are horizontal.

e. The solution cannot be determined unless the timing of the cash flows is known.

(12.4) NPV profiles Answer: a Diff: M

xiv. Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash flows

from Project L are $15,000, while the undiscounted cash flows from Project S total $13,000.

Their NPV profiles cross at a discount rate of 10 percent. Which of the following statements best

describes this situation?

a. The NPV and IRR methods will select the same project if the cost of capital is greater than

10 percent; for example, 18 percent.

b. The NPV and IRR methods will select the same project if the cost of capital is less than 10

percent; for example, 8 percent.

c. To determine if a ranking conflict will occur between the two projects the cost of capital is

needed as well as an additional piece of information.



d. Project L should be selected at any cost of capital, because it has a higher IRR.

e. Project S should be selected at any cost of capital, because it has a higher IRR.

(12.4) NPV and IRR Answer: c Diff: M

xv. Assume that you are comparing two mutually exclusive projects. Which of the following


a. The NPV and IRR rules will always lead to the same decision unless one or both of the

projects are "non-normal" in the sense of having only one change of sign in the cash flow

stream, i.e., one or more initial cash outflows (the investment) followed by a series of cash

inflows.

b. If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by

dropping the IRR and replacing it with the MIRR.

c. There will be a meaningful (as opposed to irrelevant) conflict only if the projects' NPV

profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the

discount rate at which the crossover occurs.

d. Statements a, b, and c are true.

(12.4) NPV and IRR Answer: a Diff: M

xvi. Which of the following statements is incorrect ?

a. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than

the cost of capital.

b. If the multiple IRR problem does not exist, any independent project acceptable by the NPV

method will also be acceptable by the IRR method.

c. If IRR = r (the cost of capital), then NPV = 0.

d. NPV can be negative if the IRR is positive.

e. The NPV method is not affected by the multiple IRR problem.



(12.4) Ranking methods Answer: b Diff: M

xvii. Which of the following statements is correct?

a. Because discounted payback takes account of the cost of capital, a project's discounted

payback is normally shorter than its regular payback.

b. The NPV and IRR methods use the same basic equation, but in the NPV method the discount

rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set

equal to zero and the discount rate is found.

c. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV

profiles, a NPV/IRR conflict will not occur.

d. If you are choosing between two projects which have the same life, and if their NPV profiles

cross, then the smaller project will probably be the one with the steeper NPV profile.

e. If the cost of capital is relatively high, this will favor larger, longer-term projects oversmaller, shorter-term alternatives because it is good to earn high rates on larger amounts overlonger periods.

(12.4) Ranking methods Answer: e Diff: M

xviii. In comparing two mutually exclusive projects of equal size and equal life, which of the following


a. The project with the higher NPV may not always be the project with the higher IRR.

b. The project with the higher NPV may not always be the project with the higher MIRR.

c. The project with the higher IRR may not always be the project with the higher MIRR.






(Comp.) Miscellaneous concepts Answer: e Diff: M


a. The IRR method is appealing to some managers because it produces a rate of return uponwhich to base decisions rather than a dollar amount like the NPV method.

b. The discounted payback method solves all the problems associated with the payback method.

c. For independent projects, the decision to accept or reject will always be the same using either

the IRR method or the NPV method.



(Comp.) Miscellaneous concepts Answer: a Diff: M


a. One of the disadvantages of choosing between mutually exclusive projects on the basis of the

discounted payback method is that you might choose the project with the faster payback

period but with the lower total return.

b. Multiple IRRs can occur in cases when project cash flows are normal, but they are more

common in cases where project cash flows are nonnormal.

c. When choosing between mutually exclusive projects, managers should accept all projects

with IRRs greater than the weighted average cost of capital.


e. Two of the statements above are correct.

(Comp.) NPV, IRR, and MIRR Answer: b Diff: M

xxiv. Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other

cash flows are positive). Which of the following statements is most correct?








(Comp.) NPV, IRR, and payback Answer: e Diff: Mxxv. Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of

15 percent. Both projects have a positive net present value. Which of the following statements ismost correct?a. Project X must have a higher net present value than Project Y. b. If the two projects have the same WACC, Project X must have a higher net present value.

c. Project X must have a shorter payback than Project Y.d. Both answers b and c are correct.e. None of the above answers is correct.

(Comp.) NPV, IRR, and MIRR Answer: a Diff: M

xxvi. Which of the following statements is most correct?

a. If a project with normal cash flows has an IRR which exceeds the cost of capital, then the

project must have a positive NPV.

b. If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a higher

NPV.

c. The modified internal rate of return (MIRR) can never exceed the IRR.



(Comp.) NPV, IRR, and MIRR Answer: c Diff: M

xxvii

. Which of the following statements is most correct?

a. The MIRR method will always arrive at the same conclusion as the NPV method.

b. The MIRR method can overcome the multiple IRR problem, while the NPV method cannot.

c. The MIRR method uses a more reasonable assumption about reinvestment rates than the IRR

method.


e. All of the above statements are correct.



Easy:

(12.3) IRR Answer: c Diff: Exxviii. The capital budgeting director of Sparrow Corporation is evaluating a project which costs

$200,000, is expected to last for 10 years and produce after-tax cash flows, including

depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40

percent, what is the project's IRR?

a. 8%

b. 14%

c. 18%

d. -5%

e. 12%

(12.3) IRR Answer: c Diff: E

xxix. An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100

per year at the end of each year for 20 years. Find the internal rate of return to the nearest whole

percentage point.

a. 9%

b. 7%

c. 5%

d. 3%

e. 11%



(12.4) IRR and mutually exclusive projects Answer: d Diff: Exxx. A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown

below:

Years 0 r = 12% 1 2 3

| | | |

S -1,100 1,000 350 50

L -1,100 0 300 1,500

The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that

cost. What is the regular IRR (not MIRR) of the better project, i.e., the project which the

company should choose if it wants to maximize its stock price?

a. 12.00% b. 15.53% c. 18.62% d. 19.08% e. 20.46%

12.4) NPV and IRR Answer: b Diff: E

xxxi. Your company is choosing between the following non-repeatable, equally risky, mutually

exclusive projects with the cash flows shown below. Your cost of capital is 10 percent. How

much value will your firm sacrifice if it selects the project with the higher IRR?

Project S: 0 r = 10% 1 2 3

| | | |

-1,000 500 500 500

Project L: 0 r = 10% 1 2 3 4 5

| | | | | |

-2,000 668.76 668.76 668.76 668.76 668.76

a. $243.43 b. $291.70 c. $332.50 d. $481.15 e. $535.13



(12.4) NPV and IRR Answer: e Diff: E

xxxii. Green Grocers is deciding among two mutually exclusive projects. The two projects have the

following cash flows:

Project A Project B

Year Cash Flow Cash Flow

0 -$50,000 -$30,000

1 10,000 6,000

2 15,000 12,000

3 40,000 18,000

4 20,000 12,000

The company’s cost of capital is 10 percent (WACC = 10%). What is the net present value

(NPV) of the project with the highest internal rate of return (IRR)?

a. $ 7,090 b. $ 8,360 c. $11,450 d. $12,510 e. $15,200

(12.11) Replacement chain Answer: d Diff: E

xxxiii. Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo

shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2

years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years.

The company has a contract that requires it to produce the shirts for 4 years, but the patent will

expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be

zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's

cost of capital is 10 percent, by what amount will the better project increase Vanderheiden's

value?

a. $ 677.69

b. $1,098.89

c. $1,179.46

d. $1,237.76

e. $1,312.31



(Comp.) NPV, IRR, and payback Answer: d Diff: Exxxiv. Braun Industries is considering an investment project which has the following cash flows:

Year Cash Flow

0 -$1,000

1 400

2 300

3 500

4 400

The company’s WACC is 10 percent. What is the project’s payback, internal rate of return, and

net present value?

a. Payback = 2.4, IRR = 10.00%, NPV = $600.

b. Payback = 2.4, IRR = 21.22%, NPV = $260.

c. Payback = 2.6, IRR = 21.22%, NPV = $300.

d. Payback = 2.6, IRR = 21.22%, NPV = $260.

e. Payback = 2.6, IRR = 24.12%, NPV = $300.



i. (12.1) IRR Answer: b Diff: E

The cor r ect st at ement i s b; t he ot her st at ements are f al se. Si nceProj ect A’ s I RR i s 15%, at a WACC of 15% NPVA = 0; however, Proj ect B

woul d st i l l have a posi t i ve NPV. Gi ven t he i nf or mat i on i n a, we can’ tconcl ude whi ch pr oj ect ’ s NPV i s goi ng t o be gr eat er. Si nce we ar egi ven no det ai l s about each pr oj ect ’ s cash f l ows we cannot concl udeanythi ng about payback. Fi nal l y, I RR i s i ndependent of t he di scountr ate, i . e. , I RR st ays t he same no matt er what t he WACC i s.

ii. (12.4) Ranking conflicts Answer: a Diff: E iii. (12.4) NPV and IRR Answer: a Diff: E

St at ement a i s t r ue; pr oj ect s wi t h I RRs gr eat er t han t he cost ofcapi t al wi l l have a posi t i ve NPV. St at ement b i s f al se because youknow not hi ng about t he r el at i ve magni t udes of t he pr oj ects. St atementc i s f al se because t he I RR i s i ndependent of t he cost of capi t al .

Theref or e, t he cor r ect choi ce i s st at ement a.

iv. (12.4) NPV profiles Answer: b Diff: E v. (12.4) NPV and IRR Answer: a Diff: E

Statement a is correct; the other statements are false. If the projects are mutually exclusive,

then project B may have a higher NPV even though Project A has a higher IRR. IRR is calculated

assuming cash flows are reinvested at the IRR, not the cost of capital.

vi. (12.8) Payback period Answer: e Diff: E vii. (12.10) Post‐audit Answer: e Diff: E

viii.

(12.12)

Project selection

Answer: e Diff: E

For mutually exclusive projects, always take the one with the greatest NPV.

ix. (Comp.) NPV, IRR, and MIRR Answer: b Diff: E

St at ement b i s corr ect ; t he other st at ement s ar e i ncor r ect . St at ementa i s i ncor r ect ; i f t he NPV > 0, t hen t he return must be > 12%.Statement c i s i ncor r ect ; i f NPV > 0, t hen MI RR > WACC.

x. (Comp.) Ranking methods Answer: b Diff: E

A project's NPV increases as the cost of capital declines. A project's IRR is independent of its

cost of capital, while a project's MIRR is dependent on the cost of capital since the terminal

value in the MIRR equation is compounded at the cost of capital.

xi. (12.2) Project selection Answer: a Diff: M

This is the only project with either a positive NPV or an IRR which exceeds the cost of capital.



xii. (12.3) IRR Answer: e Diff: M

xiii. (12.4) NPV profiles Answer: b Diff: M

xiv.

(12.4) NPV

profiles

Answer:

a Diff:

M

xv. (12.4) NPV and IRR Answer: c Diff: M

xvi. (12.4) NPV and IRR Answer: a Diff: M

Statement a is the incorrect statement. NPV is positive if IRR is greater than the cost of capital.

xvii. (12.4) Ranking methods Answer: b Diff: M

This statement reflects exactly the difference between the NPV and IRR methods.

xviii

.

(12.4) Ranking

methods

Answer:

e Diff:

M

Both statements a and c are correct; therefore, statement e is the correct choice. Due to

reinvestment rate assumptions, NPV and IRR can lead to conflicts; however, there will be no

conflict between NPV and MIRR if the projects are equal in size (which is one of the assumptions

in this question).

xix. (12.4) Miscellaneous concepts Answer: e Diff: M

Statement e is correct; the other statements are false. IRR can lead to conflicting decisions with

NPV even with normal cash flows if the projects are mutually exclusive. Cash outflows are

discounted at

the

cost

of

capital

with

the

MIRR

method,

while

cash

inflows

are

compounded

at

the cost of capital. Conflicts between NPV and IRR arise when the cost of capital is below the

crossover point. The discounted payback method does correct the problem of ignoring the time

value of money, but it still does not account for cash flows beyond the payback period.

xx. (12.4) Miscellaneous concepts Answer: a Diff: M

Statement a is correct; the other statements are false. Sketch the profiles. From the

information given, D has the higher IRR. The project’s scale cannot be determined from the

information given. As C’s NPV declines more rapidly with an increase in rates, this implies that

more of

the

cash

flows

are

coming

later

on.

So

C would

have

a slower

payback

than

D.

xxi. (12.6) Modified IRR Answer: e Diff: M

xxii. (Comp.) Miscellaneous concepts Answer: e Diff: M



Statements a and c are correct; therefore, statement e is the correct choice. The discounted

payback method still ignores cash flows after the payback period.

xxiii.

(Comp.) Miscellaneous

concepts

Answer:

a Diff:

M

Statement a is correct; the other statements are false. Multiple IRRs can occur only for projects

with nonnormal cash flows. Mutually exclusive projects imply that only one project should be

chosen. The project with the highest NPV should be chosen.

xxiv. (Comp.) NPV, IRR, and MIRR Answer: b Diff: M

xxv. (Comp.) NPV, IRR, and payback Answer: e Diff: M

St at ement e i s corr ect ; t he other st atement s are i ncorr ect . St at ement ai s i ncor r ect ; t he t wo pr oj ect s' NPV pr of i l es coul d cross, consequent l y,a hi gher I RR doesn' t guar ant ee a hi gher NPV. St at ement b i s i ncor r ect ;

i f t he t wo pr oj ect s' NPV pr of i l es cr oss, Y coul d have a hi gher NPV.St at ement c i s i ncor r ect ; we don' t have enough i nf ormat i on.

xxvi. (Comp.) NPV, IRR, and MIRR Answer: a Diff: M

The correct answer is a; the other statements are false. The IRR is the discount rate at which a

project's NPV is zero. If a project's IRR exceeds the firm's cost of capital, then its NPV must be

positive, since NPV is calculated using the firm's cost of capital to discount project cash flows.

xxvii

.

(Comp.) NPV,

IRR,

and

MIRR

Answer:

c Diff:

M

Statement c is correct; the other statements are false. MIRR and NPV can conflict for mutually

exclusive projects if the projects differ in size. NPV does not suffer from the multiple IRR

problem.



xxviii. (12.3) IRR Answer: c Diff: E

Ti me l i ne:

r = 14% 0 I RR = ? 1 2 10 Year s

- 200, 000 44, 503 44, 503 44, 503

Financial calculator solution:

Inputs: CF0 = ‐200,000; CF1 = 44,503; N j = 10. Output: IRR = 18%.

xxix. (12.3) IRR Answer: c Diff: E

Ti me l i ne : 0

I RR = ? 1 2 20 Year s

PMT = - 100 - 100 - 100 FV = 3, 310


Inputs: CF0

= 0;

CF1

= ‐100;

N j

= 19;

CF2

= 3,210.

Output:

IRR

= 5.0%.

Alternate method annuity calculation

Inputs: N = 20; PMT = ‐100; FV = 3,310. Output: I = 5.0%

xxx. (12.3) IRR and mutually exclusive projects Answer: d Diff: E

Because the two projects are mutually exclusive, the project with the higher positive NPV is the

"better" project.

0r = 1 2 %

1 2 3

S - 1 , 1 0 0 1 , 0 0 0 3 5 0 5 0

NPVS = $107.46. IRRS = 20.46%.



0r = 1 2 %

1 2 3

L - 1 , 1 0 0 0 3 0 0 1 , 5 0 0

NPVL = $206.83.

IRRL

= 19.08%.

Project L is the "better" project; its IRR = 19.08%.

xxxi. (12.4) NPV and IRR Answer: b Diff: E

NPVS = $243.43; IRRS = 23.38%.

NPVL = $535.13; IRRL = 20.00%.

Value sacrificed: $535.13 ‐ $243.43 = $291.70.

xxxii. (12.4) NPV and IRR Answer: e Diff: E

Enter the

cash

flows

for

each

project

into

the

cash

flow

register

on

the

calculator

and

get

the

NPV and IRR.

NPVA = $15,200; IRRA = 21.3811%.

NPVB = $7,092; IRRB = 19.2783%.

Project A has the highest IRR, so the answer is $15,200.

xxxiii. (12.11) Replacement chain Answer: d Diff: E

0r = 1 0 %

1 2 3 4

S - 8 , 0 00 5 , 0 00 5 , 0 00 5, 0 00 5, 0 00- 8 , 0 0 0- 3 , 0 0 0

IRRS = 16.26%.

NPVS = $1,237.76. (extended NPV)

0r = 1 0 %

1 2 3 4

L- 1 1 , 5 00 4 , 0 00 4 , 0 00 4 , 0 00 4 , 0 00

IRRL = 14.66%.

NPVL

= $1,179.46.

xxxiv. (Comp.) NPV, IRR, and payback Answer: d Diff: E

Payback = 2 + 300/500 = 2.6 years.

Using the cash flow register, calculate NPV and IRR: IRR = 21.22%. NPV = $260.43 $260.




CAPITAL BUDGETING: ESTIMATING CASH FLOWS

AND ANALYZING RISK

Easy:

(13.3) Relevant cash flows

i. When evaluating a new project, the firm should consider all of the following factors except :

a. Changes in working capital attributable to the project.

b. Previous expenditures associated with a market test to determine the feasibility of the project,

if the expenditures have been expensed for tax purposes.

c. The current market value of any equipment to be replaced.

d. The resulting difference in depreciation expense if the project involves replacement.

e. All of the statements above should be considered.

(13.3) Relevant cash flows

ii. Which of the following statements is most correct?

a. The rate of depreciation will often affect operating cash flows, even though depreciation is

not a cash expense.

b. Corporations should fully account for sunk costs when making investment decisions.

c. Corporations should fully account for opportunity costs when making investment decisions.



(13.3) Incremental cash flows

iii. Which of the following is not a cash flow that results from the decision to accept a project?

a. Changes in working capital.

b. Shipping and installation costs.

c. Sunk costs.

d. Opportunity costs.

e. Externalities.



(13.3) Relevant and incremental cash flows

iv. Twin Hills Inc. is considering a proposed project. Given available information, it is currentlyestimated that the proposed project is risky but has a positive net present value. Which of thefollowing factors would make the company less likely to adopt the current project?a. It is revealed that if the company proceeds with the proposed project, the company will lose

two other accounts, both of which have positive NPVs. b. It is revealed that the company has an option to back out of the project 2 years from now, if itis discovered to be unprofitable.

c. It is revealed that if the company proceeds with the project, it will have an option to repeatthe project 4 years from now.

d. Answers a and b are correct.e. Answers b and c are correct.

(13.3) Expansion project cash flows

v. A company is considering a proposed expansion to its facilities. Which of the following statements is

most correct?

a. In calculating the project's operating cash flows, the firm should not subtract out financing

costs such as interest expense, since these costs are already included in the WACC, which is

used to discount the project’s net cash flows.

b. Since depreciation is a non-cash expense, the firm does not need to know the depreciation

rate when calculating the operating cash flows.

c. When estimating the project’s operating cash flows, it is important to include any opportunity

costs and sunk costs, but the firm should ignore cash flows from externalities since they are

accounted for elsewhere.





(13.4) NPV and depreciation

vi. Other things held constant, which of the following would increase the NPV of a project being

considered?

a. A shift from MACRS to straight-line depreciation.

b. Making the initial investment in the first year rather than spreading it over the first 3 years.

c. A decrease in the discount rate associated with the project.

d. The sale of the old machine in a replacement decision at a capital loss rather than at book

value.

e. An increase in required working capital.

(13.6) Corporate risk

vii. Which of the following statements is correct?

a. Well diversified stockholders do not consider corporate risk when determining required rates

of return.

b. Undiversified stockholders, including the owners of small businesses, are more concerned

about corporate risk than market risk.

c. Managers care only about market risk.

d. Market risk is important but does not have a direct effect on stock price because it only

affects beta.




(13.6) Accepting risky projects

viii. A firm is considering the purchase of an asset whose risk is greater than the current risk of the

firm, based on any method for assessing risk. In evaluating this asset, the decision maker should

a. Increase the IRR of the asset to reflect the greater risk.

b. Increase the NPV of the asset to reflect the greater risk.

c. Reject the asset, since its acceptance would increase the risk of the firm.

d. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of

the total assets of the firm.

e. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project.

(13.8) Risk adjustment

ix

. Risk in a revenue-producing project can best be adjusted for by

a. Ignoring it.

b. Adjusting the discount rate upward for increasing risk.

c. Adjusting the discount rate downward for increasing risk.

d. Picking a risk factor equal to the average discount rate.

e. Reducing the NPV by 10 percent for risky projects.

(13.8) Risk and project selection

x. A company estimates that an average-risk project has a WACC of 10 percent, a below-average-

risk project has a WACC of 8 percent, and an above-average-risk project has a WACC of 12

percent. Which of the following independent projects should the company accept?

a. Project A has average risk and an IRR = 9 percent.

b. Project B has below-average risk and an IRR = 8.5 percent.

c. Project C has above-average risk and an IRR = 11 percent.

d. All of the projects above should be accepted.




(13.8) Risk-adjusted NPV

xi. Project X has an up-front cost of $1 million, whereas Project Y has an up-front cost of only $200,000.

Both projects last five years and provide positive cash flows in Years 1-5. Project X is riskier; its risk-

adjusted WACC is 12 percent. Project Y is safer; its risk-adjusted WACC is 8 percent. After

discounting each of the project’s cash flows at the project’s risk-adjusted WACC, you find that Project

X has a NPV of $20,000, and Project Y has a NPV of $15,000. The projects are mutually exclusive

and cannot be repeated. The firm is not capital constrained; it can raise as much capital as it needs,

provided it has profitable projects in which to invest. Given this information, which of the following


a. The firm should select Project Y because it has a higher return; ($15,000/$200,000) is greater

than ($20,000/$1,000,000).

b. The firm should select Project X because it has a higher NPV.

c. The firm should select Project Y because it is less risky.

d. The firm should reject both projects because their IRRs are less than the risk-adjusted

WACC.




Medium

(13.2) Cash flows and accounting measures

xii. Which of the following statements is correct?

a. An asset that is sold for less than book value at the end of a project's life will generate a lossfor the firm and will cause an actual cash outflow attributable to the project.

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.

c. It is unrealistic to expect that increases in net operating working capital that are required at

the start of an expansion project are simply recovered at the project's completion. Thus, these

cash flows are included only at the start of a project.

d. Equipment sold for more than its book value at the end of a project's life will increase income

and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at

book value.




(3.2) ow estimation

xiii. Which of the following statements is correct?

a. In a capital budgeting analysis where part of the funds used to finance the project are raised

as debt, failure to include interest expense as a cost in the cash flow statement when

determining the project's cash flows will lead to an upward bias in the NPV.

b. The preceding statement would be true if "upward" were replaced with "downward."

c. The existence of "externalities" reduces the NPV to a level below the value that would exist

in the absence of externalities.

d. If one of the assets that would be used by a potential project is already owned by the firm,

and if that asset could be leased to another firm if the project is not undertaken, then the net

rent that could be obtained should be charged as a cost to the project under consideration.

e. The rent referred to in statement d is a sunk cost, and as such it should be ignored.

(13.3) Factors affecting cash flows

xiv. Which of the following is not considered a relevant concern in determining incremental cash

flows for a new product?

a. The use of factory floor space which is currently unused but available for production of any

product.

b. Revenues from the existing product that would be lost as a result of some customers

switching to the new product.

c. Shipping and installation costs associated with preparing the machine to be used to produce

the new product.

d. The cost of a product analysis completed in the previous tax year and specific to the new

product.

e. None of the above. (All are relevant concerns in estimating relevant cash flows attributable

to a new-product project.)



(13.5) Inflation effects

xvi. Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are

expressed in real dollars. In this situation, other things held constant, the calculated NPV would

a. Be correct.

b. Be biased downward.

c. Be biased upward.

d. Possibly have a bias, but it could be upward or downward.

e. More information is needed; otherwise, we can make no reasonable statement.

(13.6) Corporate risk

xvii. In theory, the decision maker should view market risk as being of primary importance. However,

within-firm, or corporate, risk is relevant to a firm's

a. Well-diversified stockholders, because it may affect debt capacity and operating income.

b. Management, because it affects job stability.

c. Creditors, because it affects the firm's credit worthiness.


e. Only answers a and c are correct.



(13.6) Methods of analysis

xviii. Which of the following statements is correct?

a. Sensitivity analysis is incomplete because it fails to consider the range of likely values of key

variables as reflected in their probability distributions.

b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be

considered less risky, because a small error in estimating a variable, such as unit sales, would

produce only a small error in the project's NPV.

c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis

requires a relatively powerful computer, coupled with an efficient financial planning software

package, whereas simulation analysis can be done using a PC with a spreadsheet program or

even a calculator.

d. Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to

changes in key variables and the likely range of variable values.


(13.6) Monte Carlo simulation

xix. Monte Carlo simulation

a. Can be useful for estimating a project's stand-alone risk.

b. Is capable of using probability distributions for variables as input data instead of a single

numerical estimate for each variable.

c. Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.

d. All of the answers above.

e. Only answers a and b are correct.




(Note: MACRS accelerated depreciation rates should be given for many of these problems. These rates

are provided in the text in Chapter 13, Table 13-2.)

Easy:

(13.2) Investment outlay

xxii. The Target Copy Company is contemplating the replacement of its old printing machine with a

new model costing $60,000. The old machine, which originally cost $40,000, has 6 years of

expected life remaining and a current book value of $30,000 versus a current market value of

$24,000. Target's corporate tax rate is 40 percent. If Target sells the old machine at market value,

what is the initial after-tax outlay for the new printing machine?

a. -$22,180

b. -$30,000

c. -$33,600

d. -$36,000

e. -$40,000

(13.8) Risk-adjusted discount rate

xxiii. Dandy Product's overall weighted average required rate of return is 10 percent. Its yogurt division

is riskier than average, its fresh produce division has average risk, and its institutional foods

division has below-average risk. Dandy adjusts for both divisional and project risk by adding or

subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is

the risk-adjusted required rate of return for a low-risk project in the yogurt division?

a. 6%

b. 8%

c. 10%

d. 12%

e. 14%



Medium:

[MACRS table required]

(13.2) New project NPV

xxiv. Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by

$5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it

expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to

be able to reduce net operating working capital by $15,000 when the machine is installed, but

required working capital will return to the original level when the machine is sold after 5 years.

Mars's marginal tax rate is 40 percent, and it uses a 12 percent cost of capital to evaluate projects

of this nature. If the machine costs $60,000, what is the project’s NPV?

a. -$15,394

b. -$14,093

c. -$58,512

d. -$21,493

e. -$46,901

[MACRS table required]

(13.2) New project NPV

xxv. Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs

by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually.

Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine

at the end of its 5-year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40

percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's

cost is $40,000, what is the project's NPV?

a. $1,014

b. $2,292

c. $7,550

d. $ 817

e. $5,040



(13.6) Scenario analysis

xxvi. Klott Company encounters significant uncertainty with its sales volume and price in its primary

product. The firm uses scenario analysis in order to determine an expected NPV, which it then

uses in its budget. The base case, best case, and worse case scenarios and probabilities are

provided in the table below. What is Klott's expected NPV, standard deviation of NPV, and

coefficient of variation of NPV?

Probability Unit Sales Sales NPV

of Outcome Volume Price (In Thousands)

Worst case 0.30 6,000 $3,600 -$6,000

Base case 0.50 10,000 4,200 +13,000

Best case 0.20 13,000 4,400 +28,000

a. Expected NPV = $35,000; σ NPV = 17,500; CV NPV = 2.00.

b. Expected NPV = $35,000; σ NPV = 11,667; CV NPV = 0.33.

c. Expected NPV = $10,300; σ NPV = 12,083; CV NPV = 1.17.

d. Expected NPV = $13,900; σ NPV = 8,476; CV NPV = 0.61.

e. Expected NPV = $10,300; σ NPV = 13,900; CV NPV = 1.35.



(13.8) Risk-adjusted NPV

xxvii. Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12 percent

to evaluate average-risk projects, and it adds or subtracts 2 percentage points to evaluate projects

of more or less risk. Currently, two mutually exclusive projects are under consideration. Both

have a cost of $200,000 and will last 4 years. Project A, a riskier-than-average project, will

produce annual end of year cash flows of $71,104. Project B, of less than average risk, will

produce cash flows of $146,411 at the end of Years 3 and 4 only. Virus Stopper should accept

a. B with a NPV of $10,001.

b. Both A and B because both have NPVs greater than zero.

c. B with a NPV of $8,042.

d. A with a NPV of $7,177.

e. A with a NPV of $15,968.




CAPITAL BUDGETING: ESTIMATING CASH FLOWS

AND ANALYZING RISK

Easy:

(13.3) Relevant cash flows Answer: b Diff: E

i. When evaluating a new project, the firm should consider all of the following factors except :

a. Changes in working capital attributable to the project.

b. Previous expenditures associated with a market test to determine the feasibility of the project,

if the expenditures have been expensed for tax purposes.

c. The current market value of any equipment to be replaced.

d. The resulting difference in depreciation expense if the project involves replacement.

e. All of the statements above should be considered.

(13.3) Relevant cash flows Answer: e Diff: E

ii. Which of the following statements is most correct?

a. The rate of depreciation will often affect operating cash flows, even though depreciation is

not a cash expense.

b. Corporations should fully account for sunk costs when making investment decisions.

c. Corporations should fully account for opportunity costs when making investment decisions.



(13.3) Incremental cash flows Answer: c Diff: E

iii. Which of the following is not a cash flow that results from the decision to accept a project?

a. Changes in working capital.

b. Shipping and installation costs.

c. Sunk costs.

d. Opportunity costs.

e. Externalities.



(13.3) Relevant and incremental cash flows Answer: a Diff: E

iv. Twin Hills Inc. is considering a proposed project. Given available information, it is currentlyestimated that the proposed project is risky but has a positive net present value. Which of thefollowing factors would make the company less likely to adopt the current project?a. It is revealed that if the company proceeds with the proposed project, the company will lose

two other accounts, both of which have positive NPVs. b. It is revealed that the company has an option to back out of the project 2 years from now, if itis discovered to be unprofitable.

c. It is revealed that if the company proceeds with the project, it will have an option to repeatthe project 4 years from now.

d. Answers a and b are correct.e. Answers b and c are correct.

(13.3) Expansion project cash flows Answer: a Diff: E

v. A company is considering a proposed expansion to its facilities. Which of the following statements is

most correct?

a. In calculating the project's operating cash flows, the firm should not subtract out financing

costs such as interest expense, since these costs are already included in the WACC, which is

used to discount the project’s net cash flows.

b. Since depreciation is a non-cash expense, the firm does not need to know the depreciation

rate when calculating the operating cash flows.

c. When estimating the project’s operating cash flows, it is important to include any opportunity

costs and sunk costs, but the firm should ignore cash flows from externalities since they are

accounted for elsewhere.



(13.4) NPV and depreciation Answer: c Diff: E

vi. Other things held constant, which of the following would increase the NPV of a project being considered?

a. A shift from MACRS to straight-line depreciation.

b. Making the initial investment in the first year rather than spreading it over the first 3 years.

c. A decrease in the discount rate associated with the project.

d. The sale of the old machine in a replacement decision at a capital loss rather than at book

value.

e. An increase in required working capital.



(13.6) Corporate risk Answer: b Diff: E

vii. Which of the following statements is correct?

a. Well diversified stockholders do not consider corporate risk when determining required ratesof return.

b. Undiversified stockholders, including the owners of small businesses, are more concerned

about corporate risk than market risk.

c. Managers care only about market risk.

d. Market risk is important but does not have a direct effect on stock price because it only

affects beta.


(13.6) Accepting risky projects Answer: e Diff: E

viii. A firm is considering the purchase of an asset whose risk is greater than the current risk of the

firm, based on any method for assessing risk. In evaluating this asset, the decision maker should

a. Increase the IRR of the asset to reflect the greater risk.

b. Increase the NPV of the asset to reflect the greater risk.

c. Reject the asset, since its acceptance would increase the risk of the firm.

d. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of

the total assets of the firm.

e. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project.

(13.8) Risk adjustment Answer: b Diff: E

ix. Risk in a revenue-producing project can best be adjusted for by

a. Ignoring it.

b. Adjusting the discount rate upward for increasing risk.

c. Adjusting the discount rate downward for increasing risk.

d. Picking a risk factor equal to the average discount rate.

e. Reducing the NPV by 10 percent for risky projects.



(13.8) Risk and project selection Answer: b Diff: E

x. A company estimates that an average-risk project has a WACC of 10 percent, a below-average-

risk project has a WACC of 8 percent, and an above-average-risk project has a WACC of 12

percent. Which of the following independent projects should the company accept?

a. Project A has average risk and an IRR = 9 percent.

b. Project B has below-average risk and an IRR = 8.5 percent.

c. Project C has above-average risk and an IRR = 11 percent.

d. All of the projects above should be accepted.


(13.8) Risk-adjusted NPV Answer: b Diff: E

xi. Project X has an up-front cost of $1 million, whereas Project Y has an up-front cost of only $200,000.

Both projects last five years and provide positive cash flows in Years 1-5. Project X is riskier; its risk-

adjusted WACC is 12 percent. Project Y is safer; its risk-adjusted WACC is 8 percent. After

discounting each of the project’s cash flows at the project’s risk-adjusted WACC, you find that Project

X has a NPV of $20,000, and Project Y has a NPV of $15,000. The projects are mutually exclusive

and cannot be repeated. The firm is not capital constrained; it can raise as much capital as it needs,

provided it has profitable projects in which to invest. Given this information, which of the following


a. The firm should select Project Y because it has a higher return; ($15,000/$200,000) is greater

than ($20,000/$1,000,000).

b. The firm should select Project X because it has a higher NPV.

c. The firm should select Project Y because it is less risky.

d. The firm should reject both projects because their IRRs are less than the risk-adjusted

WACC.




Medium

(13.2) Cash flows and accounting measures Answer: d Diff: M

xii. Which of the following statements is correct?

a. An asset that is sold for less than book value at the end of a project's life will generate a lossfor the firm and will cause an actual cash outflow attributable to the project.

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.

c. It is unrealistic to expect that increases in net operating working capital that are required at

the start of an expansion project are simply recovered at the project's completion. Thus, these

cash flows are included only at the start of a project.

d. Equipment sold for more than its book value at the end of a project's life will increase income

and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at

book value.




(3.2) ow estimation Answer: d Diff: M

xiii. Which of the following statements is correct?

a. In a capital budgeting analysis where part of the funds used to finance the project are raised

as debt, failure to include interest expense as a cost in the cash flow statement when

determining the project's cash flows will lead to an upward bias in the NPV.

b. The preceding statement would be true if "upward" were replaced with "downward."

c. The existence of "externalities" reduces the NPV to a level below the value that would exist

in the absence of externalities.

d. If one of the assets that would be used by a potential project is already owned by the firm,

and if that asset could be leased to another firm if the project is not undertaken, then the net

rent that could be obtained should be charged as a cost to the project under consideration.

e. The rent referred to in statement d is a sunk cost, and as such it should be ignored.

(13.3) Factors affecting cash flows Answer: d Diff: M

xiv. Which of the following is not considered a relevant concern in determining incremental cash

flows for a new product?

a. The use of factory floor space which is currently unused but available for production of any

product.

b. Revenues from the existing product that would be lost as a result of some customers

switching to the new product.

c. Shipping and installation costs associated with preparing the machine to be used to produce

the new product.

d. The cost of a product analysis completed in the previous tax year and specific to the new

product.

e. None of the above. (All are relevant concerns in estimating relevant cash flows attributable

to a new-product project.)



(13.4) Depreciation cash flows Answer: c Diff: M

xv. Which of the following statement completions is incorrect ? For a profitable firm, when MACRS

accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances

produce

a. Higher depreciation charges in the early years of an asset's life.

b. Larger cash flows in the earlier years of an asset's life.

c. Larger total undiscounted profits from the project over the project's life.

d. Smaller accounting profits in the early years, assuming the company uses the same

depreciation method for tax and book purposes.

e. None of the above. (All of the above are correct.)



(13.5) Inflation effects Answer: b Diff: M

xvi. Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are

expressed in real dollars. In this situation, other things held constant, the calculated NPV would

a. Be correct.

b. Be biased downward.

c. Be biased upward.

d. Possibly have a bias, but it could be upward or downward.

e. More information is needed; otherwise, we can make no reasonable statement.

(13.6) Corporate risk Answer: d Diff: M

xvii. In theory, the decision maker should view market risk as being of primary importance. However,

within-firm, or corporate, risk is relevant to a firm's

a. Well-diversified stockholders, because it may affect debt capacity and operating income.

b. Management, because it affects job stability.

c. Creditors, because it affects the firm's credit worthiness.


e. Only answers a and c are correct.



(13.8) Risk-adjusted discount rate Answer: e Diff: M

xx. If a company uses the same discount rate for evaluating all projects, which of the following

results is likely?

a. Accepting poor, high-risk projects.

b. Rejecting good, low-risk projects.

c. Accepting only good, low-risk projects.

d. Accepting no projects.


(13.8) Risk-adjusted discount rate Answer: a Diff: Mxxi. If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most

likely become

a. Riskier over time, and its value will decline.

b. Riskier over time, and its value will rise.

c. Less risky over time, and its value will rise.

d. Less risky over time, and its value will decline.

e. There is no reason to expect its risk position or value to change over time as a result of its useof a single discount rate.




(Note: MACRS accelerated depreciation rates should be given for many of these problems. These rates

are provided in the text in Chapter 13, Table 13-2.)

Easy:

(13.2) Investment outlay Answer: c Diff: E

xxii. The Target Copy Company is contemplating the replacement of its old printing machine with a

new model costing $60,000. The old machine, which originally cost $40,000, has 6 years of

expected life remaining and a current book value of $30,000 versus a current market value of

$24,000. Target's corporate tax rate is 40 percent. If Target sells the old machine at market value,

what is the initial after-tax outlay for the new printing machine?

a. -$22,180

b. -$30,000

c. -$33,600

d. -$36,000

e. -$40,000

(13.8) Risk-adjusted discount rate Answer: c Diff: E

xxiii. Dandy Product's overall weighted average required rate of return is 10 percent. Its yogurt division

is riskier than average, its fresh produce division has average risk, and its institutional foods

division has below-average risk. Dandy adjusts for both divisional and project risk by adding or

subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is

the risk-adjusted required rate of return for a low-risk project in the yogurt division?

a. 6%

b. 8%

c. 10%

d. 12%

e. 14%



Medium:

[MACRS table requir ed]

(13.2) New project NPV Answer: d Diff: M

xxiv. Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by

$5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it

expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to

be able to reduce net operating working capital by $15,000 when the machine is installed, but

required working capital will return to the original level when the machine is sold after 5 years.

Mars's marginal tax rate is 40 percent, and it uses a 12 percent cost of capital to evaluate projects

of this nature. If the machine costs $60,000, what is the project’s NPV?

a. -$15,394

b. -$14,093

c. -$58,512

d. -$21,493

e. -$46,901

[MACRS table requir ed]

(13.2) New project NPV Answer: b Diff: M

xxv. Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs

by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually.

Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine

at the end of its 5-year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40

percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's

cost is $40,000, what is the project's NPV?

a. $1,014

b. $2,292

c. $7,550

d. $ 817

e. $5,040



(13.8) Risk-adjusted NPV Answer: a Diff: M

xxvii. Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12 percent

to evaluate average-risk projects, and it adds or subtracts 2 percentage points to evaluate projects

of more or less risk. Currently, two mutually exclusive projects are under consideration. Both

have a cost of $200,000 and will last 4 years. Project A, a riskier-than-average project, will

produce annual end of year cash flows of $71,104. Project B, of less than average risk, will

produce cash flows of $146,411 at the end of Years 3 and 4 only. Virus Stopper should accept

a. B with a NPV of $10,001.

b. Both A and B because both have NPVs greater than zero.

c. B with a NPV of $8,042.

d. A with a NPV of $7,177.

e. A with a NPV of $15,968.



(13.8) Risk-adjusted NPV Answer: c Diff: M

xxviii. Real Time Systems Inc. is considering the development of one of two mutually exclusive new

computer models. Each will require a net investment of $5,000. The cash flow figures for each

project are shown below:

Period Project A Project B

1 $2,000 $3,000

2 2,500 2,600

3 2,250 2,900

Model B, which will use a new type of laser disk drive, is considered a high-risk project, whileModel A is of average risk. Real Time adds 2 percentage points to arrive at a risk-adjusted cost of

capital when evaluating a high-risk project. The cost of capital used for average-risk projects is 12

percent. Which of the following statements regarding the NPVs for Models A and B is most

correct?

a. NPVA = $380; NPVB = $1,815.

b. NPVA = $197; NPVB = $1,590.

c. NPVA = $380; NPVB = $1,590.

d. NPVA = $5,380; NPVB = $6,590.


i. (13.3) Relevant cash flows Answer: b Diff: Eii.

(13.3)Relevant cash flows Answer: e Diff: E

Statements a and c are correct; therefore, statement e is the correct answer. Net cash flow =

Net income + depreciation; therefore, depreciation affects operating cash flows. Sunk costs

should be disregarded when making investment decisions, while opportunity costs should be

considered when making investment decisions, as they represent the best alternative use of an

asset.

iii. (13.3) Incremental cash flows Answer: c Diff: E



iv. (13.3) Relevant and incremental cash flows Answer: a Diff: E

Statement a is correct; the other statements are false. If the company

lost two other accounts with positive NPVs, this would obviously be a

huge negative when considering the proposed project. If the firm has

an option to abandon a project if it is unprofitable, this would make

the company more likely to adopt it. An option to repeat a project is

a plus not a negative.

v. (13.3) Expansion project cash flows Answer: a Diff: E

Statement a is correct; the others are false. Depreciation cash flows

must be considered when calculating operating cash flows. In addition,

externality cash flows should be considered; however, sunk costs are

not included in the analysis.

vi.(13.4)

NPV and depreciation Answer: c Diff: E

vii. (13.6) Corporate risk Answer: b Diff: E

viii. (13.6) Accepting risky projects Answer: e Diff: E

ix. (13.8) Risk adjustment Answer: b Diff: E

x. (13.8) Risk and project selection Answer: b Diff: E

xi. (13.8) Risk-adjusted NPV Answer: b Diff: E

Statement a is false because the firm is not capital constrained;

therefore, it should consider only NPV when evaluating projects. The

return measure in statement a is irrelevant. Statement c is false

because a risk-adjusted cost of capital has been used to evaluate the

projects and arrive at the NPV. Statement d is false; we do not know

what the projects' IRRs are. Statement b is the correct answer.

xii. (13.2) Cash flows and accounting measures Answer: d Diff: M

xiii. (13.2) Cash flow estimation Answer: d Diff: M

Statement d is true--the foregone rent is an "opportunity cost" which should be charged to the

project under consideration. Note that Statements a and b are both false--the cash flows should

not take account of interest, because financial costs are dealt with by discounting at the WACC.

If interest were deducted to find cash flows, then this cost would be "double counted," and the

NPV would be downward biased. Ignoring interest when determining cash flows produces no

bias in the NPV whatever. Note also that externalities can be either positive or negative--they

tend to be negative if the new project is a substitute for existing products, but positive if the

new project is complementary to the firm's other products.

xiv. (13.3) Factors affecting cash flows Answer: d Diff: M

xv.(13.4)

Depreciation cash flows Answer: c Diff: M

xvi. (13.5) Inflation effects Answer: b Diff: M



xvii. (13.6) Corporate risk Answer: d Diff: M

xviii. (13.6) Methods of analysis Answer: a Diff: M

xix

. (13.6) Monte Carlo simulation Answer: d Diff: M

xx. (13.8) Risk-adjusted discount rate Answer: e Diff: M

xxi. (13.8) Risk-adjusted discount rate Answer: a Diff: M

xxii. (13.2) Investment outlay Answer: c Diff: E

Initial outlay

Cost of new machine -$60,000

Salvage value (old) + 24,000

Tax effect of sale = $6,000(0.4) = + 2,400

After-tax outlay = -$33,600

xxiii. (13.8) Risk-adjusted discount rate Answer: c Diff: E

rYD = 10% + 2% = 12%.

However, for a low-risk project, Dandy Product subtracts 2 percentage points. Therefore, therequired rate of return is 10 percent.

rYD,Low-risk project = 10% + 2% - 2% = 10%.



xxiv

. (13.2) New project NPV Answer: d Diff: M

T me l ne:

0r = 12%

1 2 3 4 5 Years

-45,000 7,800 10,680 7,560 5,880 -1,920

NPV = ?

Depreciation cash flows:

MACRS Depreciable Annual

Year Percent Basis Depreciation

1 0.20 $60,000 $12,000

2 0.32 60,000 19,200

3 0.19 60,000 11,400

4 0.12 60,000 7,200

5 0.11 60,000 6,600

6 0.06 60,000 3,600

$60,000



Project analysis worksheet:

Year: 0 1 2 3 4 5

I Initial outlay

1) Machine cost ($60,000)

2) Decrease in NWC 15,000

3) Total net inv. ($45,000)

II Operating cash flows

4) Reduction in cost $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000

5) After-tax dec. in cost 3,000 3,000 3,000 3,000 3,000

6) Deprec. (from table) 12,000 19,200 11,400 7,200 6,600

7) Tax savings deprec.

(line 6 0.4) 4,800 7,680 4,560 2,880 2,640

8) Net operating CFs

(line 5 + 7) $ 7,800 $10,680 $ 7,560 $ 5,880 $ 5,640

III Terminal year CFs

9) Estimated salvage value $10,000

10) Tax on salvage value

($10,000 - $3,600)(0.4) (2,560)

11) Return of NWC (15,000)

12) Total termination CFs (7,560)

IV Net CFs

13) Total Net CFs ($45,000) $ 7,800 $10,680 $ 7,560 $ 5,880 ($ 1,920)

Numerical solution:

NPV = -$45,000 + $7,800(1/1.12) + $10,680(1/1.122) + $7,560(1/1.123)



+ $5,880(1/1.124) - $1,920(1/1.125)

= -$45,000 + $7,800(0.8929) + $10,680(0.7972) + $7,560(0.7118)

+ $5,880(0.6355) - $1,920(0.5674) = -$21,492.74 -$21,493.


Inputs: CF0 = -45,000; CF1 = 7,800; CF2 = 10,680; CF3 = 7,560;

CF4 = 5,880; CF5 = -1,920; I = 12.

Output: NPV = -$21,493.24 -$21,493.

xxv. (13.2) New project NPV Answer: b Diff: M

T me l ne:

0r = 9%

1 2 3 4 5 Years

-40,000 9,800 11,720 9,640 8,520 15,320

NPV = ?

Depreciation cash flows:

MACRS Depreciable Annual

Year Percent Basis Depreciation

1 0.20 $40,000 $ 8,000

2 0.32 40,000 12,800

3 0.19 40,000 7,600

4 0.12 40,000 4,800

5 0.11 40,000 4,400

6 0.06 40,000 2,400

$40,000



Project analysis worksheet:

Year: 0 1 2 3 4 5

I Initial outlay

1) Machine cost ($40,000)

2) Decrease in NWC --

3) Total net inv. ($40,000)

II Operating cash flows

4) Inc. in earnings

before deprec. & tax $ 6,000 $ 6,000 $ 6,000 $ 6,000 $ 6,000

5) After-tax increase in

earnings (line 4 0.6) 3,600 3,600 3,600 3,600 3,600

6) Before tax reduction

in cost 5,000 5,000 5,000 5,000 5,000

7) After tax reduction

in cost (line 6 0.4) 3,000 3,000 3,000 3,000 3,000

8) Deprec. (from table) 8,000 12,800 7,600 4,800 4,400

9) Deprec. tax savings

(line 8 0.4) 3,200 5,120 3,040 1,920 1,760

10) Net operating CFs _______ _______ _______ _______ _______

(line 5 + 7 + 9) $ 9,800 $11,720 $ 9,640 $ 8,520 $ 8,360

III Terminal year CFs

11) Estimated salvage value $10,000

12) Tax on salvage value

($10,000 - $2,400)(0.4) (3,040)

13) Return of NWC --



14) Total termination CFs 6,960

IV Net CFs

15) Total Net CFs ($40,000) $ 9,800 $11,720 $ 9,640 $ 8,520 $15,320

Numerical solution:

NPV = -$40,000 + $9,800(1/1.09) + $11,720(1/1.092) + $9,640(1/1.093)

+ $8,520(1/1.094) + $15,320(1/1.095)

= -$40,000 + $9,800(0.9174) + $11,720(0.8417) + $9,640(0.7722)

+ $8,520(0.7084) + $15,320(0.6499) = $2,291.29 $2,292.


Inputs: CF0 = -40,000; CF1 = 9,800; CF2 = 11,720; CF3 = 9,640;

CF4 = 8,520; CF5 = 15,320; I = 9.

Output: NPV = $2,291.90 $2,292.



xxvi

. (13.6) Scenario analysis Answer: c Diff: M

Calculate expected value of NPV (in thousands):

Probability of Unit Sales Sales NPV

Outcome, Pi Volume Price (In 000s) Pi(x)

Worst case 0.30 6,000 $3,600 -$6,000 0.3(-6,000) = -1,800

Base case 0.50 10,000 4,200 13,000 0.5(13,000) = 6,500

Best case 0.20 13,000 4,400 28,000 0.2(28,000) = 5,600

Expected NPV = $10,300

Calculate standard deviation of NPV (in thousands):

Pi(x - x )2 (x - x )2 Pi(x - x )2

_____________________________________ ____________________ _________________________

Worst case 0.3(-6 - 10.3)2 265.69 79.707

Base case 0.5(13 - 10.3)2 7.29 3.645

Best case 0.2(28 - 10.3)2 313.29 62.658

Sum 146.01

(146.01)½ = 12,083.

Calculate coefficient of variation (CV) of NPV:

CVNPV = σNPV/E(NPV) = $12,083/$10,300 = 1.17.



xxvii

. (13.8) Risk-adjusted NPV Answer: a Diff: M

Time lines:

Project A

0 r = 14%

1 2 3 4 Years

| | | | |CFsA -200,000 71,104 71,104 71,104 71,104

NPVA = ?

Project B

0 r = 10% 1 2 3 4 Years

| | | | |

CFsB -200,000 0 0 146,411 146,411

NPVB = ?

Calculate required returns on A and B:

Project A High risk rRisk adjusted = 12% + 2% = 14%.

Project B Low risk rRisk adjusted = 12% - 2% = 10%.

Tabular solution:

NPVA = $71,104 [(1/0.14)-(1/(0.14 (1.144)))] - $200,000

= $71,104(2.9137) - $200,000 = $7,175.72.

NPVB = $146,411(1/1.143) + $146,411(1/1.144) - $200,000

= $146,411(0.7513) + $146,411(0.6830) - $200,000 = $9,997.30.

Project B has the higher NPV. Since they are mutually exclusive, select Project B.


A Inputs: CF0 = -200,000; CF1 = 71,104; N j = 4; I = 14.

Output: NPVA = $7,176.60 $7,177.

B Inputs: CF0 = -200,000;CF1 = 0;N j = 2;CF2 = 146,411;N j = 2;I = 10.

Output: NPVB = $10,001.43 $10,001.



Note: The difference in the NPVB between the numerical solution and financial calculator cash

flow solution of $4.13 is due to rounding. Greater precision in the PVIF factors produces

identical answers.



xxviii

. (13.8) Risk-adjusted NPV Answer: c Diff: M

Time lines:

Project A

0 r = 12%

1 2 3 Per ods

| | | |CFsA -5,000 2,000 2,500 2,250

NPVA = ?

Project B

0 r = 14%

1 2 3 Per ods

| | | |

CFsB -5,000 3,000 2,600 2,900

NPVB = ?

Project A: rAverage risk = 12%.

Project B: rHigh risk = 12% + 2% = 14%.

Numerical solution:

NPVA = $2,000(1/1.12) + $2,500(1/1.122) + $2,250(1/1.123) - $5,000

= $2,000(0.8929) + $2,500(0.7972) + $2,250(0.7118) - $5,000

= $380.35 $380.

NPVB = $3,000(1/14) + $2,600(1/142) + $2,900(1/143) - $5,000

= $3,000(0.8772) + $2,600(0.7695) + $2,900(0.6750) - $5,000

= $1,589.80 $1,590.


A: Inputs: CF0 = -5,000; CF1 = 2,000; CF2 = 2,500; CF3 = 2,250; I% = 12.

Output: NPV = $380.20 $380.

B: Inputs: CF0 = -5,000; CF1 = 3,000; CF2 = 2,600; CF3 = 2,900; I% = 14.

Output: NPV = $1,589.61 $1,590.




CAPITAL STRUCTURE DECISIONS: PART I

Multiple Choice: Conceptual

Easy:

(15.2) Capital structure, ROA, and ROEi. Ridgefield Enterprises has total assets of $300 million. The company currently has no

debt in its capital structure. The company’s basic earning power is 15 percent. Thecompany is contemplating a recapitalization where it will issue debt at 10 percent and usethe proceeds to buy back shares of the company’s common stock. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will

remain the same. Which of the following will occur as a result of the recapitalization?

a. The company’s ROA will decline. b. The company’s ROE will increase.c. The company’s basic earning power will decline.d. Answers a and b are correct.e. All of the above answers are correct.

(15.5) Capital structure and WACCii. Which of the following statements is most correct?

a. Since debt financing raises the firm's financial risk, raising a company’s debt ratiowill always increase the company’s WACC.

b. Since debt financing is cheaper than equity financing, raising a company’s debt ratiowill always reduce the company’s WACC.

c. Increasing a company’s debt ratio will typically reduce the marginal cost of both debtand equity financing; however, it still may raise the company’s WACC.

d. Statements a and c are correct.e. None of the statements above is correct.

(15.5) Target debt ratioiii

. Which of the following events is likely to encourage a company to raise its target debtratio?a. An increase in the corporate tax rate. b. An increase in the personal tax rate.c. An increase in the company’s operating leverage.d. Statements a and c are correct.e. All of the statements above are correct.



(15.5) Leverage and capital structure

iv. Which of the following would increase the likelihood that a company would increase its

debt ratio in its capital structure?

a. An increase in costs incurred when filing for bankruptcy. b. An increase in the corporate tax rate.c. An increase in the personal tax rate.d. A decrease in the firm’s business risk.e. Statements b and d are correct.

(15. 5) Financial leverage and EPS

v. Volga Publishing is considering a proposed increase in its debt ratio, which will also

increase the company’s interest expense. The plan would involve the company issuing

new bonds and using the proceeds to buy back shares of its common stock. The

company’s CFO expects that the plan will not change the company’s total assets oroperating income. However, the company’s CFO does estimate that it will increase the

company’s earnings per share (EPS). Assuming the CFO’s estimates are correct, which of

the following statements is most correct?

a. Since the proposed plan increases Volga’s financial risk, the company’s stock price

still might fall even though its EPS is expected to increase.

b. If the plan reduces the company’s WACC, the company’s stock price is also likely to

decline.

c. Since the plan is expected to increase EPS, this implies that net income is alsoexpected to increase.



(15.2) Operating leverage

vi. Which of the following statements is false? As a firm increases its operating leverage for a given

quantity of output, this

a. changes its operating cost structure.

b. increases its business risk.

c. increases the standard deviation of its EBIT.

d. increases the variability in earnings per share.

e. decreases its financial leverage.



(15.2) Use of financial leverage

vii. If debt financing is used, which of the following is true?

a. The percentage change in net operating income is greater than a given percentage

change in net income.

b. The percentage change in net operating income is equal to a given percentage change in

net income.

c. The percentage change in net income relative to the percentage change in net operating

income depends on the interest rate charged on debt.

d. The percentage change in net operating income is less than the percentage change in net

income.

e. The degree of operating leverage is greater than 1.

(15.2) Financial leverage and ratios

viii. Company A and Company B have the same total assets, operating income (EBIT), tax rate,

and business risk. Company A, however, has a much higher debt ratio than Company B.

Company A’s basic earning power (BEP) exceeds its cost of debt financing (r

d

). Which of


a. Company A has a higher return on assets (ROA) than Company B.

b. Company A has a higher times interest earned (TIE) ratio than Company B.

c. Company A has a higher return on equity (ROE) than Company B, and its risk, as

measured by the standard deviation of ROE, is also higher than Company B’s.


e. All of the statements above are correct.



(15.5) Capital structure and WACC

ix. Which of the following statements is most correct?

a. A firm can use retained earnings without paying a flotation cost. Therefore, while the

cost of retained earnings is not zero, the cost of retained earnings is generally lower

than the after-tax cost of debt financing.

b. The capital structure that minimizes the firm’s cost of capital is also the capital

structure that maximizes the firm’s stock price.

c. The capital structure that minimizes the firm’s cost of capital is also the capital

structure that maximizes the firm’s earnings per share.

d. If a firm finds that the cost of debt financing is currently less than the cost of equity

financing, an increase in its debt ratio will always reduce its cost of capital.

e. Statements a and b are correct.


Easy:

(15.2) Breakeven point

x. Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At

current annual sales of 200,000 books, the publisher is just breaking even. It is estimated

that if the authors' royalties are reduced, the variable cost per book will drop by $1.

Assume authors' royalties are reduced and sales remain constant; how much more money

can the publisher put into advertising (a fixed cost) and still break even?

a. $600,000

b. $466,667

c. $333,333

d. $200,000

e. None of the above



Medium:

(15.2) Net operating income

xi. The Congress Company has identified two methods for producing playing cards. One

method involves using a machine having a fixed cost of $10,000 and variable costs of$1.00 per deck of cards. The other method would use a less expensive machine (fixed cost

= $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the

selling price per deck of cards will be the same under each method, at what level of output

will the two methods produce the same net operating income?

a. 5,000 decks

b. 10,000 decks

c. 15,000 decks

d. 20,000 decks

e. 25,000 decks

(15.5) Capital structure and value of the firm

xii. A consultant has collected the following information regarding Young Publishing:

Total assets $3,000 million Tax rate 40%

Operating income (EBIT) $800 million Debt ratio 0%

Interest expense $0 million WACC 10%

Net income $480 million M/B ratio 1.00×

Share price $32.00 EPS = DPS $3.20

The company has no growth opportunities (g = 0), so the company pays out all of its

earnings as dividends (EPS = DPS). The consultant believes that if the company moves toa capital structure financed with 20 percent debt and 80 percent equity (based on marketvalues) that the cost of equity will increase to 11 percent and that the pre-tax cost of debtwill be 10 percent. If the company makes this change, what would be the total marketvalue of the firm? (The answers are in millions.)

a. $3,200 b. $3,600 c. $4,000 d. $4,200 e. $4,800



Tough:

(15.5) Capital structure and P0 xiii. Dabney Electronics currently has no debt. Its operating income is $20 million and its tax

rate is 40 percent. It pays out all of its net income as dividends and has a zero growth

rate. The current stock price is $40 per share, and it has 2.5 million shares of stockoutstanding. If it moves to a capital structure that has 40 percent debt and 60 percentequity (based on market values), its investment bankers believe its weighted average costof capital would be 10 percent. What would its stock price be if it changes to the newcapital structure?

a. $40 b. $48 c. $52 d. $54 $60

(15.5) Hamada equation and cost of equityxiv

. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simonhas a capital structure that consists of 20 percent debt and 80 percent equity, based onmarket values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, r M – r RF, is 5 percent. Currently the company’s cost of equity, which is basedon the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon’sestimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity?

a. 14.35% b. 30.00% c. 14.72% d. 15.60% 13.64%



(15.5) Optimal capital structure and Hamada equation

xv. Aaron Athletics is trying to determine its optimal capital structure. The company’s capital

structure consists of debt and common stock. In order to estimate the cost of debt, the

company has produced the following table:

Percent financed Percent financed Debt-to-equity Bond Before-tax

With debt (wd ) with equity (wc) ratio (D/S) rating cost of debt

0.10 0.90 0.10/0.90 = 0.11 AA 7.0%

0.20 0.80 0.20/0.80 = 0.25 A 7.2

0.30 0.70 0.30/0.70 = 0.43 A 8.0

0.40 0.60 0.40/0.60 = 0.67 BB 8.8

0.50 0.50 0.50/0.50 = 1.00 B 9.6

The company’s tax rate, T, is 40 percent.

The company uses the CAPM to estimate its cost of common equity, r s. The risk-free rate

is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no

debt its beta would be 1.0. (Its “unlevered beta,” bU, equals 1.0.)

On the basis of this information, what is the company’s optimal capital structure, and

what is the firm’s cost of capital at this optimal capital structure?

a. wc = 0.9; wd = 0.1; WACC = 14.96% b. wc = 0.8; wd = 0.2; WACC = 10.96%c. wc = 0.7; wd = 0.3; WACC = 7.83%d. wc = 0.6; wd = 0.4; WACC = 10.15%e. wc = 0.5; wd = 0.5; WACC = 10.18%



(The following data are required for the next 4 problems.)

The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of

perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest

and taxes (EBIT) are $100,000, and it is a zero-growth company. AJC's current cost of

equity is 8.8 percent, and its tax rate is 40 percent. The firm has 10,000 shares of common

stock outstanding selling at a price per share of $60.00.

(15.5) Market value and WACC

xvi. What is AJC's current total market value and weighted average cost of capital?

a. $600,000; 7.5%

b. $600,000; 8.0%

c. $800,000; 7.0%

d. $800,000; 7.5%

e. $800,000; 8.0%

(15.5) WACC and value in a recapitalizationxvii. The firm is considering moving to a capital structure that is comprised of 40 percent debt

and 60 percent equity, based on market values. The new funds would be used to replace

the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting

from the leverage increase would cause the required rate of return on debt to rise to 7

percent, while the required rate of return on equity would increase to 9.5 percent. If this

plan were carried out, what would be AJC's new WACC and total value?

a. 7.38%; $800,008

b. 7.38%; $813,008

c. 7.50%; $813,008

d. 7.50%; $790,008

e. 7.80%; $790,008



(15.5) Stock price in a recapitalizationxviii

. Now assume that AJC is considering changing from its original capital structure to a new

capital structure with 50 percent debt and 50 percent equity. If it makes this change, its

resulting market value would be $820,000. What would be its new stock price per share?

a. $58

b. $59

c. $60

d. $61

e. $62

(15.5) Number of shares repurchased in a recapitalization

xix. Now assume that AJC is considering changing from its original capital structure to a new

capital structure that results in a stock price of $64 per share. The resulting capital structure

would have a $336,000 total market value of equity and $504,000 market value of debt.

How many shares would AJC repurchase in the recapitalization?

a. 4,250

b. 4,500

c. 4,750

d. 5,000

e. 5,250




CAPITAL STRUCTURE DECISIONS: PART I


Easy:

(15.2) Capital structure, ROA, and ROE Answer: d Diff: Ei. Ridgefield Enterprises has total assets of $300 million. The company currently has no

debt in its capital structure. The company’s basic earning power is 15 percent. Thecompany is contemplating a recapitalization where it will issue debt at 10 percent and usethe proceeds to buy back shares of the company’s common stock. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will

remain the same. Which of the following will occur as a result of the recapitalization?

a. The company’s ROA will decline. b. The company’s ROE will increase.c. The company’s basic earning power will decline.d. Answers a and b are correct.e. All of the above answers are correct.

(15.5) Capital structure and WACC Answer: e Diff: Eii. Which of the following statements is most correct?

a. Since debt financing raises the firm's financial risk, raising a company’s debt ratiowill always increase the company’s WACC.

b. Since debt financing is cheaper than equity financing, raising a company’s debt ratiowill always reduce the company’s WACC.

c. Increasing a company’s debt ratio will typically reduce the marginal cost of both debtand equity financing; however, it still may raise the company’s WACC.

d. Statements a and c are correct.e. None of the statements above is correct.

(15.5) Target debt ratio Answer: a Diff: Eiii

. Which of the following events is likely to encourage a company to raise its target debtratio?a. An increase in the corporate tax rate. b. An increase in the personal tax rate.c. An increase in the company’s operating leverage.d. Statements a and c are correct.e. All of the statements above are correct.



(15.5) Leverage and capital structure Answer: e Diff: E

iv. Which of the following would increase the likelihood that a company would increase its

debt ratio in its capital structure?

a. An increase in costs incurred when filing for bankruptcy. b. An increase in the corporate tax rate.c. An increase in the personal tax rate.d. A decrease in the firm’s business risk.e. Statements b and d are correct.

(15. 5) Financial leverage and EPS Answer: a Diff: E

v. Volga Publishing is considering a proposed increase in its debt ratio, which will also

increase the company’s interest expense. The plan would involve the company issuing

new bonds and using the proceeds to buy back shares of its common stock. The

company’s CFO expects that the plan will not change the company’s total assets oroperating income. However, the company’s CFO does estimate that it will increase the

company’s earnings per share (EPS). Assuming the CFO’s estimates are correct, which of


a. Since the proposed plan increases Volga’s financial risk, the company’s stock price

still might fall even though its EPS is expected to increase.

b. If the plan reduces the company’s WACC, the company’s stock price is also likely to

decline.

c. Since the plan is expected to increase EPS, this implies that net income is alsoexpected to increase.



(15.2) Operating leverage Answer: e Diff: M

vi. Which of the following statements is false? As a firm increases its operating leverage for a given

quantity of output, this

a. changes its operating cost structure.

b. increases its business risk.

c. increases the standard deviation of its EBIT.

d. increases the variability in earnings per share.

e. decreases its financial leverage.



(15.2) Use of financial leverage Answer: d Diff: M

vii. If debt financing is used, which of the following is true?

a. The percentage change in net operating income is greater than a given percentage

change in net income.

b. The percentage change in net operating income is equal to a given percentage change in

net income.

c. The percentage change in net income relative to the percentage change in net operating

income depends on the interest rate charged on debt.

d. The percentage change in net operating income is less than the percentage change in net

income.

e. The degree of operating leverage is greater than 1.

(15.2) Financial leverage and ratios Answer: c Diff: M

viii. Company A and Company B have the same total assets, operating income (EBIT), tax rate,

and business risk. Company A, however, has a much higher debt ratio than Company B.

Company A’s basic earning power (BEP) exceeds its cost of debt financing (r

d

). Which of


a. Company A has a higher return on assets (ROA) than Company B.

b. Company A has a higher times interest earned (TIE) ratio than Company B.

c. Company A has a higher return on equity (ROE) than Company B, and its risk, as

measured by the standard deviation of ROE, is also higher than Company B’s.





(15.5) Capital structure and WACC Answer: b Diff: M


a. A firm can use retained earnings without paying a flotation cost. Therefore, while the

cost of retained earnings is not zero, the cost of retained earnings is generally lower

than the after-tax cost of debt financing.

b. The capital structure that minimizes the firm’s cost of capital is also the capital

structure that maximizes the firm’s stock price.

c. The capital structure that minimizes the firm’s cost of capital is also the capital

structure that maximizes the firm’s earnings per share.

d. If a firm finds that the cost of debt financing is currently less than the cost of equity

financing, an increase in its debt ratio will always reduce its cost of capital.

e. Statements a and b are correct.


Easy:

(15.2) Breakeven point Answer: d Diff: E

x. Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At

current annual sales of 200,000 books, the publisher is just breaking even. It is estimated

that if the authors' royalties are reduced, the variable cost per book will drop by $1.

Assume authors' royalties are reduced and sales remain constant; how much more money

can the publisher put into advertising (a fixed cost) and still break even?

a. $600,000

b. $466,667

c. $333,333

d. $200,000

e. None of the above



Medium:

(15.2) Net operating income Answer: b Diff: M

xi. The Congress Company has identified two methods for producing playing cards. One

method involves using a machine having a fixed cost of $10,000 and variable costs of$1.00 per deck of cards. The other method would use a less expensive machine (fixed cost

= $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the

selling price per deck of cards will be the same under each method, at what level of output

will the two methods produce the same net operating income?

a. 5,000 decks

b. 10,000 decks

c. 15,000 decks

d. 20,000 decks

e. 25,000 decks

(15.5) Capital structure and value of the firm Answer: e Diff: M

xii. A consultant has collected the following information regarding Young Publishing:

Total assets $3,000 million Tax rate 40%

Operating income (EBIT) $800 million Debt ratio 0%

Interest expense $0 million WACC 10%

Net income $480 million M/B ratio 1.00×

Share price $32.00 EPS = DPS $3.20

The company has no growth opportunities (g = 0), so the company pays out all of its

earnings as dividends (EPS = DPS). The consultant believes that if the company moves toa capital structure financed with 20 percent debt and 80 percent equity (based on marketvalues) that the cost of equity will increase to 11 percent and that the pre-tax cost of debtwill be 10 percent. If the company makes this change, what would be the total marketvalue of the firm? (The answers are in millions.)

a. $3,200 b. $3,600 c. $4,000 d. $4,200 e. $4,800



Tough:

(15.5) Capital structure and P0 Answer: b Diff: Txiii. Dabney Electronics currently has no debt. Its operating income is $20 million and its tax

rate is 40 percent. It pays out all of its net income as dividends and has a zero growth

rate. The current stock price is $40 per share, and it has 2.5 million shares of stockoutstanding. If it moves to a capital structure that has 40 percent debt and 60 percentequity (based on market values), its investment bankers believe its weighted average costof capital would be 10 percent. What would its stock price be if it changes to the newcapital structure?

a. $40 b. $48 c. $52 d. $54 $60

(15.5) Hamada equation and cost of equity Answer: a Diff: Txiv

. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simonhas a capital structure that consists of 20 percent debt and 80 percent equity, based onmarket values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, r M – r RF, is 5 percent. Currently the company’s cost of equity, which is basedon the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon’sestimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity?

a. 14.35% b. 30.00% c. 14.72% d. 15.60% 13.64%



(15.5) Optimal capital structure and Hamada equation Answer: d Diff: T

xv. Aaron Athletics is trying to determine its optimal capital structure. The company’s capital

structure consists of debt and common stock. In order to estimate the cost of debt, the

company has produced the following table:

Percent financed Percent financed Debt-to-equity Bond Before-tax

With debt (wd ) with equity (wc) ratio (D/S) rating cost of debt

0.10 0.90 0.10/0.90 = 0.11 AA 7.0%

0.20 0.80 0.20/0.80 = 0.25 A 7.2

0.30 0.70 0.30/0.70 = 0.43 A 8.0

0.40 0.60 0.40/0.60 = 0.67 BB 8.8

0.50 0.50 0.50/0.50 = 1.00 B 9.6

The company’s tax rate, T, is 40 percent.

The company uses the CAPM to estimate its cost of common equity, r s. The risk-free rate

is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no

debt its beta would be 1.0. (Its “unlevered beta,” bU, equals 1.0.)

On the basis of this information, what is the company’s optimal capital structure, and

what is the firm’s cost of capital at this optimal capital structure?

a. wc = 0.9; wd = 0.1; WACC = 14.96% b. wc = 0.8; wd = 0.2; WACC = 10.96%c. wc = 0.7; wd = 0.3; WACC = 7.83%d. wc = 0.6; wd = 0.4; WACC = 10.15%e. wc = 0.5; wd = 0.5; WACC = 10.18%



(The following data are required for the next 4 problems.)

The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of

perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest

and taxes (EBIT) are $100,000, and it is a zero-growth company. AJC's current cost of

equity is 8.8 percent, and its tax rate is 40 percent. The firm has 10,000 shares of common

stock outstanding selling at a price per share of $60.00.

(15.5) Market value and WACC Answer: d Diff: M

xvi. What is AJC's current total market value and weighted average cost of capital?

a. $600,000; 7.5%

b. $600,000; 8.0%

c. $800,000; 7.0%

d. $800,000; 7.5%

e. $800,000; 8.0%

(15.5) WACC and value in a recapitalization Answer: b Diff: Txvii. The firm is considering moving to a capital structure that is comprised of 40 percent debt

and 60 percent equity, based on market values. The new funds would be used to replace

the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting

from the leverage increase would cause the required rate of return on debt to rise to 7

percent, while the required rate of return on equity would increase to 9.5 percent. If this

plan were carried out, what would be AJC's new WACC and total value?

a. 7.38%; $800,008

b. 7.38%; $813,008

c. 7.50%; $813,008

d. 7.50%; $790,008

e. 7.80%; $790,008



(15.5) Stock price in a recapitalization Answer: e Diff: Txviii

. Now assume that AJC is considering changing from its original capital structure to a new

capital structure with 50 percent debt and 50 percent equity. If it makes this change, its

resulting market value would be $820,000. What would be its new stock price per share?

a. $58

b. $59

c. $60

d. $61

e. $62

(15.5) Number of shares repurchased in a recapitalization Answer: c Diff: T

xix. Now assume that AJC is considering changing from its original capital structure to a new

capital structure that results in a stock price of $64 per share. The resulting capital structure

would have a $336,000 total market value of equity and $504,000 market value of debt.

How many shares would AJC repurchase in the recapitalization?

a. 4,250

b. 4,500

c. 4,750

d. 5,000

e. 5,250



i. (15.2) Capital structure, ROA, and ROE Answer: d Diff: E

St at ement s a and b ar e cor r ect ; t heref ore, st at ement d i s t heappr opr i at e choi ce. ROA = NI / TA. I f t otal asset s r emai n t he same, but

NI decreases ( because of t he new i nt erest payment ) , ROA wi l l decrease.NI wi l l f al l , but not as much i n compar i son t o the amount t hat commonequi t y wi l l f al l , t hus ROE = NI / CE wi l l r i se. BEP wi l l r emai n t hesame. BEP = EBI T/ TA, where TA and EBI T r emai n t he same.

ii. (15.5) Capital structure and WACC Answer: e Diff: E

St at ement a i s f al se; i f you ar e t o t he l ef t of t he f i r m' s opt i malcapi t al st r uct ur e on the WACC cur ve, r ai si ng a company' s debt r at i owi l l act ual l y decrease t he f i r m' s WACC. St at ement b i s f al se; i f youar e to t he ri ght of t he f i r m' s opt i mal capi t al st r uct ur e on t he WACCcur ve, r ai si ng a company' s debt r at i o wi l l act ual l y i ncrease t he f i r m' sWACC. St at ement c i s f al se; as you i ncr ease the f i r m' s debt r at i o thecost of debt wi l l i ncr ease because you' r e usi ng more debt . Because

you' r e usi ng more debt t he cost of equi t y i ncr eases because t he f i r m' sf i nanci al r i sk has i ncr eased. From st at ement s a and b you can see t hatwhet her t he WACC i s i ncr eased depends on where you are on t he WACCcur ve r el at i ve t o t he f i r m' s opt i mal capi t al st r uct ur e. Ther ef or e, t hecorr ect answer i s st at ement e.

iii. (15.5) Target debt ratio Answer: a Diff: E

An i ncrease i n the t ax rat e woul d l ower t he af t er - t ax cost of debtr el at i ve t o equi t y; t her ef ore, t hi s woul d encour age a company t o r ai sei t s t ar get debt r at i o. An i ncrease i n t he per sonal t ax r at e af f ect st he f i r m' s i nvest or s' i nt er est ( f r om debt ) and di vi dend i ncome (f r omequi t y) . Si nce al l of i nt er est i ncome i s taxed but capi t al gai ns (f r omequi t y) r ecei ve pr ef er ent i al t r eat ment ( l ower t ax) t hi s woul d cause t he

f i r m t o l ower i t s t ar get debt r at i o. An i ncrease i n a company' soper at i ng l ever age woul d act ual l y cause a f i r m t o decr ease i t s t ar getdebt r at i o. Ther ef or e, t he cor r ect choi ce i s stat ement a.

iv. (15.5) Leverage and capital structure Answer: e Diff: E

I f t he cost s i ncur r ed when f i l i ng f or bankrupt cy i ncr eased, f i r ms woul dbe penal i zed more i f t hey f i l ed f or bankrupt cy and woul d be l esswi l l i ng t o take that r i sk. Ther ef or e, t hey woul d r educe debt l evel s t ohel p avoi d bankrupt cy ri sk, so stat ement a i s f al se. An i ncr ease i n t hecorporate t ax r ate woul d mean t hat f i r ms woul d get l arger t ax breaksf or i nt er est payment s. Ther ef or e, f i r ms have an i ncent i ve t o i ncreasei nt er est payment s, i n order t o r educe t axes. Ther ef or e, t hey wi l l

i ncrease t hei r debt r at i os, so st at ement b i s t r ue. An i ncr ease i n t heper sonal t ax rate decreases t he af t er - t ax return that i nvest or s wi l lr ecei ve. Fi r ms wi l l have t o i ssue debt at hi gher i nt er est r at es i norder t o pr ovi de i nvest ors wi t h t he same af t er- t ax ret ur ns t hey used t or ecei ve. Thi s wi l l r ai se f i r ms’ cost s of debt , whi ch wi l l i ncreaset hei r WACCs, so f i r ms wi l l not i ncrease t hei r debt r at i os. Ther ef or e,st at ement c i s f al se. I f a f i r m’ s busi ness ri sk decreases, t hen t hi swi l l t end t o i ncrease i t s debt r at i o. Ther ef or e, st at ement d i s f al se.Si nce both st at ement s b and d ar e t r ue, t he corr ect choi ce i s st at e-ment e.



v. (15.5) Financial leverage and EPS Answer: a Diff: E

Statement a i s t r ue; a hi gher EPS does not al ways mean t hat t he st ock

pr i ce wi l l i ncr ease. St at ement b i s f al se; a l ower WACC wi l l mean ahi gher st ock pr i ce. St at ement c i s f al se; EPS can i ncrease j ust becauseshar es out st andi ng decl i ne.

vi. (15.2) Operating leverage Answer: e Diff: M

vii. (15.2) Use of financial leverage Answer: d Diff: M

viii. (15.2) Financial leverage and ratios Answer: c Diff: M

St at ement a i s f al se; A’ s net i ncome i s l ower t han B’ s due t o hi gheri nt er est expense, but i t s asset s are equal t o B’ s, so A’ s ROA must bel ower t han B’ s ROA. Statement b i s f al se; A has t he same EBI T as B, but

hi gher i nt er est payment s t han B; t her ef ore, A’ s TI E i s l ower t han B’ s.St at ement c i s cor r ect .

ix. (15.5) Capital structure and WACC Answer: b Diff: M

Statement b is correct; the other statements are false. The cost of retained earnings should be

higher than debt financing. EPS is maximized at a higher capital structure than the one that

minimizes the firm’s cost of capital. Increasing debt increases the risk of bankruptcy which can

increase the costs of debt and equity.

x. (15.2) Breakeven point Answer: d Diff: E

$7(200,000) ‐ $5(200,000) ‐ F = 0; F = $400,000.

$7(200,000) ‐ $4(200,000) ‐ F = 0; F = $600,000.

$600,000 ‐ $400,000 = $200,000.

xi. (15.2) Net operating income Answer: b Diff: M

Total costMethod 1 = $1.00Q + $10,000.

Total costMethod 2 = $1.50Q + $5,000.

Set equal and solve for Q:



xiv. (15.5) Hamada equation and cost of equity Answer: a Diff: T

Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%.

Step 1:

Find

the

firm’s

current

levered

beta

using

the

CAPM:

rs = rRF + RPM(b)

12% = 6% + 5%(b)

b = 1.2.

Step 2: Find the firm’s unlevered beta using the Hamada equation:

b

= bU[1

+ (1

‐T)(D/E)]

1.2 = bU[1 + (0.6)(0.25)]

1.2 = 1.15bU

1.0435 = bU.

Step 3: Find the new levered beta given the new capital structure using the Hamada

equation:

b = bU[1 + (1 ‐ T)(D/E)]

b = 1.0435[1 + (0.6)(1)]

b = 1.6696.

Step 4: Find the

firm’s

new

cost

of

equity

given

its

new

beta

and

the

CAPM:

rs = rRF + RPM(b)

rs = 6% + 5%(1.6696)

rs = 14.35%.



xv. (15.5) Optimal capital structure and Hamada equation Answer: d Diff: T

rRF = 5%; rM ‐ rRF = 6%.

rs = rRF + (rM ‐ rRF)b.

WACC = rd wd (1 ‐ T) + rs wc.

You need to use the D/E ratio given for each capital structure to find the levered beta using the

Hamada equation. Then, use each of these betas with the CAPM to find the rs for that capital

structure. Use this rs and rd for each capital structure to find the WACC. The optimal capital

structure is the one that minimizes the WACC.

(D/E)

b = bU[1

+ (1

‐T)(D/E)]

rs =

rRF +

(rM

‐rRF)b

wc rd wd

WACC

0.11 1.0667 11.4005% 0.9 7.0% 0.1 10.68%

0.25 1.1500 11.9000 0.8 7.2 0.2 10.38

0.43 1.2571 12.5429 0.7 8.0 0.3 10.22

0.67 1.4000 13.4000 0.6 8.8 0.4 10.15

1.00 1.6000 14.6000 0.5 9.6 0.5 10.18

For example, if the D/E is 0.11:

b = 1.0[1 + (1 ‐ T)(D/E)] = 1.0[1 + (1 ‐ 0.4)(0.1111)] = 1.0667.

rs = rRF + (rM ‐ rRF)b = 5% + 6%(1.0667) = 11.40%.

The weights

are

given

at

0.9

and

0.1

for

equity

and

debt,

respectively,

and

the

rd

for

that

capital

structure is given as 7 percent.

WACC = rd wd (1 ‐ T) + rs wc

= 7% 0.1 (1 ‐ 0.4) + 11.40% 0.9 = 10.68%.



Do the same calculation for each of the capital structures and find each WACC. The optimal capital structure is the

one that minimizes the WACC, which is 10.15%. Therefore, the optimal capital structure is 40% debt and 60%

equity.

xvi. (15.5) Market value and WACC Answer: d Diff: M

V = Debt + Equity = $200,000 + $60(10,000) = $200,000 + $600,000

= $800,000.

WACC = wers + wd(1‐T)rd

= (($600,000/$800,000)(0.088)) + ($200,000/$800,000)(1‐0.4)0.06)

= (0.75(0.088))

+ (.25(.036)

= 0.075

= 7.5%.

As a check, V = FCF/WACC. Since g=0, FCF = NOPAT = EBIT(1‐T).

V = $100,000(1‐0.4)/0.075 = $800,000.

xvii. (15.5) WACC and value in a recapitalization Answer: b Diff: T

WACC = wers + wd(1‐T)rd

= (0.6(0.095)) + (.4(.07)(1‐0.4)) = 0.738 = 7.38%.

V = FCF/WACC. Since g=0, FCF = NOPAT = EBIT(1‐T).

V = $100,000(1‐0.4)/0.0738 = $813,008.

xviii. (15.5) Stock price in a recapitalization Answer: e Diff: T

St ep 1. Fi nd t he new val ue of equi t y and debt af t er t herecapi t al i zat i on:S = we V = 0. 5($820, 000) = $410, 000.D = wd V = 0. 5($820, 000) = $410, 000.

St ep 2. Fi nd t he new pr i ce per shar e af t er t he r ecapi t al i zat i on:P = [ S+ ( D- D0) ] / n0 = [ $410, 000 + ( $410, 000 - $200, 000) ] / 10, 000

= $62.

xix. (15.5) Number of shares repurchased in a recapitalization Answer: c Diff: T




DISTRIBUTIONS TO SHAREHOLDERS:

DIVIDENDS AND REPURCHASES


Easy:

(17.3) Dividends versus capital gains

i. Myron Gordon and John Lintner believe that the required return on equity increases as

the dividend payout ratio is decreased. Their argument is based on the assumption that

a. Investors are indifferent between dividends and capital gains.

b. Investors require that the dividend yield and capital gains yield equal a constant.

c. Capital gains are taxed at a higher rate than dividends.

d. Investors view dividends as being less risky than potential future capital gains.

e. Investors value a dollar of expected capital gains more highly than a dollar ofexpected dividends because of the lower tax rate on capital gains.

(17.3) Dividend theories

ii. Which of the following statements best describes the theories of investors’ preferences

for dividends?

a. Modigliani and Miller argue that investors prefer dividends to capital gains.

b. The bird-in-hand theory suggests that a company can reduce its cost of equity capital

by reducing its dividend payout ratio.

c. The tax preference theory suggests that a company can increase its stock price by

increasing its dividend payout ratio.

d. One key advantage of a residual distribution policy (with all distributions as

dividends) is that it enables a company to follow a stable dividend policy.

e. The clientele effect suggests that companies should follow a stable dividend policy.



(17.3) Dividend theory and policy

iii. Which of the following statements is most correct?

a. The bird-in-the-hand theory implies that a company can reduce its WACC by

reducing its dividend payout. b. The bird-in-the-hand theory implies that a company can increase its stock price by

reducing its dividend payout.c. One problem with following a residual distribution policy (with all distributions in the

form of dividends) is that it can lead to erratic dividend payouts that may prevent thefirm from establishing a reliable clientele of investors who prefer a particulardividend policy.

d. Statements a and c are correct.e. All of the statements above are correct.

(17.3) Optimal distribution policy

iv. Which of the following would not have an influence on the optimal distribution policy?

a. The possibility of accelerating or delaying investment projects.

b. A strong shareholders' preference for current income versus capital gains.

c. Bond indenture constraints.

d. The costs associated with selling new common stock.

e. All of the statements above can have an effect on dividend policy.

(17.6) Dividend payout

v. In the real world, we find that dividends

a. Usually exhibit greater stability than earnings.

b. Fluctuate more widely than earnings.

c. Tend to be a lower percentage of earnings for mature firms.

d. Are usually changed every year to reflect earnings changes.

e. Are usually set as a fixed percentage of earnings.



(17.6) Dividend payout

vi. A decrease in a firm's willingness to pay dividends is likely to result from an increase in

its

a. Earnings stability.

b. Access to capital markets.

c. Profitable investment opportunities.

d. Collection of accounts receivable.

e. Stock price.

(17.13) Stock split

vii. A stock split will cause a change in the total dollar amounts shown in which of the

following balance sheet accounts?

a. Cash.

b. Common stock.

c. Paid-in capital.

d. Retained earnings.

e. None of the above.

(17.13) Stock split

viii. You currently own 100 shares of stock in Beverly Brothers Inc. The stock currently

trades at $120 a share. The company is contemplating a 2-for-1 stock split. Which of thefollowing best describes your position after the proposed stock split takes place?

a. You will have 200 shares of stock, and the stock will trade at or near $120 a share. b. You will have 200 shares of stock, and the stock will trade at or near $60 a share.c. You will have 100 shares of stock, and the stock will trade at or near $60 a share.d. You will have 50 shares of stock, and the stock will trade at or near $120 a share.e. You will have 50 shares of stock, and the stock will trade at or near $60 a share.



(17.14) Stock repurchases and DRIPs


a. One advantage of stock repurchases is that they are generally taxed more favorablythan dividend payments.

b.

One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

c. Stock repurchases make sense if a company is interested in increasing its equity ratio.d. Stock repurchases make sense if a company believes that its stock is overvalued and

that it has a lot of profitable projects to fund over the next year.e. One advantage of an open market dividend reinvestment plan is that it increases the

number of shares the company has outstanding.

(17.14) Dividends, DRIPs, and repurchases

x. Which of the following statements is most correct?

a. In general, stock repurchases are taxed the same way as dividends.

b. One nice feature of dividend reinvestment plans is that they enable investors to

reduce the taxes paid on their dividends.

c. On average, companies send a negative signal to the marketplace when they

announce an increase in their dividend.

d. If a company is interested in issuing new equity capital, a new stock dividend

reinvestment plan probably makes more sense than an open market dividendreinvestment plan.

e. Statements b and d are correct.



(17.14) Repurchases, DRIPs, and stock splits


a. One reason that companies tend to avoid stock repurchases is that dividend payments

are taxed more favorably than stock repurchases.

b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid

paying taxes on the dividends that they choose to reinvest.

c. If a company announces a 2-for-1 stock split and the overall value of the firm remains

unchanged, the company’s stock price must have doubled.



(Comp.) Miscellaneous dividend concepts


a. If a company puts in place a 2-for-1 stock split, its stock price should roughly double. b. Share repurchases are taxed less favorably than dividends; this explains why

companies typically pay dividends and avoid share repurchases.c. On average, a company’s stock price tends to rise when it announces that it is

initiating a share repurchase program.d. Statements a and b are correct.e. All of the statements above are correct.



a. The tax preference hypothesis suggests that companies can reduce their costs ofcapital by increasing their dividend payout ratios.

b. One advantage of the residual distribution policy (with all distributions as dividends)is that it leads to a stable dividend payout, which is desired by investors.

c. Firms with a large number of investment opportunities and a relatively small amountof cash tend to have above average dividend payouts.

d. Answers a and b are correct.e. None of the answers above is correct.



Medium:

(17.3) MM dividend theory

xiv. If the MM hypothesis about dividends is correct, and if one found a group of companies

that differed only with respect to dividend policy, which of the following statements

would be most correct?

a. The residual distribution model should not be used, because it is inconsistent with the

MM dividend hypothesis.

b. The total expected return, which in equilibrium is also equal to the required return,

would be higher for those companies with lower payout ratios because of the greater

risk associated with capital gains versus dividends.

c. If the expected total return of each of the sample companies were divided into a

dividend yield and a growth rate, and then a scatter diagram (or regression) analysis

were undertaken, then the slope of the regression line (or b in the equation D1/P0 = a

+ b(g)) would be equal to +1.0.

d. None of the statements above is true.




(17.3) Dividend theory


a. If the dividend irrelevance theory (which is associated with the names Modigliani and

Miller) were exactly correct, and if this theory could be tested with "clean" data, thenwe would find, in a regression of dividend yield and capital gains, a line with a slope

of -1.0.

b. The tax preference and bird-in-the-hand theories lead to identical conclusions as to

the optimal dividend policy.

c. If a company raises its dividend by an unexpectedly large amount, the announcement

of this new and higher dividend is generally accompanied by an increase in the stock

price. This is consistent with the bird-in-the-hand theory, and Modigliani and Miller

used these findings to support their position on dividend theory.

d. If it could be demonstrated that a clientele effect exists, this would suggest that firms

could alter their dividend payment policies from year to year to take advantage of

investment opportunities without having to worry about the effects of changing

dividends on capital costs.

e. Each of the statements above is false.

(17.3) Dividend policy


a. The bird-in-the-hand theory would predict that companies could decrease their cost of

equity financing by raising their dividend payout.

b. The clientele effect can explain why firms often change their dividend policies.

c. One advantage of adopting a residual distribution policy (with all distributions in the

form of dividends) is that it makes it easier for corporations to maintain dividend

clienteles.





(17.3) Dividends versus capital gains

xvii. Modigliani and Miller (MM) argued that dividend policy is irrelevant. On the other hand,

Gordon and Lintner (GL) argued that dividend policy does matter. GL's argument rests

on the contention that

a. r s = D1/P0 + g is constant for any dividend policy.

b. Because of perceived differences in risk, investors value a dollar of dividends more

highly than a dollar of expected capital gains.

c. Investors, because of tax differentials, value a dollar of expected capital gains more

highly than a dollar of dividends.

d. Most investors will reinvest rather than spend dividends, so it would save investors

money (taxes) if corporations simply reinvested earnings rather than paid them out as

dividends.

e. None of the answers above.

(17.3) Theories of dividend preference


a. The tax preference theory states that, all else equal, investors prefer stocks that pay

low dividends because retained earnings can lead to capital gains that are taxed

preferentially.

b. An increase in the cost of equity capital (r s) when a company announces an increase

in its dividend per share would be consistent with the bird-in-the-hand theory.

c. An increase in the stock price when a company decreases its dividend is consistent

with the signaling theory.

d. A dividend policy that involves paying a consistent percentage of net income is the

best policy if the “clientele effect” is correct.

e. Both statements a and d are correct.



(17.3) Miscellaneous dividend concepts


a. Companies can repurchase shares either (1) to change their capital structures or (2) to

distribute cash to stockholders without paying cash dividends. In the secondsituation, tax considerations will probably play a key role in the decision to

repurchase stock versus to pay more cash dividends.

b. Stock dividends provide investors with additional shares of stock, not cash, yet many

investors must pay cash in the form of taxes on the value of the stock dividends. For

this reason, stock dividends are rarely used today.

c. The bird-in-the-hand theory of dividend policy could be rejected immediately if

personal income taxes were abolished.

d. If the curve relating the WACC and the debt ratio looks like a sharp 'V', this wouldmake it more feasible for a firm to follow the residual dividend policy than if the

curve looks like a shallow bowl (or a shallow 'U').

e. The open market type of dividend reinvestment plan is the best type for firms that

need to bring in new equity capital.

(17.7) Residual distribution policy

xx

. If a firm adheres strictly to the residual distribution policy (with all distributions in theform of dividends), a sale of new common stock by the company would suggest that

a. The dividend payout ratio has remained constant.

b. The dividend payout ratio is increasing.

c. No dividends were paid for the year.

d. The dividend payout ratio is decreasing.

e. The dollar amount of investments has decreased.




xxi. If a firm adheres strictly to the residual distribution policy with all distributions in the

form of dividends), then if its optimal capital budget requires the use of all earnings for

that year (along with new debt according to the optimal debt/total assets ratio), the firm

should pay

a. No dividends except out of past retained earnings.

b. No dividends to common stockholders.

c. Dividends, in effect, out of a new issue of common stock.

d. Dividends by borrowing the money (debt).

e. Either c or d above could be used.

(17.14) Taxes, dividends, and DRIPs


a. "New-stock" dividend reinvestment plans are similar to stock dividends because they

both increase the number of shares outstanding but don't change the total equity of a

firm.

b. Investors receiving stock dividends must pay taxes on the new shares at the time the

stock dividends are received.

c. Stockholders pay no income tax on dividends reinvested in a dividend reinvestment

plan.

d. Both statements a and b are correct.




(Comp.) Dividend policy


a. The tax code encourages companies to pay large dividends to their shareholders.

b. If your company has established a clientele of investors who prefer large dividends,

the company is unlikely to adopt a residual dividend policy.

c. If a firm follows a residual distribution policy (with all distributions in the form of

dividends), holding all else constant, its dividend payout will tend to rise whenever

the firm's investment opportunities improve.



(Comp.) Miscellaneous dividend concepts

xxiv. Which of the following statements is most correct?

a. If a firm repurchases its stock in the open market, the shareholders that tender are

subject to capital gains taxes.

b. If you own 100 shares in a company's stock, and the company does a 2- for-1 stocksplit, you will own 200 shares in the company following the split.

c. Some dividend reinvestment plans increase the amount of equity capital available to

the firm.





(Comp.) Stock repurchases and stock splits

xxix. Which of the following statements is most correct?

a. Stock repurchases can be used by firms to defend against hostile takeovers since they

increase the proportion of debt in a firm's capital structure.

b. After a 3-for-1 stock split, a company's price per share will fall and its number of

shares outstanding will rise.

c. Investors can interpret a stock repurchase by a firm as a signal that the firm's

managers believe the stock is underpriced.




xxx. Firm M is a mature firm in a mature industry. Its annual net income and net cash flow

are both consistently high and very stable. The company’s growth prospects are quite

limited; therefore, the company’s capital budget is small relative to its net income. Firm

N is a relatively new firm in a new industry. Its annual operating income fluctuates

considerably, but the company has substantial growth opportunities. Its capital budget is

expected to be large relative to its net income for the foreseeable future. Which of the


a. Firm M probably has a lower debt ratio than Firm N.

b. Firm M probably has a higher distribution ratio (the total of dividend payout ratio and

stock repurchase ratio) than Firm N.

c. If the corporate tax rate increases, the debt ratio of both firms is likely to fall.


e. Statements b and c are correct.




Easy:


xxxi. Petersen Co. has a capital budget of $1,200,000. The company wants to maintain a target

capital structure that is 60 percent debt and 40 percent equity. The company forecasts

that its net income this year will be $600,000. If the company follows a residual

distribution policy (with all distributions in the form of dividends), what will be its

payout ratio?

a. 0% b. 20% c. 40% d. 60% e. 80%


xxxii. Chandler Communications’ CFO has provided the following information:

The company’s capital budget is expected to be $5,000,000.

The company’s target capital structure is 70 percent debt and 30 percent equity.

The company’s net income is $4,500,000.

If the company follows a residual distribution policy (with all distributions in the form of

dividends), what portion of its net income should it pay out as dividends this year?

a. 33.33% b. 40.00% c. 50.00% d. 60.00% e. 66.67%




xxxiii. Strategic Systems Inc. expects to have net income of $800,000 during the next year. Its

target, and current, capital structure is 40 percent debt and 60 percent common equity.

The Director of Capital Budgeting has determined that the optimal capital budget for next

year is $1.2 million. If Strategic uses the residual distribution model (with alldistributions in the form of dividends) to determine next year's dividend payout, what is

the expected dividend payout ratio?

a. 0% b. 10% c. 28% d. 42% e. 56%


xxxiv. Powell Products anticipates that its capital budget next year will be $3 million. The

company expects to report net income of $5 million this year. The company’s targetcapital structure is 65 percent common equity and 35 percent long-term debt. Assumethe company follows a strict residual distribution policy (with all distributions in the formof dividends). What is the expected dividend payout ratio this year?

a. 65% b. 39% c. 61% d. 56% e. 100%


xxxv. Arden Manufacturing follows a strict residual distribution policy (with all distributions inthe form of dividends). The company is forecasting that its net income will be $500million this year. The company anticipates that its capital budget will be $250 million.The company has a target capital structure that consists of 50 percent equity and 50 percent long-term debt. What is the company’s anticipated dividend payout ratio?

a. 75% b. 55% c. 50% d. 25% e. 47%




xxxvi. Redwood Systems follows a strict residual distribution policy (with all distributions in the

form of dividends). The company estimates that its capital expenditures this year will be

$40 million, its net income will be $30 million, and its target capital structure is 60

percent equity and 40 percent debt. What will be the company’s dividend payout ratio?

a. 80% b. 60% c. 40% d. 20% e. 15%

(17.7) Residual distribution policyxxxvii. Wolfpack Multimedia follows a strict residual distribution policy (with all distributions

in the form of dividends). Wolfpack forecasts that its net income will be $12 million this

year. The company has no depreciation expense so its net cash flow is $12 million, and its target

capital structure consists of 70 percent equity and 30 percent debt. Wolfpack’s capital budget is $10

million. What is the company’s dividend payout ratio?

a. 16.67% b. 41.67% c. 11.67% d. 0.00% e. 58.30%

(17.13) Stock split

xxxviii. Albany Motors recently completed a 3-for-1 stock split. Prior to the split, the company

had 10 million shares outstanding and its stock price was $150 per share. After the split,the total market value of the company’s stock equaled $1.5 billion. What was the price of

the company’s stock following the stock split?

a. $ 15 b. $ 45c. $ 50d. $150e.

$450



(17.13) Stock split

xxxix. Loiselle Graphics recently announced a 3-for-1 stock split. Prior to the split, the

company’s stock was trading at $90 per share. The split had no effect on the wealth of the

company’s investors. What will be the new stock price?

a. $270 b. $ 45 c. $180 d. $ 60 e. $ 30

(17.13) Stock split

xl. Tarheel Computing’s stock was trading at $150 per share before its recent 3-for-1 stock split.

The 3-for-1 split led to a 5 percent increase in Tarheel’s market capitalization. (Market

capitalization equals the stock price times the number of shares.) What was Tarheel’s price

after the stock split?

a. $472.50 b. $ 50.00 c. $ 47.62 d. $428.57 e. $ 52.50

Medium:


xli

. Flavortech Inc. expects EBIT of $2,000,000 for the current year. The firm’

s capitalstructure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40

percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its

$5,000,000 of long-term debt. One million shares of common stock are outstanding. For

the next year, the firm expects to fund one large positive NPV project costing $1,200,000,

and it will fund this project in accordance with its target capital structure. If the firm

follows a residual distribution policy (with all distributions in the form of dividends) and

has no other projects, what is its expected dividend payout ratio?

a. 100% b. 60% c. 40% d. 20% e. 0%




xlii. Driver Corporation has plans calling for a capital budget of $60 million. Its optimal

capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and

taxes (EBIT) were $98 million for the year. The firm has $200 million in assets, pays an

average of 10 percent on all its debt, and faces a marginal tax rate of 35 percent. If thefirm maintains a residual distribution policy (with all distributions in the form of

dividends) and will keep its optimal capital structure intact, what will be the amount of

the dividends it pays out after financing its capital budget?

a. $22.5 million

b. $59.4 million

c. $60.0 million

d. $30.0 million

e. $ 0


xliii. Your company has decided that its capital budget during the coming year will be $20

million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings

before interest and taxes (EBIT) are projected to be $34.667 million for the year. Thecompany has $200 million of assets; its average interest rate on outstanding debt is 10

percent; and its tax rate is 40 percent. If the company follows the residual distribution

policy (with all distributions in the form of dividends) and maintains the same capital

structure, what will its dividend payout ratio be?

a. 15% b. 20% c. 25% d. 30% e. 35%




xliv. Plato Inc. expects to have net income of $5,000,000 during the next year. Plato's target

capital structure is 35 percent debt and 65 percent equity. The company's director of

capital budgeting has determined that the optimal capital budget for the coming year is

$6,000,000. If Plato follows a residual distribution policy (with all distributions in theform of dividends) to determine the coming year’s dividend, then what is Plato's payout

ratio?

a. 38% b. 42% c. 58% d.33% e. None of the answers above is correct.

(17.7) Residual distribution and capital budget

xlv. Brock Brothers wants to maintain its capital structure that is 30 percent debt, and 70

percent equity. The company forecasts that its net income this year will be $1,000,000.

The company follows a residual distribution policy (with all distributions in the form of

dividends), and anticipates a dividend payout ratio of 40 percent. What is the size of the

company’s capital budget?

a. $ 600,000 b. $ 857,143 c. $1,000,000 d. $1,428,571 e. $2,000,000

(17.7) Residual distribution and capital budget

xlvi

. The following facts apply to your company:

Target capital structure: 50% debt; 50% equity.

EBIT: $200 million.

Assets: $500 million.

Tax rate: 40%.

Cost of new and old debt: 8%.

Based on the residual distribution policy (with all distributions in the form of dividends),the payout ratio is 60 percent. How large (in millions of dollars) will the capital budget

be?

a. $ 43.2 b. $ 50.0 c. $ 64.8 d. $ 86.4 e. $108.0




DISTRIBUTIONS TO SHAREHOLDERS:

DIVIDENDS AND REPURCHASES


Easy:

(17.3) Dividends versus capital gains Answer: d Diff: E

i. Myron Gordon and John Lintner believe that the required return on equity increases as

the dividend payout ratio is decreased. Their argument is based on the assumption that

a. Investors are indifferent between dividends and capital gains.

b. Investors require that the dividend yield and capital gains yield equal a constant.

c. Capital gains are taxed at a higher rate than dividends.

d. Investors view dividends as being less risky than potential future capital gains.

e. Investors value a dollar of expected capital gains more highly than a dollar ofexpected dividends because of the lower tax rate on capital gains.

(17.3) Dividend theories Answer: e Diff: E

ii. Which of the following statements best describes the theories of investors’ preferences

for dividends?

a. Modigliani and Miller argue that investors prefer dividends to capital gains.

b. The bird-in-hand theory suggests that a company can reduce its cost of equity capital

by reducing its dividend payout ratio.

c. The tax preference theory suggests that a company can increase its stock price by

increasing its dividend payout ratio.

d. One key advantage of a residual distribution policy (with all distributions as

dividends) is that it enables a company to follow a stable dividend policy.

e. The clientele effect suggests that companies should follow a stable dividend policy.



(17.6) Dividend payout Answer: c Diff: E

vi. A decrease in a firm's willingness to pay dividends is likely to result from an increase in

its

a. Earnings stability.

b. Access to capital markets.

c. Profitable investment opportunities.

d. Collection of accounts receivable.

e. Stock price.

(17.13) Stock split Answer: e Diff: E

vii. A stock split will cause a change in the total dollar amounts shown in which of the

following balance sheet accounts?

a. Cash.

b. Common stock.

c. Paid-in capital.

d. Retained earnings.

e. None of the above.

(17.13) Stock split Answer: b Diff: E

viii. You currently own 100 shares of stock in Beverly Brothers Inc. The stock currentlytrades at $120 a share. The company is contemplating a 2-for-1 stock split. Which of thefollowing best describes your position after the proposed stock split takes place?

a. You will have 200 shares of stock, and the stock will trade at or near $120 a share. b. You will have 200 shares of stock, and the stock will trade at or near $60 a share.c. You will have 100 shares of stock, and the stock will trade at or near $60 a share.d. You will have 50 shares of stock, and the stock will trade at or near $120 a share.e. You will have 50 shares of stock, and the stock will trade at or near $60 a share.



(17.14) Stock repurchases and DRIPs Answer: a Diff: E


a. One advantage of stock repurchases is that they are generally taxed more favorablythan dividend payments.

b. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

c. Stock repurchases make sense if a company is interested in increasing its equity ratio.d. Stock repurchases make sense if a company believes that its stock is overvalued and

that it has a lot of profitable projects to fund over the next year.e. One advantage of an open market dividend reinvestment plan is that it increases the

number of shares the company has outstanding.

(17.14) Dividends, DRIPs, and repurchases Answer: d Diff: E

x. Which of the following statements is most correct?

a. In general, stock repurchases are taxed the same way as dividends.

b. One nice feature of dividend reinvestment plans is that they enable investors to

reduce the taxes paid on their dividends.

c. On average, companies send a negative signal to the marketplace when they

announce an increase in their dividend.

d. If a company is interested in issuing new equity capital, a new stock dividend

reinvestment plan probably makes more sense than an open market dividendreinvestment plan.

e. Statements b and d are correct.



(17.14) Repurchases, DRIPs, and stock splits Answer: e Diff: E


a. One reason that companies tend to avoid stock repurchases is that dividend payments

are taxed more favorably than stock repurchases.

b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid

paying taxes on the dividends that they choose to reinvest.

c. If a company announces a 2-for-1 stock split and the overall value of the firm remains

unchanged, the company’s stock price must have doubled.



(Comp.) Miscellaneous dividend concepts Answer: c Diff: E


a. If a company puts in place a 2-for-1 stock split, its stock price should roughly double. b. Share repurchases are taxed less favorably than dividends; this explains why

companies typically pay dividends and avoid share repurchases.c. On average, a company’s stock price tends to rise when it announces that it is

initiating a share repurchase program.

d. Statements a and b are correct.e. All of the statements above are correct.

(Comp.) Miscellaneous concepts Answer: e Diff: E


a. The tax preference hypothesis suggests that companies can reduce their costs ofcapital by increasing their dividend payout ratios.

b. One advantage of the residual distribution policy (with all distributions as dividends)is that it leads to a stable dividend payout, which is desired by investors.

c. Firms with a large number of investment opportunities and a relatively small amountof cash tend to have above average dividend payouts.

d. Answers a and b are correct.e. None of the answers above is correct.



Medium:

(17.3) MM dividend theory Answer: d Diff: M

xiv. If the MM hypothesis about dividends is correct, and if one found a group of companies

that differed only with respect to dividend policy, which of the following statements

would be most correct?

a. The residual distribution model should not be used, because it is inconsistent with the

MM dividend hypothesis.

b. The total expected return, which in equilibrium is also equal to the required return,

would be higher for those companies with lower payout ratios because of the greater

risk associated with capital gains versus dividends.

c. If the expected total return of each of the sample companies were divided into a

dividend yield and a growth rate, and then a scatter diagram (or regression) analysis

were undertaken, then the slope of the regression line (or b in the equation D1/P0 = a

+ b(g)) would be equal to +1.0.

d. None of the statements above is true.




(17.3) Dividend theory Answer: a Diff: M


a. If the dividend irrelevance theory (which is associated with the names Modigliani and

Miller) were exactly correct, and if this theory could be tested with "clean" data, thenwe would find, in a regression of dividend yield and capital gains, a line with a slope

of -1.0.

b. The tax preference and bird-in-the-hand theories lead to identical conclusions as to

the optimal dividend policy.

c. If a company raises its dividend by an unexpectedly large amount, the announcement

of this new and higher dividend is generally accompanied by an increase in the stock

price. This is consistent with the bird-in-the-hand theory, and Modigliani and Miller

used these findings to support their position on dividend theory.

d. If it could be demonstrated that a clientele effect exists, this would suggest that firms

could alter their dividend payment policies from year to year to take advantage of

investment opportunities without having to worry about the effects of changing

dividends on capital costs.

e. Each of the statements above is false.

(17.3) Dividend policy Answer: a Diff: M


a. The bird-in-the-hand theory would predict that companies could decrease their cost of

equity financing by raising their dividend payout.

b. The clientele effect can explain why firms often change their dividend policies.

c. One advantage of adopting a residual distribution policy (with all distributions in the

form of dividends) is that it makes it easier for corporations to maintain dividend

clienteles.





(17.3) Miscellaneous dividend concepts Answer: a Diff: M


a. Companies can repurchase shares either (1) to change their capital structures or (2) to

distribute cash to stockholders without paying cash dividends. In the secondsituation, tax considerations will probably play a key role in the decision to

repurchase stock versus to pay more cash dividends.

b. Stock dividends provide investors with additional shares of stock, not cash, yet many

investors must pay cash in the form of taxes on the value of the stock dividends. For

this reason, stock dividends are rarely used today.

c. The bird-in-the-hand theory of dividend policy could be rejected immediately if

personal income taxes were abolished.

d. If the curve relating the WACC and the debt ratio looks like a sharp 'V', this wouldmake it more feasible for a firm to follow the residual dividend policy than if the

curve looks like a shallow bowl (or a shallow 'U').

e. The open market type of dividend reinvestment plan is the best type for firms that

need to bring in new equity capital.

(17.7) Residual distribution policy Answer: c Diff: M

xx

. If a firm adheres strictly to the residual distribution policy (with all distributions in theform of dividends), a sale of new common stock by the company would suggest that

a. The dividend payout ratio has remained constant.

b. The dividend payout ratio is increasing.

c. No dividends were paid for the year.

d. The dividend payout ratio is decreasing.

e. The dollar amount of investments has decreased.



(17.7) Residual distribution policy Answer: b Diff: M

xxi. If a firm adheres strictly to the residual distribution policy with all distributions in the

form of dividends), then if its optimal capital budget requires the use of all earnings for

that year (along with new debt according to the optimal debt/total assets ratio), the firm

should pay

a. No dividends except out of past retained earnings.

b. No dividends to common stockholders.

c. Dividends, in effect, out of a new issue of common stock.

d. Dividends by borrowing the money (debt).

e. Either c or d above could be used.

(17.14) Taxes, dividends, and DRIPs Answer: e Diff: M


a. "New-stock" dividend reinvestment plans are similar to stock dividends because they

both increase the number of shares outstanding but don't change the total equity of a

firm.

b. Investors receiving stock dividends must pay taxes on the new shares at the time the

stock dividends are received.

c. Stockholders pay no income tax on dividends reinvested in a dividend reinvestment

plan.





(Comp.) Dividend policy Answer: b Diff: M


a. The tax code encourages companies to pay large dividends to their shareholders.

b. If your company has established a clientele of investors who prefer large dividends,

the company is unlikely to adopt a residual dividend policy.

c. If a firm follows a residual distribution policy (with all distributions in the form of

dividends), holding all else constant, its dividend payout will tend to rise whenever

the firm's investment opportunities improve.



(Comp.) Miscellaneous dividend concepts Answer: d Diff: M

xxiv. Which of the following statements is most correct?

a. If a firm repurchases its stock in the open market, the shareholders that tender are

subject to capital gains taxes.

b. If you own 100 shares in a company's stock, and the company does a 2- for-1 stocksplit, you will own 200 shares in the company following the split.

c. Some dividend reinvestment plans increase the amount of equity capital available to

the firm.





(Comp.) Miscellaneous dividend concepts Answer: e Diff: M

xxv. Which of the following statements is most correct?

a. An open-market dividend reinvestment plan is likely to be attractive to companies

that are looking to issue additional shares of common stock.

b. Stock repurchases have the effect of reducing financial leverage.

c. If a company does a 2-for-1 stock split, its stock price will roughly double.



(Comp.) Miscellaneous dividend concepts Answer: a Diff: M xxvi. Which of the following statements is most correct?

a. If a company wants to issue new shares of common stock and also wants to

implement a dividend reinvestment plan, then it should implement a new-stock

dividend reinvestment plan, rather than an open-market purchase plan.

b. If a company undertakes a 3-for-1 stock split, then the number of shares outstanding

should fall, and the stock price should rise.

c. If a company wants to reduce its debt ratio, then it should repurchase some of itscommon stock.





(Comp.) Miscellaneous dividend concepts Answer: d Diff: M

xxvii. Which of the following statements is most correct?

a. If you were testing dividend theories and found that a dividend increase resulted in

higher stock prices, then you could rule out all other theories and conclude that the bird-in-the-hand theory was most consistent with the evidence you found.

b. The clientele effect suggests that investors choose their investments based on firms'

past dividend policies and changes to established dividend policies may be costly to

investors.

c. Dividends paid under a residual dividend policy might send conflicting signals to

investors.

d. Both statements b and c are correct.


(Comp.) Miscellaneous dividend concepts Answer: a Diff: M

xxviii. Which of the following actions will enable a company to raise additional equity capital

(that is, which of the following will raise the total book value of equity)?

a. The establishment of a new-stock dividend reinvestment plan.

b. A stock split.

c. The establishment of an open-market purchase dividend reinvestment plan.

d. A stock repurchase.

e. Answers a and d are correct.



(Comp.) Stock repurchases and stock splits Answer: e Diff: M

xxix. Which of the following statements is most correct?

a. Stock repurchases can be used by firms to defend against hostile takeovers since they

increase the proportion of debt in a firm's capital structure.

b. After a 3-for-1 stock split, a company's price per share will fall and its number of

shares outstanding will rise.

c. Investors can interpret a stock repurchase by a firm as a signal that the firm's

managers believe the stock is underpriced.



(Comp.) Miscellaneous concepts Answer: b Diff: M

xxx. Firm M is a mature firm in a mature industry. Its annual net income and net cash flow

are both consistently high and very stable. The company’s growth prospects are quite

limited; therefore, the company’s capital budget is small relative to its net income. Firm

N is a relatively new firm in a new industry. Its annual operating income fluctuates

considerably, but the company has substantial growth opportunities. Its capital budget is

expected to be large relative to its net income for the foreseeable future. Which of the


a. Firm M probably has a lower debt ratio than Firm N.

b. Firm M probably has a higher distribution ratio (the total of dividend payout ratio and

stock repurchase ratio) than Firm N.

c. If the corporate tax rate increases, the debt ratio of both firms is likely to fall.


e. Statements b and c are correct.



(17.7) Residual distribution policy Answer: b Diff: E

xxxiii. Strategic Systems Inc. expects to have net income of $800,000 during the next year. Its

target, and current, capital structure is 40 percent debt and 60 percent common equity.

The Director of Capital Budgeting has determined that the optimal capital budget for next

year is $1.2 million. If Strategic uses the residual distribution model (with alldistributions in the form of dividends) to determine next year's dividend payout, what is

the expected dividend payout ratio?

a. 0% b. 10% c. 28% d. 42% e. 56%

(17.7) Residual distribution policy Answer: c Diff: E

xxxiv. Powell Products anticipates that its capital budget next year will be $3 million. Thecompany expects to report net income of $5 million this year. The company’s target

capital structure is 65 percent common equity and 35 percent long-term debt. Assumethe company follows a strict residual distribution policy (with all distributions in the formof dividends). What is the expected dividend payout ratio this year?

a. 65% b. 39% c. 61% d. 56% e. 100%

(17.7) Residual distribution policy Answer: a Diff: E

xxxv. Arden Manufacturing follows a strict residual distribution policy (with all distributions inthe form of dividends). The company is forecasting that its net income will be $500million this year. The company anticipates that its capital budget will be $250 million.The company has a target capital structure that consists of 50 percent equity and 50 percent long-term debt. What is the company’s anticipated dividend payout ratio?

a. 75% b. 55% c. 50% d. 25% e. 47%




xxxix. Loiselle Graphics recently announced a 3-for-1 stock split. Prior to the split, the

company’s stock was trading at $90 per share. The split had no effect on the wealth of the

company’s investors. What will be the new stock price?

a. $270 b. $ 45 c. $180 d. $ 60 e. $ 30


xl. Tarheel Computing’s stock was trading at $150 per share before its recent 3-for-1 stock split.

The 3-for-1 split led to a 5 percent increase in Tarheel’s market capitalization. (Market

capitalization equals the stock price times the number of shares.) What was Tarheel’s price

after the stock split?

a. $472.50 b. $ 50.00 c. $ 47.62 d. $428.57 e. $ 52.50

Medium:

(17.7) Residual distribution policy Answer: d Diff: M

xli

. Flavortech Inc. expects EBIT of $2,000,000 for the current year. The firm’

s capitalstructure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40

percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its

$5,000,000 of long-term debt. One million shares of common stock are outstanding. For

the next year, the firm expects to fund one large positive NPV project costing $1,200,000,

and it will fund this project in accordance with its target capital structure. If the firm

follows a residual distribution policy (with all distributions in the form of dividends) and

has no other projects, what is its expected dividend payout ratio?

a. 100% b. 60% c. 40% d. 20% e. 0%



(17.7) Residual distribution policy Answer: a Diff: M

xlii. Driver Corporation has plans calling for a capital budget of $60 million. Its optimal

capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and

taxes (EBIT) were $98 million for the year. The firm has $200 million in assets, pays an

average of 10 percent on all its debt, and faces a marginal tax rate of 35 percent. If thefirm maintains a residual distribution policy (with all distributions in the form of

dividends) and will keep its optimal capital structure intact, what will be the amount of

the dividends it pays out after financing its capital budget?

a. $22.5 million

b. $59.4 million

c. $60.0 million

d. $30.0 million

e. $ 0

(17.7) Residual distribution policy Answer: c Diff: M

xliii. Your company has decided that its capital budget during the coming year will be $20

million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings

before interest and taxes (EBIT) are projected to be $34.667 million for the year. Thecompany has $200 million of assets; its average interest rate on outstanding debt is 10

percent; and its tax rate is 40 percent. If the company follows the residual distribution

policy (with all distributions in the form of dividends) and maintains the same capital

structure, what will its dividend payout ratio be?

a. 15% b. 20% c. 25% d. 30% e. 35%



(17.7) Residual distribution policy Answer: e Diff: M

xliv. Plato Inc. expects to have net income of $5,000,000 during the next year. Plato's target

capital structure is 35 percent debt and 65 percent equity. The company's director of

capital budgeting has determined that the optimal capital budget for the coming year is

$6,000,000. If Plato follows a residual distribution policy (with all distributions in theform of dividends) to determine the coming year’s dividend, then what is Plato's payout

ratio?

a. 38% b. 42% c. 58% d.33% e. None of the answers above is correct.

(17.7) Residual distribution and capital budget Answer: b Diff: M

xlv. Brock Brothers wants to maintain its capital structure that is 30 percent debt, and 70

percent equity. The company forecasts that its net income this year will be $1,000,000.

The company follows a residual distribution policy (with all distributions in the form of

dividends), and anticipates a dividend payout ratio of 40 percent. What is the size of the

company’s capital budget?

a. $ 600,000 b. $ 857,143 c. $1,000,000 d. $1,428,571 e. $2,000,000

(17.7) Residual distribution and capital budget Answer: d Diff: M

xlvi

. The following facts apply to your company:

Target capital structure: 50% debt; 50% equity.

EBIT: $200 million.

Assets: $500 million.

Tax rate: 40%.

Cost of new and old debt: 8%.

Based on the residual distribution policy (with all distributions in the form of dividends),the payout ratio is 60 percent. How large (in millions of dollars) will the capital budget

be?

a. $ 43.2 b. $ 50.0 c. $ 64.8 d. $ 86.4 e. $108.0



i. (17.3) Dividends versus capital gains Answer: d Diff: E ii. (17.3) Dividend theories Answer: e Diff: E

Statement e is true; the others are false. MM developed the dividend irrelevance theory.

Reducing the payout would have the effect of increasing the cost of equity if the bird-in-the-

hand theory holds. The tax preference theory suggests that a company can increase its stock

price by reducing its payout ratio. The residual distribution policy (with all distributions in the

form of dividends) should be followed to determine the long-run target payout ratio. If followed

year to year, dividends would fluctuate.

iii. (17.3) Dividend theory and policy Answer: c Diff: E

Statement c is correct; the others are false. The bird-in-the-handtheory implies that a company can reduce its WACC and increase its

stock price by increasing its dividend payout.

iv. (17.3) Optimal distribution policy Answer: e Diff: E

v. (17.6) Dividend payout Answer: a Diff: E

vi. (17.6) Dividend payout Answer: c Diff: E

vii. (17.13) Stock split Answer: e Diff: E

viii. (17.13) Stock split Answer: b Diff: E

With a 2-for-1 stock split, the price is (roughly) halved and thenumber of shares doubles.

ix. (17.14) Stock repurchases and DRIPs Answer: a Diff: E

Statement a is true. If a company repurchases stock instead of paying dividends, the existing shares will go

up in value. This capital gain is taxed at a lower rate than dividends, which are taxed at ordinary income

tax rates. Statement b is false. As soon as the dividend is paid, the taxes due are calculated. The IRS

doesn’t care if the investor reinvests them or buys a plane with them. Statement c is false. If a company

repurchases its stock, it reduces assets (it uses cash to buy back the shares) and reduces equity. The

amount of debt remains unchanged; however, since equity has decreased the proportion of debt

increases. Statement d is false. If a company believes the stock is overvalued, it will not repurchase shares

because it will end up paying too much for the shares. If the company has many profitable projects, it will

want to invest in those and not use its cash to repurchase shares. Statement e is false. An open-market

DRIP means that dividends are used to buy shares from someone else on the secondary market. The total

number of shares outstanding does not change.

x. (17.14) Dividends, DRIPs, and repurchases Answer: d Diff: E



Statement a is false; repurchases are taxed as capital gains. Statement b is false; investors still have to

pay income taxes on reinvested dividends. Statement c is false; an increase in dividends is usually a

positive signal. Statement d is true.

xi. (17.14) Repurchases, DRIPs, and stock splits Answer: e Diff: E

Dividend payments are taxed at the personal tax rate. Stock repurchases end up producing capital gains,

which are taxed at a lower rate than the personal tax rate. Therefore, statement a is false. Dividend

reinvestment plans (DRIPs) are not a way to circumvent the IRS. The company really paid a dividend,

which is taxed like ordinary income. You chose to reinvest it. The IRS doesn’t care whether you bought

more stock or bought a new car. You still receive the income and you still pay income taxes on it.

Therefore, statement b is false. If there is a 2-for-1 stock split, this means that for every share you used to

own, you now own two. In order for your net wealth to remain unchanged, the stock price would have to

fall by half, not double. Therefore, statement c is false. Since statements a, b, and c are false, the correct

choice is statement e.

xii. (Comp.) Miscellaneous dividend concepts Answer: c Diff: E

Statement c is correct; the others are false. If a 2-for-1 stock split

is initiated, a firm's stock price should decrease by one-half its

original price. Repurchases allow shareholders to obtain capital gains

by selling their stock, which are taxed at a lower rate than dividends.

Since repurchase announcements are viewed as positive signals by

investors, the stock price would tend to increase.

xiii. (17.14) Miscellaneous concepts Answer: e Diff: E

Statement e is the correct choice. The tax preference theory suggests

that individuals prefer capital gains to dividends due to the capital

gains preferential tax treatment. A residual dividend policy (with all

distributions in the form of dividends) leads to an unstable dividend

payment. The residual policy is used only to develop a long-run

dividend payout policy. A firm with a large number of investment

opportunities and a small amount of cash would have a low dividend

payout.

xiv. (17.3) MM dividend theory Answer: d Diff: M

xv. (17.3) Dividend theory Answer: a Diff: M

The dividend irrelevance theory is MM's theory, and states that dividend policy has no effect on

either the price of a firm's stock or its cost of capital. Therefore, the slope of a regression of

dividend yield and capital gains would equal -1.0. The tax preference theory prefers capitalgains to dividends, while the bird-in-the-hand (G-L) theory prefers dividends to capital gains.

The clientele effect assumes that investors are attracted to a firm's particular dividend payout

policy.



xvi

. (17.3) Dividend policy Answer: a Diff: M

Statement a is correct; the other statements are false. The clientele effect suggests that firms

should change dividend policies infrequently. The residual distribution policy (with all

distributions in the form of dividends) would make it difficult for investors to reliably predict

dividends and form clienteles.

xvii. (17.3) Dividends versus capital gains Answer: b Diff: M

xviii. (17.3) Theories of dividend preference Answer: a Diff: M

Statement a is correct because dividends are taxed immediately, but capital gains are taxed only

when the stock is sold; the other statements are false. The bird-in-the-hand theory states that

investors prefer dividends; therefore, if dividends are increased, the cost of equity decreases.

The signaling theory states that dividend decreases are "bad news", so stock price will decrease.

Paying a consistent percentage of net income will result in fluctuating dividends because netincome fluctuates. The clientele effect states that investors prefer a stock that has a high or low

steady dividend, but not a fluctuating one.

xix. (17.3) Miscellaneous dividend concepts Answer: a Diff: M

Firms often repurchase shares to enable them to change their capital structure more quickly

than they could do so normally. Also, firms repurchase shares to distribute cash to those

stockholders desiring to sell their stock. Stockholders receive capital gains, and long-term

capital gains are taxed at lower rates than cash dividends. Thus, for individuals in high-tax

brackets capital gains would be preferred to cash dividends. Consequently, tax considerationsplay a key role in the decision to repurchase stock versus to pay more cash dividends. The other

statements are false.

xx. (17.7) Residual distribution policy Answer: c Diff: M

Statement c is correct; the other statements are false. The residual dividend policy (with all

distributions in the form of dividends) implies that dividends should be paid only out of

“leftover” earnings. The sale of new stock implies that the firm has already used all retained

earnings. Therefore, no dividends would have been paid.

xxi. (17.7) Residual distribution policy Answer: b Diff: M

xxii. (17.14) Taxes, dividends, and DRIPs Answer: e Diff: M

Statement e is correct. New-stock DRIPs increase the equity of a firm. Investors receive new

shares with a stock dividend, but don't incur any taxes unless they sell the shares later for a gain.

Stockholders do pay taxes on dividends reinvested.



xxiii. (Comp.) Dividend policy Answer: b Diff: M

xxiv. (Comp.) Miscellaneous dividend concepts Answer: d Diff: M

xxv. (Comp.) Miscellaneous dividend concepts Answer: e Diff: M

Statement e is correct. An open-market dividend reinvestment plan buys existing shares in the

market. No new additional shares are issued. Stock repurchases increase financial leverage by

reducing equity. With a 2-for-1 split, a firm’s stock price would roughly halve.

xxvi. (Comp.) Miscellaneous dividend concepts Answer: a Diff: M

Statement a is correct; the other statements are false. A 3-for-1 split results in an increase in

the number of shares outstanding and a fall in the price per share. The firm would increase its

debt ratio by repurchasing some of its own shares.

xxvii. (Comp.) Miscellaneous dividend concepts Answer: d Diff: M

Statements b and c are correct; therefore, statement d is the correct choice. A dividend

increase leading to an increase in stock price is consistent with signaling also.

xxviii. (Comp.) Miscellaneous dividend concepts Answer: a Diff: M

The correct answer is a. Of the statements, only statement a will result in new equity for the

firm.

xxix. (Comp.) Stock repurchases and stock splits Answer: e Diff: M

xxx. (Comp.) Miscellaneous concepts Answer: b Diff: M

Statement a is false. Since Firm M has less business risk than N, it is likely to have a higher debt ratio than

N because M can take on more financial risk. Statement b is true. Firm M will have a higher dividend

payout ratio than N since it does not need the funds for investment. Statement c is false. If the corporate

tax rate increases, debt financing will become more attractive to both firms.

xxxi. (17.7) Residual distribution policy Answer: b Diff: E

The amount of new investment which must be financed with equity is:

$1,200,000 40% = $480,000. Since the firm has $600,000 of net income only $120,000 will be

left for dividends. This means the payout ratio is $120,000/$600,000 = 20%.



xxxii

. (17.7) Residual distribution policy Answer: e Diff: E

$5,000,000 0.3 = $1,500,000 of retained earnings needed to fund the capital budget.

$4,500,000 - $1,500,000 = $3,000,000 of net income available for dividends. Dividend payout

ratio = $3,000,000/$4,500,000 = 0.6667, or 66.67%.

xxxiii. (17.7) Residual distribution policy Answer: b Diff: E

Equity requirement = 0.6($1,200,000) = $720,000.

Expected NI $800,000

Equity requirement 720,000

Available for dividends $ 80,000

Payout ratio = $80,000/$800,000 = 0.10 = 10%.

xxxiv. (17.7) Residual distribution policy Answer: c Diff: E

Out of the $3 million capital budget, 65 percent must be funded by

equity, so (0.65)($3,000,000) = $1,950,000 of the capital budget must

be funded from retained earnings.

Earnings available to be paid out as dividends = $5,000,000 -$1,950,000 = $3,050,000.

Payout ratio = $3,050,000/$5,000,000 = 61%.

xxxv. (17.7) Residual distribution policy Answer: a Diff: E

Since the capital budget is $250M and the capital structure is 50%

equity and 50% debt, $125M of the capital budget will come from debt

and $125M will come from equity. Subtracting the $125M (needed for the

equity portion) from NI, leaves you with $375M to pay out as dividends.

$375/$500 is a 75% payout ratio.



xlii

. (17.7) Residual distribution policy Answer: a Diff: M

Calculate interest cost:

Total assets = $200M; 40% debt $200M = $80 million in debt.

Interest cost = $80M 0.10 = $8.0 million.

Calculate net income (in millions):

EBIT $98.0

less: Interest - 8.0

EBT $90.0

less: Taxes (@35%) - 31.5

Net income $58.5

Calculate portion of projects financed with retained earnings:

Capital budget calls for $60 million in positive NPV projects.

Retained earnings portion: $60M 0.60 = $36.0 million

Debt portion: $60M 0.40 = $24.0 million

Calculate residual available for dividends:

$58.5M - $36.0M = $22.5 million in dividends.



xliii

. (17.7) Residual distribution policy Answer: c Diff: M

Capital budget = $20 million.

Optimal capital structure: 60% equity, 40% debt.

EBIT = $34.667 million.

Assets = $200 million.

rd = 10%; T = 40%; Dividend Payout = ?

Debt = 0.40($200 million) = $80 million.

Interest = 0.10($80 million) = $8 million.

EBIT $34.667

Int 8.000

EBT $26.667

Taxes (40%) 10.667

NI $16.000

Capital Budget = $20 million.

Equity needed = 0.60($20 million) = $12 million.

NI $16

Equity needed 12

Amount remaining

for dividend $ 4

Dividend Payout = $4/$16 = 25%.



xliv

. (17.7) Residual distribution policy Answer: e Diff: M

If the firm's optimal capital budget requires $6,000,000 in financing, then, to stay at its target

capital structure, Plato will retain earnings of $6,000,000 0.65 = $3,900,000. This leaves

$5,000,000 - $3,900,000 = $1,100,000 available for dividends. Thus, Plato's payout ratio is

$1,100,000/$5,000,000 = 0.22 = 22%.

xlv. (17.7) Residual distribution and capital budget Answer: b Diff: M

Since the company expects to pay out 40 percent of net income or $400,000, it must expect to

have $600,000 of retained earnings available for capital investment. Given that the firm will

finance new investment with 70 percent equity and 30 percent debt, $600,000 must represent

70 percent of the firm's capital budget, that is, $600,000 = (0.7)CB or CB = $857,143.

xlvi. (17.7) Residual distribution and capital budget Answer: d Diff: M

Debt = 0.5(Assets) = 0.5($500) = $250 million.

Interest = 0.08($250) = $20 million.

EBT = EBIT - I

= $200 - $20 = $180.

NI = $180 - Taxes

= $180 - $180(0.4) = 0.6($180) = $108 million.

Dividends = $108(0.6) = $64.80 million.

Retained earnings = NI - D = $108.00 - $64.80 = $43.20 million.

Half of the capital budget will be debt, half common equity from retained earnings, so the

capital budget will be:

Capital budget =0.5

43.20 = $86.40 million.




INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND

FINANCIAL RESTRUCTURING

(18.2) Going public

1. Which of the following is generally NOT true and an advantage of going public?

a. Facilitates stockholder diversification.

b. Increases the liquidity of the firm's stock.

c. Makes it easier to obtain new equity capital.

d. Establishes a market value for the firm.

e. Makes it easier for owner-managers to engage in profitable self-dealings.

(18.2) Listing

2. Which of the following statements about listing on a stock exchange is most CORRECT?

a. Listing is a decision of more significance to a firm than going public.

b. Any firm can be listed on the NYSE as long as it pays the listing fee.

c. Listing provides a company with some "free" advertising, and it may enhance the firm's

prestige and help it do more business.

d. Listing reduces the reporting requirements for firms, because listed firms file reports with

the exchange rather than with the SEC.

e. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.



(18.5) Private placements

3. Which of the following statements is most CORRECT?

a. In a private placement, securities are sold to private (individual) investors rather than to

institutions.

b. Private placements occur most frequently with stocks, but bonds can also be sold in a

private placement.

c. Private placements are convenient for issuers, but the convenience is offset by higher

flotation costs.

d. The SEC requires that all private placements be handled by a registered investment banker.

e. Private placements can generally bring in funds faster than is the case with public offerings.

(18.8) Refunding decision4. Which of the following statements is most CORRECT?

a. If new debt is used to refund old debt, the correct discount rate to use in the refunding

analysis is the before-tax cost of new debt.

b. The key benefits associated with refunding debt are the reduction in the firm's debt ratio

and the creation of more reserve borrowing capacity.

c. The mechanics of finding the NPV of a refunding decision are fairly straightforward.

However, the decision of when to refund is not always clear because it requires a forecast of

future interest rates.

d. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the

firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low,

even though it actually refunds the debt after rates have risen.

e. Suppose a firm is considering refunding and interest rates rise during time when the analysis

is being done. The rise in rates would tend to lower the expected price of the new bonds,

which would make them cheaper to the firm and thus increase the expected interest

savings.



(18.8) Refunding decision

5. Which of the following factors would increase the likelihood that a company would call its

outstanding bonds at this time?

a. The yield to maturity on the company’s outstanding bonds increases due to a weakening of

the firm’s financial situation.

b. A provision in the bond indenture lowers the call price on specific dates, and yesterday was

one of those dates.

c. The flotation costs associated with issuing new bonds rise.

d. The firm’s CFO believes that interest rates are likely to decline in the future.

e. The firm’s CFO believes that corporate tax rates are likely to be increased in the future.

(Comp: 18.3,18.5) Investment banking process

6. Which of the following statements concerning common stock and the investment banking

process is NOT CORRECT?

a. The preemptive right gives each existing common stockholder the right to purchase his or

her proportionate share of a new stock issue.

b. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary

market.

c. Listing a large firm's stock is often considered to be beneficial to stockholders because the

increases in liquidity and reputation probably outweigh the additional costs to the firm.

d. Stockholders have the right to elect the firm's directors, who in turn select the officers who

manage the business. If stockholders are dissatisfied with management's performance, an

outside group may ask the stockholders to vote for it in an effort to take control of the

business. This action is called a tender offer.

e. The announcement of a large issue of new stock could cause the stock price to fall. This loss

is called "market pressure," and it is treated as a flotation cost because it is a cost to

stockholders that is associated with the new issue.



(Comp: 18.3,18.5) Investment banking process

7. Which of the following statements is NOT CORRECT?

a. When a corporation’s shares are owned by a few individuals who own most of the stock or are

part of the firm’s management, we say that the firm is “closely, or privately, held.”

b. “Going public” establishes a firm’s true intrinsic value and ensures that a liquid market will

always exist for the firm’s shares.

c. Publicly owned companies have sold shares to investors who are not associated with

management, and they must register with and report to a regulatory agency such as the SEC.

d. When stock in a closely held corporation is offered to the public for the first time, the

transaction is called “going public,” and the market for such stock is called the new issue market.

e. It is possible for a firm to go public and yet not raise any additional new capital.


Medium:

(18.3) Investment bankers compensation

8. Tuttle Buildings Inc. has decided to go public by selling $5,000,000 of new common stock. Its

investment bankers agreed to take a smaller fee now (6% of gross proceeds versus their normal

10%) in exchange for a 1-year option to purchase an additional 200,000 shares at $5.00 per

share. The investment bankers expect to exercise the option and purchase the 200,000 shares

in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is

a chance that the stock price will actually be $12.00 per share one year from now. If the $12

price occurs, what would the present value of the entire underwriting compensation be?

Assume that the investment banker's required return on such arrangements is 15%, and ignore

taxes.

a. $1,235,925

b. $1,300,973

c. $1,369,446

d. $1,441,522

e. $1,517,391



(18.5) Flotation costs

9. Europa Corporation is financing an ongoing construction project. The firm will need $5,000,000

of new capital during each of the next 3 years. The firm has a choice of issuing new debt or

equity each year as the funds are needed, or issue only debt now and equity later. Its target

capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years,

when the project has been completed. Debt flotation costs for a single debt issue would be

1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be

3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising

all of the debt now, in a single issue, rather than in 3 separate issues?

a. $79,425

b. $83,606

c. $88,006

d. $92,406

e. $97,027

(18.8) Refunding NPV

10. The City of Charleston issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-

exempt muni bonds 10 years ago. The bonds had 10 years of call protection, but now the bonds

can be called if the city chooses to do so. The call premium would be 6% of the face amount.

New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue

would be 2% of the amount of bonds sold. What is the net present value of the refunding?

Note that cities pay no income taxes, hence taxes are not relevant.

a. $453,443

b. $476,115

c. $499,921

d. $524,917

e. $551,163



(18.8) Refunding NPV

11. The State of Idaho issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt

bonds 5 years ago. The bonds had 5 years of call protection, but now the state can call the

bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year,

5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%.

What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are

not relevant.

a. $278,606 b. $292,536 c. $307,163 d. $322,521 e. $338,647

Tough:

(18.8) Refunding; breakeven interest rate

12. Thompson Enterprises has $5,000,000 of bonds outstanding. Each bond has a maturity value of

$1,000, an annual coupon of 12.0%, and 15 years left to maturity. The bonds can be called at

any time with a premium of $50 per bond. If the bonds are called, the company must pay

flotation costs of $10 per new refunding bond. Ignore tax considerations--assume that the

firm's tax rate is zero.

The company's decision of whether to call the bonds depends critically on the current interest

rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would

be profitable to call in the bonds?

a. 9.57% b. 10.07% c. 10.60% d. 11.16% e. 11.72%

(18.8) Breakeven rate for bond refunding

13. Rainier Bros. has 12.0% semiannual coupon bonds outstanding that mature in 10 years. Each

bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company

must replace them with new 10-year bonds. The flotation cost of issuing new bonds is

estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to

be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual

"breakeven rate"?

a. 9.29% b. 9.78% c. 10.29% d. 10.81% e. 11.35%



Multi-part:

(The following data apply to Problems 24 through 27. The problems MUST be kept together.)

New York Waste (NYW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-yearbond issue that was issued 5 years ago. It has been amortizing $3 million of flotation costs on these

bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest

rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and

flotation costs on the new issue would amount to $3 million. NYW's marginal tax rate is 40%. The new

bonds would be issued when the old bonds are called.

(18.8) Refunding investment outlay

14. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of

the refunding?

a. $5,049,939 b. $5,315,725 c. $5,595,500 d. $5,890,000 e. $6,200,000

(18.8) Refunding interest savings

15. What will the after-tax annual interest savings for NYW be if the refunding takes place?

a. $664,050 b. $699,000 c. $768,900 d. $845,790 e. $930,369

(18.8) Refunding flotation costs16. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What

will the net increase or decrease in the annual flotation cost tax savings be if refunding takes

place?

a. $6,480 b. $7,200 c. $8,000 d. $8,800 e. $9,680

(18.8) Refunding flotation costs

17. What is the NPV if NYW refunds its bonds today?

a. $1,746,987 b. $1,838,933 c. $1,935,719 d. $2,037,599 e. $2,241,359



1.(18.2) Going public Answer: e Diff: M

Publicly owned firms are regulated by the SEC, and this limits the sort of deals that the owner/managers of private companies can make with themselves.

2.(18.2) Listing Answer: c Diff: M

3.(18.5) Private placements Answer: e Diff: M

4.(18.8) Refunding decision Answer: c Diff: M

5.(18.8) Refunding decision Answer: b Diff: M

6.(Comp: 18.3,18.5) Investment banking process Answer: d Diff: M

7.(Comp: 18.3,18.5) Investment banking process Answer: b Diff: M

8.(18.3) Investment bankers compensation Answer: d Diff: M

Gross funds: $5,000,000 Current price: $5.00

Small fee: 6% Expected price: $6.50

Normal fee: 10% Possible price: $12.00

Option shares: 200,000 Required return: 15%

Fee received now =6% × $5,000,000 = $300,000

Additional fee: Option profit if the stock price is $12 in 1 year = ($12 – $5) 200,000 =

$1,400,000

PV of total compensation if $12 price = $300,000 + $1,400,000/(1.15)1 = $1,517,391

9.(18.5) Flotation costs Answer: c Diff: M

Flotation%, 3 issues: 3.0% Flotation %, 1 issue: 1.6%

Total funds needed = 3 $5,000,000 = $15,000,000

Total debt needed = 40% $15,000,000 = $6,000,000

Debt/year if use 3 separate issues = Total debt/3 = $2,000,000

Grossed-up debt if use a single issue = Net debt needed/(1 − F) = $6,000,000/(1 − 0.016) =

$6,097,561

Flotation cost for single issue: Gross debt − Proceeds to company = $97,561

Gross debt with 3 issues: Net debt needed/(1 − F) = $6,000,000/(1 − 0.03) = $6,185,567

Flotation cost for yearly issues: Gross debt − Proceeds to company = $185,567



Difference = Additional cost of 3 issues: $185,567 − $97,561 = $88,006

10.(18.8) Refunding NPV Answer: a Diff: M

Call premium: 6% Old rate: 8%

Flotation %: 2% New rate: 6%

Amount: $3,000,000 Years: 20

Cost of refunding:

Call premium = 6%($3,000,000) $180,000

Flotation cost = 2%($3,000,000) $ 60,000

Total investment outlay: $240,000

Interest on old bond per 6 months: $120,000

Interest on new bond per 6 months: $ 90,000

Savings per six months: $ 30,000

PV of savings, 40 periods @ new rate/2 = $693,443

NPV of refunding = PV of savings − Cost of refunding = $453,443




Amount: $2,000,000 Years: 15

Cost of refunding:

Call premium = 5% ($2,000,000) $100,000



Flotation cost = 2% ($2,000,000) $ 40,000


Interest on old bond per 6 months: Old rate/2 × Amount =$70,000

Interest on new bond per 6 months: New rate/2 × Amount =$50,000

Savings per six months: $20,000


NPV of refunding = PV of savings – Cost of refunding = $278,606

12.(18.8) Refunding; breakeven interest rate Answer: d Diff: T

Call premium: $50 Old rate: 12.0%

Flotation cost per bond: $10 Years to maturity: 15

Amount of issue: $5,000,000 Number of bonds: 5,000

Par value of bonds: $1,000

Cost of refunding:

Call premium per bond × number of bonds = $250,000

Flotation cost = $10 × Number of bonds issued = $ 50,000


Interest on old bond per year = Old rate × Amount = $600,000

If the company does not call the bonds, it will have to pay $600,000 per year for 15 years, plus

$5,000,000 at Year 15. If it goes ahead and calls the bonds, it will have to pay $300,000 +

$5,000,000 = $5,300,000 today. We can find the discount rate that equates these cash flows.

Here is the time line:



0 1 2 3 15

-300000 $600,000 $600,000 $600,000 $ 600,000

-5000000 $5,000,000

-5300000 600000 600000 600000 $5,600,000

If you enter these cash flows in the cash flow register of a calculator and then press the IRR key,

you will get the breakeven rate, which is 11.1583%, rounded to 11.16%. You can do the same

thing with Excel. Note that the annual savings at this lower rate would be (0.12 – 0.111583) ×

$5,000,000 = $42,084.78. The PV of that amount, discounted back for 15 years at 11.16%, is

$300,000.

13.(18.8) Breakeven rate for bond refunding Answer: c Diff: T

Call price of bonds: $1,060 Old rate: 12.0%


Par value of bonds: $1,000 Semiannual periods: 20

Cost of refunding:

Call price per bond: $1,060

Flotation cost per bond: $ 45



Total investment outlay per bond: $1,105

Interest on old bond per year = Old rate × Amount = $120

Interest per period: $60

If the company does not call the bonds, it will have to pay $60 for 20 periods, plus $1,000 at

Period 20. If it goes ahead and calls the bonds now, it will have to pay $1,060 + $45 = $1,105

today. We can find the discount rate that equates these cash flows. Here is the time line:

0 1 2 3 20

-$1,105 $60 $60 $60 $ 60

$1,000

-$1,105 $60 $60 $60 $1,060


you will get the breakeven rate, which is 5.1469%, rounded to 5.15%. You can do the same thing

with Excel. Note that the semiannual savings at this lower rate would be (0.12/2 − 0.051469) ×

$1,000 = $8.53. The PV of that amount, discounted back for 20 periods at 5.15%, is $105.00,

which is the cost of the refunding. The semiannual discount, when doubled, is the breakeven

nominal rate.

Required nominal annual rate to break even: 10.29%

14.(18.8) Refunding investment outlay Answer: e Diff: E

Amount: $50,000,000 Call premium %: 14%

Old rate: 14.00% Tax rate: 40%

Original life: 30 New rate: 11.67%

Years ago issued: 5 New life: 25

Orig. flotation cost: $3,000,000 New flotation cost: $3,000,000



Years remaining on old bond: 25

Old issue flotation costs:

Remaining unexpensed = (25/30)($3) = $2,500,000

Tax saving on unexpensed float cost = $2.5(T) = $2.5(0.4) =-1,000,000

After tax cost of call premium: 0.14($50)(0.6) = 4,200,000

Flotation costs on new issue: 3,000,000

Net after-tax cost to call the bonds: 6,200,000

15.(18.8) Refunding interest savings Answer: b Diff: E

Old interest: $50,000,000(0.14)(0.6) = $4,200,000

New interest: $50,000,000(0.1167)(0.6) = (3,501,000)

Net annual interest savings $699,000

16.(18.8) Refunding flotation costs Answer: c Diff: M

Flotation costs benefit, new: ($3.00/25)(0.4) = $48,000

Flotation costs lost, old: ($3.00/30)(0.4) = (40,000)

Net annual amortization tax effects = $ 8,000

17.(18.8) Refunding flotation costs Answer: d Diff: M

Appropriate discount rate = New bond cost × (1 − T) = 7.002%


Inputs: N = 25; I/YR = 7.0; PMT = 699,000 + 8,000 = 707,000; FV = 0.

Output: PV = -$8,237,599 = PV of savings =$8,237,599

Cost to refund = 6,200,000

NPV of the refunding = $2,037,599




INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND

FINANCIAL RESTRUCTURING

(18.2) Going public Answer: e Diff: M

1. Which of the following is generally NOT true and an advantage of going public?

a. Facilitates stockholder diversification.

b. Increases the liquidity of the firm's stock.

c. Makes it easier to obtain new equity capital.

d. Establishes a market value for the firm.

e. Makes it easier for owner-managers to engage in profitable self-dealings.

(18.2) Listing Answer: c Diff: M

2. Which of the following statements about listing on a stock exchange is most CORRECT?

a. Listing is a decision of more significance to a firm than going public.

b. Any firm can be listed on the NYSE as long as it pays the listing fee.

c. Listing provides a company with some "free" advertising, and it may enhance the firm's

prestige and help it do more business.

d. Listing reduces the reporting requirements for firms, because listed firms file reports with

the exchange rather than with the SEC.

e. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.



(18.5) Private placements Answer: e Diff: M


a. In a private placement, securities are sold to private (individual) investors rather than to

institutions.

b. Private placements occur most frequently with stocks, but bonds can also be sold in a

private placement.

c. Private placements are convenient for issuers, but the convenience is offset by higher

flotation costs.

d. The SEC requires that all private placements be handled by a registered investment banker.

e. Private placements can generally bring in funds faster than is the case with public offerings.

(18.8) Refunding decision Answer: c Diff: M4. Which of the following statements is most CORRECT?

a. If new debt is used to refund old debt, the correct discount rate to use in the refunding

analysis is the before-tax cost of new debt.

b. The key benefits associated with refunding debt are the reduction in the firm's debt ratio

and the creation of more reserve borrowing capacity.

c. The mechanics of finding the NPV of a refunding decision are fairly straightforward.

However, the decision of when to refund is not always clear because it requires a forecast of

future interest rates.

d. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the

firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low,

even though it actually refunds the debt after rates have risen.

e. Suppose a firm is considering refunding and interest rates rise during time when the analysis

is being done. The rise in rates would tend to lower the expected price of the new bonds,

which would make them cheaper to the firm and thus increase the expected interest

savings.



(18.8) Refunding decision Answer: b Diff: M

5. Which of the following factors would increase the likelihood that a company would call its

outstanding bonds at this time?

a. The yield to maturity on the company’s outstanding bonds increases due to a weakening of

the firm’s financial situation.

b. A provision in the bond indenture lowers the call price on specific dates, and yesterday was

one of those dates.

c. The flotation costs associated with issuing new bonds rise.

d. The firm’s CFO believes that interest rates are likely to decline in the future.

e. The firm’s CFO believes that corporate tax rates are likely to be increased in the future.

(Comp: 18.3,18.5) Investment banking process Answer: d Diff: M

6. Which of the following statements concerning common stock and the investment banking

process is NOT CORRECT?

a. The preemptive right gives each existing common stockholder the right to purchase his or

her proportionate share of a new stock issue.

b. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary

market.

c. Listing a large firm's stock is often considered to be beneficial to stockholders because the

increases in liquidity and reputation probably outweigh the additional costs to the firm.

d. Stockholders have the right to elect the firm's directors, who in turn select the officers who

manage the business. If stockholders are dissatisfied with management's performance, an

outside group may ask the stockholders to vote for it in an effort to take control of the

business. This action is called a tender offer.

e. The announcement of a large issue of new stock could cause the stock price to fall. This loss

is called "market pressure," and it is treated as a flotation cost because it is a cost to

stockholders that is associated with the new issue.



(Comp: 18.3,18.5) Investment banking process Answer: b Diff: M

7. Which of the following statements is NOT CORRECT?

a. When a corporation’s shares are owned by a few individuals who own most of the stock or are

part of the firm’s management, we say that the firm is “closely, or privately, held.”

b. “Going public” establishes a firm’s true intrinsic value and ensures that a liquid market will

always exist for the firm’s shares.

c. Publicly owned companies have sold shares to investors who are not associated with

management, and they must register with and report to a regulatory agency such as the SEC.

d. When stock in a closely held corporation is offered to the public for the first time, the

transaction is called “going public,” and the market for such stock is called the new issue market.

e. It is possible for a firm to go public and yet not raise any additional new capital.


Medium:

(18.3) Investment bankers compensation Answer: e Diff: M

8. Tuttle Buildings Inc. has decided to go public by selling $5,000,000 of new common stock. Its

investment bankers agreed to take a smaller fee now (6% of gross proceeds versus their normal

10%) in exchange for a 1-year option to purchase an additional 200,000 shares at $5.00 per

share. The investment bankers expect to exercise the option and purchase the 200,000 shares

in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is

a chance that the stock price will actually be $12.00 per share one year from now. If the $12

price occurs, what would the present value of the entire underwriting compensation be?

Assume that the investment banker's required return on such arrangements is 15%, and ignore

taxes.

a. $1,235,925

b. $1,300,973

c. $1,369,446

d. $1,441,522

e. $1,517,391



(18.5) Flotation costs Answer: c Diff: M

9. Europa Corporation is financing an ongoing construction project. The firm will need $5,000,000

of new capital during each of the next 3 years. The firm has a choice of issuing new debt or

equity each year as the funds are needed, or issue only debt now and equity later. Its target

capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years,

when the project has been completed. Debt flotation costs for a single debt issue would be

1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be

3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising

all of the debt now, in a single issue, rather than in 3 separate issues?

a. $79,425

b. $83,606

c. $88,006

d. $92,406

e. $97,027

(18.8) Refunding NPV Answer: a Diff: M

10. The City of Charleston issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-

exempt muni bonds 10 years ago. The bonds had 10 years of call protection, but now the bonds

can be called if the city chooses to do so. The call premium would be 6% of the face amount.

New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue

would be 2% of the amount of bonds sold. What is the net present value of the refunding?

Note that cities pay no income taxes, hence taxes are not relevant.

a. $453,443

b. $476,115

c. $499,921

d. $524,917

e. $551,163



(18.8) Refunding NPV Answer: a Diff: M

11. The State of Idaho issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt

bonds 5 years ago. The bonds had 5 years of call protection, but now the state can call the

bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year,

5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%.

What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are

not relevant.

a. $278,606 b. $292,536 c. $307,163 d. $322,521 e. $338,647

Tough:

(18.8) Refunding; breakeven interest rate Answer: d Diff: T

12. Thompson Enterprises has $5,000,000 of bonds outstanding. Each bond has a maturity value of

$1,000, an annual coupon of 12.0%, and 15 years left to maturity. The bonds can be called at

any time with a premium of $50 per bond. If the bonds are called, the company must pay

flotation costs of $10 per new refunding bond. Ignore tax considerations--assume that the

firm's tax rate is zero.

The company's decision of whether to call the bonds depends critically on the current interest

rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would

be profitable to call in the bonds?

a. 9.57% b. 10.07% c. 10.60% d. 11.16% e. 11.72%

(18.8) Breakeven rate for bond refunding Answer: c Diff: T

13. Rainier Bros. has 12.0% semiannual coupon bonds outstanding that mature in 10 years. Each

bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company

must replace them with new 10-year bonds. The flotation cost of issuing new bonds is

estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to

be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual

"breakeven rate"?

a. 9.29% b. 9.78% c. 10.29% d. 10.81% e. 11.35%



Multi-part:

(The following data apply to Problems 24 through 27. The problems MUST be kept together.)

New York Waste (NYW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-yearbond issue that was issued 5 years ago. It has been amortizing $3 million of flotation costs on these

bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest

rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and

flotation costs on the new issue would amount to $3 million. NYW's marginal tax rate is 40%. The new

bonds would be issued when the old bonds are called.

(18.8) Refunding investment outlay Answer: e Diff: E

14. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of

the refunding?

a. $5,049,939 b. $5,315,725 c. $5,595,500 d. $5,890,000 e. $6,200,000

(18.8) Refunding interest savings Answer: b Diff: E

15. What will the after-tax annual interest savings for NYW be if the refunding takes place?

a. $664,050 b. $699,000 c. $768,900 d. $845,790 e. $930,369

(18.8) Refunding flotation costs Answer: c Diff: M16. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What

will the net increase or decrease in the annual flotation cost tax savings be if refunding takes

place?

a. $6,480 b. $7,200 c. $8,000 d. $8,800 e. $9,680

(18.8) Refunding flotation costs Answer: d Diff: M

17. What is the NPV if NYW refunds its bonds today?

a. $1,746,987 b. $1,838,933 c. $1,935,719 d. $2,037,599 e. $2,241,359



1.(18.2) Going public Answer: e Diff: M

Publicly owned firms are regulated by the SEC, and this limits the sort of deals that the owner/managers of private companies can make with themselves.

2.(18.2) Listing Answer: c Diff: M

3.(18.5) Private placements Answer: e Diff: M

4.(18.8) Refunding decision Answer: c Diff: M

5.(18.8) Refunding decision Answer: b Diff: M

6.(Comp: 18.3,18.5) Investment banking process Answer: d Diff: M

7.(Comp: 18.3,18.5) Investment banking process Answer: b Diff: M

8.(18.3) Investment bankers compensation Answer: d Diff: M

Gross funds: $5,000,000 Current price: $5.00

Small fee: 6% Expected price: $6.50

Normal fee: 10% Possible price: $12.00

Option shares: 200,000 Required return: 15%

Fee received now =6% × $5,000,000 = $300,000

Additional fee: Option profit if the stock price is $12 in 1 year = ($12 – $5) 200,000 =

$1,400,000

PV of total compensation if $12 price = $300,000 + $1,400,000/(1.15)1 = $1,517,391

9.(18.5) Flotation costs Answer: c Diff: M

Flotation%, 3 issues: 3.0% Flotation %, 1 issue: 1.6%

Total funds needed = 3 $5,000,000 = $15,000,000

Total debt needed = 40% $15,000,000 = $6,000,000

Debt/year if use 3 separate issues = Total debt/3 = $2,000,000

Grossed-up debt if use a single issue = Net debt needed/(1 − F) = $6,000,000/(1 − 0.016) =

$6,097,561

Flotation cost for single issue: Gross debt − Proceeds to company = $97,561

Gross debt with 3 issues: Net debt needed/(1 − F) = $6,000,000/(1 − 0.03) = $6,185,567

Flotation cost for yearly issues: Gross debt − Proceeds to company = $185,567



Difference = Additional cost of 3 issues: $185,567 − $97,561 = $88,006




Amount: $3,000,000 Years: 20

Cost of refunding:

Call premium = 6%($3,000,000) $180,000

Flotation cost = 2%($3,000,000) $ 60,000


Interest on old bond per 6 months: $120,000

Interest on new bond per 6 months: $ 90,000

Savings per six months: $ 30,000


NPV of refunding = PV of savings − Cost of refunding = $453,443




Amount: $2,000,000 Years: 15

Cost of refunding:

Call premium = 5% ($2,000,000) $100,000



Flotation cost = 2% ($2,000,000) $ 40,000


Interest on old bond per 6 months: Old rate/2 × Amount =$70,000

Interest on new bond per 6 months: New rate/2 × Amount =$50,000

Savings per six months: $20,000


NPV of refunding = PV of savings – Cost of refunding = $278,606

12.(18.8) Refunding; breakeven interest rate Answer: d Diff: T

Call premium: $50 Old rate: 12.0%


Amount of issue: $5,000,000 Number of bonds: 5,000

Par value of bonds: $1,000

Cost of refunding:

Call premium per bond × number of bonds = $250,000

Flotation cost = $10 × Number of bonds issued = $ 50,000


Interest on old bond per year = Old rate × Amount = $600,000

If the company does not call the bonds, it will have to pay $600,000 per year for 15 years, plus

$5,000,000 at Year 15. If it goes ahead and calls the bonds, it will have to pay $300,000 +

$5,000,000 = $5,300,000 today. We can find the discount rate that equates these cash flows.

Here is the time line:



0 1 2 3 15

-300000 $600,000 $600,000 $600,000 $ 600,000

-5000000 $5,000,000

-5300000 600000 600000 600000 $5,600,000


you will get the breakeven rate, which is 11.1583%, rounded to 11.16%. You can do the same

thing with Excel. Note that the annual savings at this lower rate would be (0.12 – 0.111583) ×

$5,000,000 = $42,084.78. The PV of that amount, discounted back for 15 years at 11.16%, is

$300,000.

13.(18.8) Breakeven rate for bond refunding Answer: c Diff: T

Call price of bonds: $1,060 Old rate: 12.0%


Par value of bonds: $1,000 Semiannual periods: 20

Cost of refunding:

Call price per bond: $1,060

Flotation cost per bond: $ 45



Total investment outlay per bond: $1,105

Interest on old bond per year = Old rate × Amount = $120

Interest per period: $60

If the company does not call the bonds, it will have to pay $60 for 20 periods, plus $1,000 at

Period 20. If it goes ahead and calls the bonds now, it will have to pay $1,060 + $45 = $1,105

today. We can find the discount rate that equates these cash flows. Here is the time line:

0 1 2 3 20

-$1,105 $60 $60 $60 $ 60

$1,000

-$1,105 $60 $60 $60 $1,060


you will get the breakeven rate, which is 5.1469%, rounded to 5.15%. You can do the same thing

with Excel. Note that the semiannual savings at this lower rate would be (0.12/2 − 0.051469) ×

$1,000 = $8.53. The PV of that amount, discounted back for 20 periods at 5.15%, is $105.00,

which is the cost of the refunding. The semiannual discount, when doubled, is the breakeven

nominal rate.

Required nominal annual rate to break even: 10.29%

14.(18.8) Refunding investment outlay Answer: e Diff: E

Amount: $50,000,000 Call premium %: 14%

Old rate: 14.00% Tax rate: 40%

Original life: 30 New rate: 11.67%

Years ago issued: 5 New life: 25

Orig. flotation cost: $3,000,000 New flotation cost: $3,000,000



Years remaining on old bond: 25

Old issue flotation costs:

Remaining unexpensed = (25/30)($3) = $2,500,000

Tax saving on unexpensed float cost = $2.5(T) = $2.5(0.4) =-1,000,000

After tax cost of call premium: 0.14($50)(0.6) = 4,200,000

Flotation costs on new issue: 3,000,000

Net after-tax cost to call the bonds: 6,200,000

15.(18.8) Refunding interest savings Answer: b Diff: E

Old interest: $50,000,000(0.14)(0.6) = $4,200,000

New interest: $50,000,000(0.1167)(0.6) = (3,501,000)

Net annual interest savings $699,000

16.(18.8) Refunding flotation costs Answer: c Diff: M

Flotation costs benefit, new: ($3.00/25)(0.4) = $48,000

Flotation costs lost, old: ($3.00/30)(0.4) = (40,000)

Net annual amortization tax effects = $ 8,000

17.(18.8) Refunding flotation costs Answer: d Diff: M

Appropriate discount rate = New bond cost × (1 − T) = 7.002%


Inputs: N = 25; I/YR = 7.0; PMT = 699,000 + 8,000 = 707,000; FV = 0.

Output: PV = -$8,237,599 = PV of savings =$8,237,599

Cost to refund = 6,200,000

NPV of the refunding = $2,037,599



Chapter 19: Lease Financing Page 1

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

or in part.


LEASE FINANCING


Easy:

(19.4) Lease cash flows

1. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the

residual value, is about the same as the riskiness of the lessee's

a. equity cash flows.

b. capital budgeting project cash flows.

c.

debt

cash

flows.

d. pension fund cash flows.

e. sales.

Medium:

(19.1) Operating lease

2. Operating leases often have terms that include

a. maintenance of the equipment by the lessor.

b. full amortization over the life of the lease.

c. very high penalties if the lease is cancelled.

d. restrictions on how much the leased property can be used.

e. much longer lease periods than for most financial leases.





or in part.

(19.1) Leasing


a. Firms that use "off balance sheet" financing, such as leasing, would show lower debt ratios if

the effects of their leases were reflected in their financial statements.

b. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital

structure, in an amount sufficient to support the lease payment obligation.

c. The fixed charges associated with a lease can be as high as, but never greater than, the fixed

payments associated with a loan.

d. Capital, or financial, leases generally provide for maintenance by the lessor.

e. A key difference between a capital lease and an operating lease is that with a capital lease,

the lease payments provide the lessor with a return of the funds invested in the asset plus a

return

on

the

invested

funds,

whereas

with

an

operating

lease

the

lessor

depends

on

the

residual value to realize a full return of and on the investment.

(19.3) Capitalizing leases

4. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit

report, financial (or capital) leases must be included in the balance sheet by reporting the

a. residual value as a fixed asset.

b. residual value as a liability.

c. present value of future lease payments as an asset and also showing this same amount as an

offsetting liability.

d. undiscounted sum of future lease payments as an asset and as an offsetting liability.

e. undiscounted sum of future lease payments, less the residual value, as an asset and as an






or in part.

d. is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at

the WACC.

e. is financed with retained earnings.





or in part.


Easy:

(19.4) Difference in payments

1

.

Sutton

Corporation,

which

has

a

zero

tax

rate

due

to

tax

loss

carry‐

forwards,

is

considering

a

5‐

year, $6,000,000 bank loan to finance service equipment. The loan has an interest rate of 10%

and would be amortized over 5 years, with 5 end‐of ‐year payments. Sutton can also lease the

equipment for 5 end‐of ‐year payments of $1,790,000 each. How much larger or smaller is the

bank loan payment than the lease payment? Note: Subtract the loan payment from the lease

payment.

a. $177,169 b. $196,854 c. $207,215 d. $217,576 e. $228,455

Medium:

(19.4) Net

advantage

to

leasing

(NAL)

2. Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it

needs for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will

depreciate the cost of the tools on a straight‐line basis over their 3‐year life. It can borrow

$4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end‐of ‐year

lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3‐year

simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual

maintenance costs associated with ownership are estimated at $240,000, but this cost would be

borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands?

(Suggestion: Delete 3 zeros from dollars and work in thousands.)

a. $96 b. $106 c. $112 d. $117 e. $123





or in part.

Tough:

(19.4) Lessee's analysis

3. Dakota Trucking Company (DTC) is evaluating a potential lease for a truck with a 4‐year life that

costs $40,000 and falls into the MACRS 3‐year class. If the firm borrows and buys the truck, the

loan rate

would

be

10%,

and

the

loan

would

be

amortized

over

the

truck’s

4‐year

life,

so

the

interest expense for taxes would decline over time. The loan payments would be made at the

end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an

estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance

contract that costs $1,000 per year, payable at the end of each year. The lease terms, which

include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of

each year. DTC's tax rate is 40%. Should the firm lease or buy? (Note: MACRS rates for Years 1

to 4 are 0.33, 0.45, 0.15, and 0.07.)

a. $849 b. $896 c. $945 d. $997 e. $1,047

(19.4) Lessee's analysis

4. Buster’s Beverages is negotiating a lease on a new piece of equipment that would cost $100,000

if purchased. The equipment falls into the MACRS 3‐year class, and it would be used for 3 years

and then sold, because the firm plans to move to a new facility at that time. The estimated

value of the equipment after 3 years is $30,000. A maintenance contract on the equipment

would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could

lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the

beginning of each year. The lease would include maintenance. The firm is in the 20% tax

bracket, and it could obtain a 3‐year simple interest loan, interest payable at the end of the

year, to

purchase

the

equipment

at

a before

‐tax

cost

of

10%.

If

there

is

a positive

Net

Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the

NAL?

a. $5,736 b. $6,023 c. $6,324 d. $6,640 e. $6,972




© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in wholeor in part.


LEASE FINANCING


Easy:

(19.4) Lease cash flows Answer: c Diff: E

1. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the

residual value, is about the same as the riskiness of the lessee's

a. equity cash flows.

b. capital budgeting project cash flows.

c. debt cash flows.

d. pension fund cash flows.

e. sales.

Medium:

(19.1) Operating lease Answer: a Diff: M

2. Operating leases often have terms that include

a. maintenance of the equipment by the lessor.

b. full amortization over the life of the lease.

c. very high penalties if the lease is cancelled.

d. restrictions on how much the leased property can be used.

e. much longer lease periods than for most financial leases.





(19.1) Leasing Answer: e Diff: M


a. Firms that use "off balance sheet" financing, such as leasing, would show lower debt ratios if

the effects of their leases were reflected in their financial statements.

b. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital

structure, in an amount sufficient to support the lease payment obligation.

c. The fixed charges associated with a lease can be as high as, but never greater than, the fixed

payments associated with a loan.

d. Capital, or financial, leases generally provide for maintenance by the lessor.

e. A key difference between a capital lease and an operating lease is that with a capital lease,

the lease payments provide the lessor with a return of the funds invested in the asset plus a

return on the invested funds, whereas with an operating lease the lessor depends on theresidual value to realize a full return of and on the investment.

(19.3) Capitalizing leases Answer: c Diff: M

4. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit

report, financial (or capital) leases must be included in the balance sheet by reporting the

a. residual value as a fixed asset.

b. residual value as a liability.

c. present value of future lease payments as an asset and also showing this same amount as an


d. undiscounted sum of future lease payments as an asset and as an offsetting liability.

e. undiscounted sum of future lease payments, less the residual value, as an asset and as an






(19.3) Off-balance sheet leasing Answer: b Diff: M

5. Heavy use of off-balance sheet lease financing will tend to

a. make a company appear more risky than it actually is because its stated debt ratio will be

increased.

b. make a company appear less risky than it actually is because its stated debt ratio will appear

lower.

c. affect a company's cash flows but not its degree of risk.

d. have no effect on either cash flows or risk because the cash flows are already reflected in the

income statement.

e. affect the lessee’s cash flows but only due to tax effects.

(19.4) Lease decision Answer: e Diff: M

6. In the lease versus buy decision, leasing is often preferable

a. because it has no effect on the firm's ability to borrow to make other investments.

b. because, generally, no down payment is required, and there are no indirect interest costs.

c. because lease obligations do not affect the firm’s risk as seen by investors.

d. because the lessee owns the property at the end of the least term.

e. because the lessee may have greater flexibility in abandoning the project in which the leased

property is used than if the lessee bought and owned the asset.

(19.4) Lease analysis discount rate Answer: c Diff: M

7. A lease versus purchase analysis should compare the cost of leasing to the cost of owning,

assuming that the asset purchased

a. is financed with short-term debt.

b. is financed with long-term debt.

c. is financed with debt whose maturity matches the term of the lease.





d. is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at

the WACC.

e. is financed with retained earnings.






Easy:

(19.4) Difference in payments Answer: c Diff: E

1

. Sutton Corporation, which has a zero tax rate due to tax loss carry-forwards, is considering a 5-year, $6,000,000 bank loan to finance service equipment. The loan has an interest rate of 10%

and would be amortized over 5 years, with 5 end-of-year payments. Sutton can also lease the

equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the

bank loan payment than the lease payment? Note: Subtract the loan payment from the lease

payment.

a. $177,169 b. $196,854 c. $207,215 d. $217,576 e. $228,455

Medium:

(19.4) Net advantage to leasing (NAL) Answer: b Diff: M2. Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it

needs for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will

depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow

$4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year

lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year

simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual

maintenance costs associated with ownership are estimated at $240,000, but this cost would be

borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands?

(Suggestion: Delete 3 zeros from dollars and work in thousands.)

a. $96 b. $106 c. $112 d. $117 e. $123





Tough:

(19.4) Lessee's analysis Answer: d Diff: T

3. Dakota Trucking Company (DTC) is evaluating a potential lease for a truck with a 4-year life that

costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the

loan rate would be 10%, and the loan would be amortized over the truck’s 4-year life, so theinterest expense for taxes would decline over time. The loan payments would be made at the

end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an

estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance

contract that costs $1,000 per year, payable at the end of each year. The lease terms, which

include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of

each year. DTC's tax rate is 40%. Should the firm lease or buy? (Note: MACRS rates for Years 1

to 4 are 0.33, 0.45, 0.15, and 0.07.)

a. $849 b. $896 c. $945 d. $997 e. $1,047

(19.4) Lessee's analysis Answer: a Diff: T

4. Buster’s Beverages is negotiating a lease on a new piece of equipment that would cost $100,000

if purchased. The equipment falls into the MACRS 3-year class, and it would be used for 3 years

and then sold, because the firm plans to move to a new facility at that time. The estimated

value of the equipment after 3 years is $30,000. A maintenance contract on the equipment

would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could

lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the

beginning of each year. The lease would include maintenance. The firm is in the 20% tax

bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the

year, to purchase the equipment at a before-tax cost of 10%. If there is a positive NetAdvantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the

NAL?

a. $5,736 b. $6,023 c. $6,324 d. $6,640 e. $6,972





1.(19.4) Lease cash flows Answer: c Diff: E

2.(19.1) Operating lease Answer: a Diff: M

3.

(19.1) Leasing Answer: e Diff: M4.(19.3) Capitalizing leases Answer: c Diff: M

5.(19.3) Off-balance sheet leasing Answer: b Diff: M

6.(19.4) Lease decision Answer: e Diff: M

7.(19.4) Lease analysis discount rate Answer: c Diff: M

1.(19.4) Difference in payments Answer: c Diff: E

Years: 5

Loan amount:$6,000,000

Interest rate: 10.0%

Lease Pmt: $1,790,000

0 1 2 3 4 5

Loan: -$6,000,000 PMT PMT PMT PMT PMT

Find the loan payment: Financial calculator solution:

Inputs: N = 5; I/YR = 10; PV = -6,000,000; FV = 0.

Output = PMT = $1,582,785





Difference in payments = $1,790,000 – $1,582,785 = $207,215.

2.(19.4) Net advantage to leasing (NAL) Answer: b Diff: M

Years: 3 Tax rate: 40%

Loan amount = equipment cost: $4,800 Maintenance costs: $240

Interest rate: 10.0% Salvage value: $0

Lease Pmt: $2,100

After tax cost of debt = Rate × (1 − T) = 6.0%

Depreciation per year = Cost/3 = $1,600

Tax saving from deprn = Deprn × T = $640

0 1 2 3

Cost of owning:

Interest -480 -480 -480

Interest tax saving 192 192 192

Maintenance -240 -240 -240

Maintenance tax saving 96 96 96

Deprn tax saving 640 640 640

Repayment of loan -4,800

Net cash loan costs 208 208 -4,592





PV cost of owning (6%): -3,474

Cost of leasing:

Lease payment -2,100 -2,100 -2,100

Tax savings from lease 840 840 840

Net cash lease costs -1,260 -1,260 -1,260

PV cost of leasing (6%): -3,368

NAL = PV Cost of Owning − PV Cost of Leasing = $106.

3.(19.4) Lessee's analysis Answer: d HARD

Life of equipment: 4 Tax rate: 40%

Loan amount = equipment cost: $40,000 Maintenance costs: $1,000

Interest rate: 10.0% Salvage value: $10,000

Lease Pmt: $10,000





Loan amortization for cash payment and interest expense:

Payment: N = 4, I/YR = 10, PV = 40000, FV = 0. PMT = -$12,618.83

Year Beg. Bal. PMT Interest Principal Ending Bal.

1 40,000 12,619 4,000 8,619 31,381

2 31,381 12,619 3,138 9,481 21,900

3 21,900 12,619 2,190 10,429 11,472

4 11,472 12,619 1,147 11,472 0

Loan Analysis: 0 1 2 3 4

MACRS factor 0.33 0.45 0.15 0.07

Depreciation 13,200 18,000 6,000 2,800

Loan Pmt -12,619 -12,619 -12,619 -12,619

Int tax saving (Int. from table T)) 1,600 1,255 876 459

Maintenance -1,000 -1,000 -1,000 -1,000

Maint. tax saving (Maint. T) 400 400 400 400

Depr'n tax saving (Deprn T) 5,280 7,200 2,400 1,120

Net operating CF -6,339 -4,764 -9,943 -11,640

Salvage value 10,000

Tax on residual -4,000





Net residual val 6,000

Total Net CF -6,339 -4,764 -9,943 -5,640

PV cost of buying at I(1 – T) = 6.00%-23,035

Lease Analysis: 0 1 2 3 4

Lease payment -10,000 -10,000 -10,000 -10,000 0

Tax saving on pmt 4,000 4,000 4,000 4,000 0

Net cost of lease -6,000 -6,000 -6,000 -6,000 0

PV cost of leasing at I(1 – T) -22,038

NAL = $997





4.(19.4) Lessee's analysis Answer: a HARD

Life of equipment: 3 Tax rate: 20%

Loan amount = equipment cost:$100,000 Maintenance costs: $3,000

Interest rate, simple: 10.0% Salvage value: $30,000

Lease Pmt: $29,000

Loan Analysis: 0 1 2 3 Totals

MACRS factor 0.33 0.45 0.15 0.93

Depreciation 33,000 45,000 15,000 93,000

Loan repayment -100,000

Interest -10,000 -10,000 -10,000

Int tax saving (Interest T)) 2,000 2,000 2,000

Maintenance -3,000 -3,000 -3,000

Maint. tax saving (Maint. T) 600 600 600

Depr'n tax saving (Deprn T) 6,600 9,000 3,000

Net operating CF -2,400 -3,800 -1,400 -105,000





Salvage value before taxes 30,000

Book value (Cost − Total dep'rn) 7,000

Taxable salvage value 23,000

Tax on salvage value -4,600

Salvage value after taxes 25,400

Total Net CF - 2,400 -3,800 -1,400 -79,600

PV cost at I(1 − T) = 8.00% -70,308

Lease Analysis: 0 1 2 3

Lease payment -29,000 -29,000 -29,000

Tax saving on pmt 5,800 5,800 5,800 0

Net cost of lease -23,200 -23,200 -23,200 0

PV cost of leasing at I(1 − T) -64,572

NAL = $5,736




WORKING CAPITAL MANAGEMENT


Easy:

(21.1) Cash conversion cycle

1. Helena Furnishings wants to sharply reduce its cash conversion cycle. Which of the

following steps would reduce its cash conversion cycle?

a. The company increases its average inventory without increasing its sales.

b. The company reduces its DSO.

c. The company starts paying its bills sooner, which reduces its average accounts payable without reducing its sales.



(21.2) Working capital

2. Other things held constant, which of the following will cause an increase in working

capital?

a. Cash is used to buy marketable securities.

b. A cash dividend is declared and paid.

c. Merchandise is sold at a profit, but the sale is on credit.

d. Long-term bonds are retired with the proceeds of a preferred stock issue.

e. Missing inventory is written off against retained earnings.



(21.4) Cash budget

3. Which of the following is typically part of the cash budget?

a. Payments lag.

b. Payment for plant construction.

c. Cumulative cash.



(21.4) Cash budget

4. Which of the following statements concerning the cash budget is correct?

a. Depreciation expense is not explicitly included, but depreciation effects are implicitly

included in estimated tax payments.

b. Cash budgets do not include financial expenses such as interest and dividend

payments.

c. Cash budgets do not include cash inflows from long-term sources such as bond issues.



(21.4) Cash budget

5. Which of the following items should a company explicitly include in its monthly cash

budget?

a. Its monthly depreciation expense. b. Its cash proceeds from selling one of its divisions.c. Interest paid on its bank loans.

d.

Statements b and c are correct.e. All of the statements above are correct.



(21.5) Cash management

6. Which of the following statements is most correct?

a. A cash management system which minimizes collections float and maximizes

disbursement float is better than one with higher collections float and lower

disbursement float.

b. A cash management system which maximizes collections float and minimizes

disbursement float is better than one with lower collections float and higher

disbursement float.

c. The use of a lockbox is designed to minimize cash theft losses. If the cost of the

lockbox is less than theft losses saved, then the lockbox should be installed.

d. Other things held constant, a firm will need an identical line of credit if it can arrange

to pay its bills by the 5th of each month than if its bills come due uniformly during

the month.




a. A good cash management system would minimize disbursement float and maximize

collections float.

b. If a firm begins to use a well-designed lockbox system, this will reduce its customers'

net float.

c. In the early 1980's, the prime interest rate hit a high of 21 percent. In 1995 the prime

rate was considerably lower. That sharp interest rate decline has increased firms'

concerns about the efficiency of their cash management programs.

d. If a firm can get its customers to permit it to pay by wire transfers rather than having

to write checks, this will increase its net float and thus reduce its required cash

balances.

e. A firm which has such an efficient cash management system that it has positive net

float can have a negative checkbook balance at most times and still not have its

checks bounce.



(21.5) Lockbox

8. A lockbox plan is

a. A method for safe-keeping of marketable securities.

b. Used to identify inventory safety stocks.

c. A system for slowing down the collection of checks written by a firm.

d. A system for speeding up a firm's collections of checks received.

e. Not described by any of the statements above.

(21.6) Inventory management

9. Which of the following might be attributed to efficient inventory management?

a. High inventory turnover ratio.

b. Low incidence of production schedule disruptions.

c. High total assets turnover.



(21.7) Monitoring receivables

10. Analyzing days sales outstanding (DSO) and the aging schedule are two common

methods for monitoring receivables. However, they can provide erroneous signals to

credit managers when

a. Customers’ payments patterns are changing.

b. Sales fluctuate seasonally.

c. Some customers take the discount and others do not.

d. Sales are relatively constant, either seasonally or cyclically.




(21.7) Credit policy

11. Which of the following is not commonly regarded as being a credit policy variable?

a. Credit period.

b. Collection policy.

c. Credit standards.

d. Cash discounts.

e. All of the statements above are credit policy variables.


12. If easing a firm’s credit policy lengthens the collection period and results in a worsening

of the aging schedule, then why do firms take such actions?

a. It normally stimulates sales.

b. To meet competitive pressures.

c. To increase the firm’s deferral period for payables.



(21.9) Working capital financing policy

13. Firms generally choose to finance temporary net operating working capital with short-

term debt because

a. Matching the maturities of assets and liabilities reduces risk.

b. Short-term interest rates have traditionally been more stable than long-term interest

rates.

c. A firm that borrows heavily long-term is more apt to be unable to repay the debt than

a firm that borrows heavily short-term.

d. The yield curve has traditionally been downward sloping.

e. Sales remain constant over the year, and financing requirements also remain constant.



(21.9) Working capital financing


a. Trade credit is provided to a business only when purchases are made.

b. Commercial paper is a form of short-term financing that is primarily used by large,

financially stable companies.

c. Short-term debt, while often cheaper than long-term debt, exposes a firm to the

potential problems associated with rolling over loans.



(21.9) Working capital financing

15. Which of the following statements is incorrect ?

a. Commercial paper can be issued by virtually any firm so long as it is willing to pay

the going interest rate.

b. Accruals are “free” in the sense that no explicit interest is paid on these funds.

c. A conservative approach to working capital will result in all permanent assets being

financed using long-term securities.

d. The risk to the firm of borrowing with short-term credit is usually greater than withlong-term debt. Added risk can stem from greater variability of interest costs on

short-term debt.

e. Bank loans have a lower interest rate than commercial paper.

(21.10) Marketable securities

16. Which of the following is not a situation that might lead a firm to hold marketable

securities?

a. The firm has purchased a fixed asset that will require a large write-off of depreciable

expense.

b. The firm must meet a known financial commitment, such as financing an ongoing

construction project.

c. The firm must finance seasonal operations.



d. The firm has just sold long-term securities and has not yet invested the proceeds in

earning assets.

e. None of the statements above is correct. (All of the situations might lead the firm to

hold marketable securities.)

(21.13) Commercial paper

17. Which of the following statements concerning commercial paper is incorrect ?

a. Commercial paper is generally written for terms less than 270 days.

b. Commercial paper generally carries an interest rate below the prime rate.

c. Commercial paper is sold to money market mutual funds, as well as to other financial

institutions and nonfinancial corporations.

d. Commercial paper can be issued by virtually any firm so long as it is willing to pay

the going interest rate.

e. Commercial paper is a type of unsecured promissory note issued by large, strong

firms.

Medium:


18. Ignoring cost and other effects on the firm, which of the following measures would tend

to reduce the cash conversion cycle?

a. Maintain the level of receivables as sales decrease.

b. Buy more raw materials to take advantage of price breaks.

c. Take discounts when offered.

d. Forgo discounts that are currently being taken.

e. Offer a longer deferral period to customers.




19. Which of the following actions are likely to reduce the length of a company’s cash

conversion cycle?

a. Adopting a new inventory system that reduces the inventory conversion period. b. Reducing the average days sales outstanding (DSO) on its accounts receivable.c. Reducing the amount of time the company takes to pay its suppliers.



(21.2) Working capital policy

20. Which of the following statements is incorrect about working capital policy?

a. A company may hold a relatively large amount of cash if it anticipates uncertain sales

levels in the coming year.

b. Credit policy has an impact on working capital since it has the potential to influence

sales levels and the speed with which cash is collected.

c. The cash budget is useful in determining future financing needs.

d. Holding minimal levels of inventory can reduce inventory carrying costs and cannot

lead to any adverse effects on profitability.

e. Managing working capital levels is important to the financial staff since it influences

financing decisions and overall profitability of the firm.



(21.3) Cash balances


a. The cash balances of most firms consist of transactions, compensating, and

precautionary balances. The total desired cash balance can be determined bycalculating the amount needed for each purpose and then summing them together.

b. The easier a firm’s access to borrowed funds, the higher its precautionary balances

will be in order to protect against sudden increases in interest rates.

c. For some firms holding highly liquid marketable securities is a substitute for holding

cash, because the marketable securities accomplish the same objective as cash.

d. All companies hold the same amount of funds for a transaction balance.


(21.3) Compensating balances


a. Compensating balance requirements apply only to businesses, not to individuals.

b. Compensating balances are essentially costless to most firms, because those firms

would normally have such funds on hand to meet transactions needs anyway.

c. If the required compensating balance is larger than the transactions balance the firm

would ordinarily hold, then the effective cost of any loan requiring such a balance is

increased.

d. Banks are prohibited from earning interest on the funds they force businesses to keep

as compensating balances.




(21.4) Cash budget


a. Shorter-term cash budgets, in general, are used primarily for planning purposes, while

longer-term budgets are used for actual cash control.

b. The cash budget and the capital budget are planned separately and although they are

both important to the firm, they are independent of each other.

c. Since depreciation is a non-cash charge, it does not appear on nor have an effect on

the cash budget.

d. The target cash balance is set optimally such that it need not be adjusted for seasonal

patterns and unanticipated fluctuations in receipts, although it is changed to reflect

long-term changes in the firm’s operations.

e. The typical actual cash budget will reflect interest on loans and income from

investment of surplus cash. These numbers are expected values and actual results

might vary from budgeted results.


24. A lockbox plan is most beneficial to firms which

a. Send payables over a wide geographic area.

b. Have widely disbursed manufacturing facilities.

c. Have a large marketable securities account to protect.

d. Hold inventories at many different sites.

e. Make collections over a wide geographic area.



(21.5) Float


a. Poor synchronization of cash flows which results in high cash management costs can

be partially offset by increasing disbursement float and decreasing collections float.

b. The size of a firm's net float is primarily a function of its natural cash flow

synchronization and how it clears its checks.

c. Lockbox systems are used mainly for security purposes as well as to decrease the

firm's net float.

d. If a firm can speed up its collections and slow down its disbursements, it will be able

to reduce its net float.

e. A firm practicing good cash management and making use of positive net float will

bring its check book balance as close to zero as possible, but must never generate a

negative book balance.

(21.7) Receivables management


a. A firm that makes 90 percent of its sales on credit and 10 percent for cash is growing

at a rate of 10 percent annually. If the firm maintains stable growth it will also be able

to maintain its accounts receivable at its current level, since the 10 percent cash sales

can be used to manage the 10 percent growth rate.

b. In managing a firm’s accounts receivable it is possible to increase credit sales per day

yet still keep accounts receivable fairly steady if the firm can shorten the length of its

collection period.

c. If a firm has a large percentage of accounts over 30 days old, it is a sign that the

firm’s receivables management needs to be reviewed and improved.

d. Since receivables and payables both result from sales transactions, a firm with a high

receivables-to-sales ratio should also have a high payables-to-sales ratio.




(21.7) DSO and aging schedule27. Which of the following statements is most correct?

a. If a firm’s volume of credit sales declines then its DSO will also decline.

b. If a firm changes its credit terms from 1/20, net 40 days, to 2/10, net 60 days, the

impact on sales can’t be determined because the increase in the discount is offset by

the longer net terms, which tends to reduce sales.

c. The DSO of a firm with seasonal sales can vary. While the sales per day figure is

usually based on the total annual sales, the accounts receivable balance will be high

or low depending on the season.

d. An aging schedule is used to determine what portion of customers pay cash and what

portion buy on credit.

e. Aging schedules can be constructed from the summary data provided in the firm’sfinancial statements.

(21.7) Days sales outstanding (DSO)


a. Other things held constant, the higher a firm’s days sales outstanding (DSO), the

better its credit department.

b. If a firm that sells on terms of net 30 changes its policy and begins offering all

customers terms of 2/10, net 30 days, and if no change in sales volume occurs, thenthe firm’s DSO will probably increase.

c. If a firm sells on terms of 2/10, net 30 days, and its DSO is 30 days, then its aging

schedule would probably show some past due accounts.







a. Depreciation is included in the estimate of cash flows (Cash flow = Net income +

Depreciation), so depreciation is set forth on a separate line in the cash budget.

b. If cash inflows and cash outflows occur on a regular basis, such as the situation in

which inflows from collections occur in equal amounts each day and most payments

are made regularly on the 10th of each month, then it is not necessary to use a daily

cash budget. A cash budget prepared at the end of the month will suffice.

c. Sound working capital policy is designed to maximize the time between cash

expenditures on materials and the collection of cash on sales.





a. Net working capital may be defined as current assets minus current liabilities. Any

increase in the current ratio will automatically lead to an increase in net workingcapital.

b. Although short-term interest rates have historically averaged less than long-term

rates, the heavy use of short-term debt is considered to be an aggressive strategy

because of the inherent risks of using short-term financing.

c. If a company follows a policy of “matching maturities,” this means that it matches its

use of common stock with its use of long-term debt as opposed to short-term debt.







a. Accruals are an expensive way to finance working capital.

b. A conservative financing policy is one in which the firm finances all of its fixed

assets with long-term capital and part of its permanent net operating working capital

with short-term, nonspontaneous credit.

c. If a company receives trade credit under the terms 2/10, net 30 days, this implies the

company has 10 days of free trade credit.



(21.10) Marketable securities portfolio

32. Which of the following statement completions is most correct? If the yield curve is

upward sloping, then a firm’s marketable securities portfolio, assumed to be held for

liquidity purposes, should be

a. Weighted toward long-term securities because they pay higher rates.

b. Weighted toward short-term securities because they pay higher rates.

c. Weighted toward U.S. Treasury securities to avoid interest rate risk.

d. Weighted toward short-term securities to avoid interest rate risk.

e. Balanced between long- and short-term securities to minimize the effects of either an

upward or a downward trend in interest rates.



(21.11) Short-term financing


a. Under normal conditions, a firm’s expected ROE would probably be higher if it

financed with short-term rather than with long-term debt, but the use of short-termdebt would probably increase the firm’s risk.

b. Conservative firms generally use no short-term debt and thus have zero current

liabilities.

c. A short-term loan can usually be obtained more quickly than a long-term loan, but the

cost of short-term debt is likely to be higher than that of long-term debt.

d. If a firm that can borrow from its bank buys on terms of 2/10, net 30 days, and if it

must pay by Day 30 or else be cut off, then we would expect to see zero accounts

payable on its balance sheet.

e. If one of your firm’s customers is “stretching” its accounts payable, this may be a

nuisance but does not represent a real financial cost to your firm as long as the firm

periodically pays off its entire balance.



(21.11) Short-term versus long-term financing


a. Under normal conditions the shape of the yield curve implies that the interest cost of

short-term debt is greater than that of long-term debt, although short-term debt hasother advantages that make it desirable as a financing source.

b. Flexibility is an advantage of short-term credit but this is somewhat offset by the

higher flotation costs associated with the need to repeatedly renew short-term credit.

c. A short-term loan can usually be obtained more quickly than a long-term loan but the

penalty for early repayment of a short-term loan is significantly higher than for a

long-term loan.

d. Statements about the flexibility, cost, and riskiness of short-term versus long-term

credit are dependent on the type of credit that is actually used.

e. Short-term debt is often less costly than long-term debt and the major reason for this

is that short-term debt exposes the borrowing firm to much less risk than long-term

debt.


Easy:

(21.1) Cash conversion cycle35. Spartan Sporting Goods has $5 million in inventory and $2 million in accounts receivable. Its

average daily sales are $100,000. The company’s payables deferral period (accounts payable divided

by daily purchases) is 30 days. What is the length of the company’s cash conversion cycle?

a. 100 days

b. 60 days

c. 50 days

d. 40 days

e. 33 days




36. For the Cook County Company, the average age of accounts receivable is 60 days, the

average age of accounts payable is 45 days, and the average age of inventory is 72 days.

Assuming a 365-day year, what is the length of the firm’s cash conversion cycle?

a. 87 days

b. 90 days

c. 65 days

d. 48 days

e. 66 days

(21.4) Sales collections

37. The Danser Company expects to have sales of $30,000 in January, $33,000 in February,

and $38,000 in March. If 20 percent of sales are for cash, 40 percent are credit sales paid

in the month following the sale, and 40 percent are credit sales paid 2 months following

the sale, what are the cash receipts from sales in March?

a. $55,000

b. $47,400

c. $38,000

d. $32,800

e. $30,000



(21.5) Float

38. Jumpdisk Company writes checks averaging $15,000 a day, and it takes 5 days for these

checks to clear. The firm also receives checks in the amount of $17,000 per day, but the

firm loses three days while its receipts are being deposited and cleared. What is the

firm's net float in dollars?

a. $126,000

b. $ 75,000

c. $ 32,000

d. $ 24,000

e. $ 16,000

(21.6) Inventory turnover ratio and DSO

39. Bowa Construction’s days sales outstanding is 50 days (on a 365-day basis). The company’s

accounts receivable equal $100 million and its balance sheet shows inventory equal to $125

million. What is the company’s inventory turnover ratio?

a. 5.84

b. 4.25

c. 3.33

d. 2.75

e. 7.25



(21.8) Accounts receivable balance

40. If Hot Tubs Inc. had sales of $2,027,773 per year (all credit) and its days sales

outstanding was equal to 35 days, what was its average amount of accounts receivable

outstanding? (Assume a 365-day year.)

a. $194,444

b. $ 57,143

c. $ 5,556

d. $ 97,222

e. $212,541

(21.8) Cost of trade credit

41. A firm is offered trade credit terms of 3/15, net 45 days. The firm does not take the

discount, and it pays after 67 days. What is the nominal annual cost of not taking the

discount? (Assume a 365-day year.)

a. 21.71%

b. 22.07%

c. 22.95%

d. 23.48%

e. 24.52%



(21.8) Cost of trade credit42. Dixie Tours Inc. buys on terms of 2/15, net 30 days. It does not take discounts, and it

typically pays 35 days after the invoice date. Net purchases amount to $720,000 per year.

What is the nominal annual cost of its non-free trade credit? (Assume a 365-day year.)

a. 17.2%

b. 23.6%

c. 26.1%

d. 37.2%

e. 50.6%

(21.8) Cost of trade credit

43. Your company has been offered credit terms on its purchases of 4/30, net 90 days. What will

be the nominal annual cost of trade credit if your company pays on the 35th day after

receiving the invoice? (Assume a 365-day year.)

a. 30%

b. 304%

c. 3%

d. 87%

e. 156%



(21.8) Free trade credit

44. Phillips Glass Company buys on terms of 2/15, net 30 days. It does not take discounts, and it


On average, how much “free” trade credit does Phillips receive during the year? (Assume a

365-day year.)

a. $30,000

b. $40,000

c. $50,000

d. $60,000

e. $70,000

(21.9) Maturity matching

45. Wildthing Amusement Company’s total assets fluctuate between $320,000 and $410,000,

while its fixed assets remain constant at $260,000. If the firm follows a maturity

matching or moderate working capital financing policy, what is the likely level of its

long-term financing?

a. $ 90,000

b. $260,000

c. $350,000

d. $410,000

e. $320,000



(21.12) Revolving credit agreement cost

46. Inland Oil arranged a $10,000,000 revolving credit agreement with a group of small

banks. The firm paid an annual commitment fee of one-half of one percent of the unused

balance of the loan commitment. On the used portion of the loan, Inland paid 1.5 percent

above prime for the funds actually borrowed on an annual, simple interest basis. The prime rate was at 9 percent for the year. If Inland borrowed $6,000,000 immediately

after the agreement was signed and repaid the loan at the end of one year, what was the

total dollar cost of the loan agreement for one year?

a. $560,000

b. $650,000

c. $540,000

d. $900,000

e. $675,000

Medium:

(21.1) Inventory conversion period

47. On average, a firm sells $2,000,000 in merchandise a month. It keeps inventory equal to

one-half of its monthly sales on hand at all times. If the firm analyzes its accounts using a

365-day year, what is the firm’s inventory conversion period?

a. 365.0 days

b. 182.5 days

c. 30.3 days

d. 15.2 days

e. 10.5 days



(21.1) Cash conversion cycle48. Porta Stadium Inc. has annual sales of $80,000,000 and keeps average inventory of

$20,000,000. On average, the firm has accounts receivable of $16,000,000. The firm

buys all raw materials on credit, its trade credit terms are net 35 days, and it pays on time.

The firm’s managers are searching for ways to shorten the cash conversion cycle. If sales

can be maintained at existing levels but inventory can be lowered by $4,000,000 and

accounts receivable lowered by $2,000,000, what will be the net change in the cash

conversion cycle? Use a 365-day year. Round to the closest whole day.

a. +105 days

b. -105 days

c. +27 days

d. -27 days

e. -3 days


49. You have recently been hired to improve the performance of Multiplex Corporation,

which has been experiencing a severe cash shortage. As one part of your analysis, you

want to determine the firm’s cash conversion cycle. Using the following information

and a 365-day year, what is your estimate of the firm’s current cash conversion cycle?

Current inventory = $120,000. Annual sales = $600,000.

Accounts receivable = $157,808.

Accounts payable = $25,000.

Total annual purchases = $365,000.

Purchases credit terms: net 30 days.

Receivables credit terms: net 50 days.

a. 49 days

b. 193 days

c. 100 days

d. 168 days

e. 144 days



(21.1) Cash conversion cycle50. Kolan Inc. has annual sales of $36,500,000 ($100,000 a day on a 365-day basis). On

average, the company has $12,000,000 in inventory and $8,000,000 in accounts

receivable. The company is looking for ways to shorten its cash conversion cycle, which

is calculated on a 365-day basis. Its CFO has proposed new policies that would result in

a 20 percent reduction in both average inventories and accounts receivables. The

company anticipates that these policies will also reduce sales by 10 percent. Accounts

payable will remain unchanged. What effect would these policies have on the company’s

cash conversion cycle? Round to the nearest whole day.

a. -40 days

b. -22 days

c. -13 days

d. +22 days

e. +40 days


51. Gaston Piston Corp. has annual sales of $50,735,000 and maintains an average

inventory level of $15,012,000. The average accounts receivable balance outstanding

is $10,008,000. The company makes all purchases on credit and has always paid on the

30th day. The company is now going to take full advantage of trade credit and pay itssuppliers on the 40th day. If sales can be maintained at existing levels but inventory

can be lowered by $1,946,000 and accounts receivable lowered by $1,946,000, what

will be the net change in the cash conversion cycle? (Assume there are 365 days in the

year.)

a. -14.0 days

b. -18.8 days

c. -28.0 days

d. -25.6 days

e. -38.0 days



(21.2) ROE and working capital policy

52. Jarrett Enterprises is considering whether to pursue a restricted or relaxed current asset

investment policy. The firm’s annual sales are $400,000; its fixed assets are $100,000;

debt and equity are each 50 percent of total assets. EBIT is $36,000, the interest rate on

the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. With a restricted policy, current assets will be 15 percent of sales. Under a relaxed policy, current assets

will be 25 percent of sales. What is the difference in the projected ROEs between the

restricted and relaxed policies?

a. 0.0%

b. 6.2%

c. 5.4%

d. 1.6%

e. 3.8%



(21.4) Cash budget

53. Chadmark Corporation’s budgeted monthly sales are $3,000. Forty percent of its

customers pay in the first month and take the 2 percent discount. The remaining 60

percent pay in the month following the sale and don’t receive a discount. Chadmark’s

bad debts are very small and are excluded from this analysis. Purchases for next month’ssales are constant each month at $1,500. Other payments for wages, rent, and taxes are

constant at $700 per month. Construct a single month’s cash budget with the information

given. What is the average cash gain or (loss) during a typical month for Chadmark

Corporation?

a. $2,600

b. $ 800

c. $ 776

d. $ 740

e. $ 728

(21.5) Lockbox

54. Cross Collectibles currently fills mail orders from all over the U.S. and receipts come in

to headquarters in Little Rock, Arkansas. The firm's average accounts receivable (A/R) is

$2.5 million and is financed by a bank loan with 11 percent annual interest. Cross is

considering a regional lockbox system to speed up collections which it believes will

reduce A/R by 20 percent. The annual cost of the system is $15,000. What is theestimated net annual savings to the firm from implementing the lockbox system?

a. $500,000

b. $ 30,000

c. $ 60,000

d. $ 55,000

e. $ 40,000



(21.8) Accounts payable balance

55. Your firm buys on credit terms of 2/10, net 45 days, and it always pays on Day 45. If

you calculate that this policy effectively costs your firm $159,621 each year, what is the

firm’s average accounts payable balance? (Hint: Use the nominal cost of trade credit

and carry its cost out to 6 decimal places.)

a. $1,234,000

b. $ 75,000

c. $ 157,500

d. $ 625,000

e. $ 750,000

(21.8) EAR cost of trade credit56

. Suppose the credit terms offered to your firm by your suppliers are 2/10, net 30 days.

Out of convenience, your firm is not taking discounts, but is paying after 20 days, instead

of waiting until Day 30. You point out that the nominal cost of not taking the discount

and paying on Day 30 is approximately 37 percent. But since your firm is not taking

discounts and is paying on Day 20, what is the effective annual cost of your firm’s

current practice, using a 365-day year?

a. 36.7%

b. 105.4%

c. 73.4%

d. 43.6%

e. 109.0%



(21.8) EAR cost of trade credit

57. Hayes Hypermarket purchases $4,562,500 in goods over a 1-year period from its sole

supplier. The supplier offers trade credit under the following terms: 2/15, net 50 days. If

Hayes chooses to pay on time but not to take the discount, what is the average level of the

company’s accounts payable, and what is the effective annual cost of its trade credit?(Assume a 365-day year.)

a. $208,333; 17.81%

b. $416,667; 17.54%

c. $416,667; 27.43%

d. $625,000; 17.54%

e. $625,000; 23.45%

(21.8) EAR cost of trade credit


discount, and it pays after 58 days. What is the effective annual cost of not taking this


a. 21.63%

b. 13.35%

c. 14.90%

d. 15.89%

e. 18.70%



(21.7) Accounts payable balance

59. Dalrymple Grocers buys on credit terms of 2/10, net 30 days, and it always pays on the 30th

day. Dalrymple calculates that its annual costly trade credit is $375,000. What is the firm’s

average accounts payable balance? Assume a 365-day year.

a. $187,475

b. $374,951

c. $223,333

d. $562,426

e. $457,443

(21.8) Financial statements and trade credit60. Quickbow Company currently uses maximum trade credit by not taking discounts on its

purchases. Quickbow is considering borrowing from its bank, using notes payable, in order

to take trade discounts. The firm wants to determine the effect of this policy change on its

net income. The standard industry credit terms offered by all its suppliers are 2/10, net 30

days, and Quickbow pays in 30 days. Its net purchases are $11,760 per day, using a 365-

day year. The interest rate on the notes payable is 10 percent and the firm’s tax rate is 40

percent. If the firm implements the plan, what is the expected change in Quickbow’s net

income?

a. -$23,520

b. -$31,440

c. +$23,520

d. +$38,448

e. +$69,888



Multiple Part:

(The following information applies to the next three problems.)

Callison Airlines is deciding whether to pursue a restricted or relaxed working capital investment

policy. Callison’s annual sales are expected to total $3.6 million, its fixed assets turnover ratio equals

4.0, and its debt and common equity are each 50 percent of total assets. EBIT is $150,000, the

interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. If the company

follows a restricted policy, its total assets turnover will be 2.5.

Under a relaxed policy, its total assets turnover will be 2.2.

(21.2) Working capital investment policy

61. If the firm adopts a restricted policy, how much will it save in interest expense (relative to

what it would be if Callison were to adopt a relaxed policy)?

a. $ 3,233

b. $ 6,175

c. $ 9,818

d. $ 7,200

e. $10,136

(21.2) Working capital investment policy and ROE

62. What is the difference in the projected ROEs between the restricted and relaxed policies?

a. 2.24% b. 1.50% c. 1.00% d. 0.50% e. 0.33%




WORKING CAPITAL MANAGEMENT


Easy:

(21.1) Cash conversion cycle Answer: b Diff: E

1. Helena Furnishings wants to sharply reduce its cash conversion cycle. Which of the

following steps would reduce its cash conversion cycle?

a. The company increases its average inventory without increasing its sales.

b. The company reduces its DSO.

c. The company starts paying its bills sooner, which reduces its average accounts payable without reducing its sales.



(21.2) Working capital Answer: c Diff: E

2. Other things held constant, which of the following will cause an increase in working

capital?

a. Cash is used to buy marketable securities.

b. A cash dividend is declared and paid.

c. Merchandise is sold at a profit, but the sale is on credit.

d. Long-term bonds are retired with the proceeds of a preferred stock issue.

e. Missing inventory is written off against retained earnings.



(21.4) Cash budget Answer: e Diff: E

3. Which of the following is typically part of the cash budget?

a. Payments lag.

b. Payment for plant construction.

c. Cumulative cash.



(21.4) Cash budget Answer: a Diff: E

4. Which of the following statements concerning the cash budget is correct?

a. Depreciation expense is not explicitly included, but depreciation effects are implicitly

included in estimated tax payments.

b. Cash budgets do not include financial expenses such as interest and dividend

payments.

c. Cash budgets do not include cash inflows from long-term sources such as bond issues.



(21.4) Cash budget Answer: d Diff: E

5. Which of the following items should a company explicitly include in its monthly cash

budget?

a. Its monthly depreciation expense. b. Its cash proceeds from selling one of its divisions.c. Interest paid on its bank loans.

d. Statements b and c are correct.e. All of the statements above are correct.



(21.5) Cash management Answer: a Diff: E


a. A cash management system which minimizes collections float and maximizes

disbursement float is better than one with higher collections float and lower

disbursement float.

b. A cash management system which maximizes collections float and minimizes

disbursement float is better than one with lower collections float and higher

disbursement float.

c. The use of a lockbox is designed to minimize cash theft losses. If the cost of the

lockbox is less than theft losses saved, then the lockbox should be installed.

d. Other things held constant, a firm will need an identical line of credit if it can arrange

to pay its bills by the 5th of each month than if its bills come due uniformly during

the month.


(21.5) Cash management Answer: e Diff: E


a. A good cash management system would minimize disbursement float and maximize

collections float.

b. If a firm begins to use a well-designed lockbox system, this will reduce its customers'

net float.

c. In the early 1980's, the prime interest rate hit a high of 21 percent. In 1995 the prime

rate was considerably lower. That sharp interest rate decline has increased firms'

concerns about the efficiency of their cash management programs.

d. If a firm can get its customers to permit it to pay by wire transfers rather than having

to write checks, this will increase its net float and thus reduce its required cash

balances.

e. A firm which has such an efficient cash management system that it has positive net

float can have a negative checkbook balance at most times and still not have its

checks bounce.



(21.5) Lockbox Answer: d Diff: E

8. A lockbox plan is

a. A method for safe-keeping of marketable securities.

b. Used to identify inventory safety stocks.

c. A system for slowing down the collection of checks written by a firm.

d. A system for speeding up a firm's collections of checks received.

e. Not described by any of the statements above.

(21.6) Inventory management Answer: e Diff: E

9. Which of the following might be attributed to efficient inventory management?

a. High inventory turnover ratio.

b. Low incidence of production schedule disruptions.

c. High total assets turnover.



(21.7) Monitoring receivables Answer: b Diff: E

10. Analyzing days sales outstanding (DSO) and the aging schedule are two common

methods for monitoring receivables. However, they can provide erroneous signals to

credit managers when

a. Customers’ payments patterns are changing.

b. Sales fluctuate seasonally.

c. Some customers take the discount and others do not.

d. Sales are relatively constant, either seasonally or cyclically.




(21.7) Credit policy Answer: e Diff: E

11. Which of the following is not commonly regarded as being a credit policy variable?

a. Credit period.

b. Collection policy.

c. Credit standards.

d. Cash discounts.

e. All of the statements above are credit policy variables.

(21.7) Credit policy Answer: d Diff: E

12. If easing a firm’s credit policy lengthens the collection period and results in a worsening

of the aging schedule, then why do firms take such actions?

a. It normally stimulates sales.

b. To meet competitive pressures.

c. To increase the firm’s deferral period for payables.



(21.9) Working capital financing policy Answer: a Diff: E

13. Firms generally choose to finance temporary net operating working capital with short-

term debt because

a. Matching the maturities of assets and liabilities reduces risk.

b. Short-term interest rates have traditionally been more stable than long-term interest

rates.

c. A firm that borrows heavily long-term is more apt to be unable to repay the debt than

a firm that borrows heavily short-term.

d. The yield curve has traditionally been downward sloping.

e. Sales remain constant over the year, and financing requirements also remain constant.



(21.1) Cash conversion cycle Answer: d Diff: M

19. Which of the following actions are likely to reduce the length of a company’s cash

conversion cycle?

a. Adopting a new inventory system that reduces the inventory conversion period. b. Reducing the average days sales outstanding (DSO) on its accounts receivable.c. Reducing the amount of time the company takes to pay its suppliers.



(21.2) Working capital policy Answer: d Diff: M 20. Which of the following statements is incorrect about working capital policy?

a. A company may hold a relatively large amount of cash if it anticipates uncertain sales

levels in the coming year.

b. Credit policy has an impact on working capital since it has the potential to influence

sales levels and the speed with which cash is collected.

c. The cash budget is useful in determining future financing needs.

d. Holding minimal levels of inventory can reduce inventory carrying costs and cannot

lead to any adverse effects on profitability.

e. Managing working capital levels is important to the financial staff since it influences

financing decisions and overall profitability of the firm.



(21.3) Cash balances Answer: c Diff: M


a. The cash balances of most firms consist of transactions, compensating, and

precautionary balances. The total desired cash balance can be determined bycalculating the amount needed for each purpose and then summing them together.

b. The easier a firm’s access to borrowed funds, the higher its precautionary balances

will be in order to protect against sudden increases in interest rates.

c. For some firms holding highly liquid marketable securities is a substitute for holding

cash, because the marketable securities accomplish the same objective as cash.

d. All companies hold the same amount of funds for a transaction balance.


(21.3) Compensating balances Answer: c Diff: M


a. Compensating balance requirements apply only to businesses, not to individuals.

b. Compensating balances are essentially costless to most firms, because those firms

would normally have such funds on hand to meet transactions needs anyway.

c. If the required compensating balance is larger than the transactions balance the firm

would ordinarily hold, then the effective cost of any loan requiring such a balance is

increased.

d. Banks are prohibited from earning interest on the funds they force businesses to keep

as compensating balances.




(21.4) Cash budget Answer: e Diff: M


a. Shorter-term cash budgets, in general, are used primarily for planning purposes, while

longer-term budgets are used for actual cash control.

b. The cash budget and the capital budget are planned separately and although they are

both important to the firm, they are independent of each other.

c. Since depreciation is a non-cash charge, it does not appear on nor have an effect on

the cash budget.

d. The target cash balance is set optimally such that it need not be adjusted for seasonal

patterns and unanticipated fluctuations in receipts, although it is changed to reflect

long-term changes in the firm’s operations.

e. The typical actual cash budget will reflect interest on loans and income from

investment of surplus cash. These numbers are expected values and actual results

might vary from budgeted results.

(21.5) Cash management Answer: e Diff: M

24. A lockbox plan is most beneficial to firms which

a. Send payables over a wide geographic area.

b. Have widely disbursed manufacturing facilities.

c. Have a large marketable securities account to protect.

d. Hold inventories at many different sites.

e. Make collections over a wide geographic area.



(21.5) Float Answer: a Diff: M


a. Poor synchronization of cash flows which results in high cash management costs can

be partially offset by increasing disbursement float and decreasing collections float.

b. The size of a firm's net float is primarily a function of its natural cash flow

synchronization and how it clears its checks.

c. Lockbox systems are used mainly for security purposes as well as to decrease the

firm's net float.

d. If a firm can speed up its collections and slow down its disbursements, it will be able

to reduce its net float.

e. A firm practicing good cash management and making use of positive net float will

bring its check book balance as close to zero as possible, but must never generate a

negative book balance.

(21.7) Receivables management Answer: b Diff: M


a. A firm that makes 90 percent of its sales on credit and 10 percent for cash is growing

at a rate of 10 percent annually. If the firm maintains stable growth it will also be able

to maintain its accounts receivable at its current level, since the 10 percent cash sales

can be used to manage the 10 percent growth rate.

b. In managing a firm’s accounts receivable it is possible to increase credit sales per day

yet still keep accounts receivable fairly steady if the firm can shorten the length of its

collection period.

c. If a firm has a large percentage of accounts over 30 days old, it is a sign that the

firm’s receivables management needs to be reviewed and improved.

d. Since receivables and payables both result from sales transactions, a firm with a high

receivables-to-sales ratio should also have a high payables-to-sales ratio.




(21.7) DSO and aging schedule Answer: c Diff: M27. Which of the following statements is most correct?

a. If a firm’s volume of credit sales declines then its DSO will also decline.

b. If a firm changes its credit terms from 1/20, net 40 days, to 2/10, net 60 days, the

impact on sales can’t be determined because the increase in the discount is offset by

the longer net terms, which tends to reduce sales.

c. The DSO of a firm with seasonal sales can vary. While the sales per day figure is

usually based on the total annual sales, the accounts receivable balance will be high

or low depending on the season.

d. An aging schedule is used to determine what portion of customers pay cash and what

portion buy on credit.

e. Aging schedules can be constructed from the summary data provided in the firm’sfinancial statements.

(21.7) Days sales outstanding (DSO) Answer: c Diff: M


a. Other things held constant, the higher a firm’s days sales outstanding (DSO), the

better its credit department.

b. If a firm that sells on terms of net 30 changes its policy and begins offering all

customers terms of 2/10, net 30 days, and if no change in sales volume occurs, thenthe firm’s DSO will probably increase.

c. If a firm sells on terms of 2/10, net 30 days, and its DSO is 30 days, then its aging

schedule would probably show some past due accounts.





(Comp.) Miscellaneous concepts Answer: e Diff: M


a. Depreciation is included in the estimate of cash flows (Cash flow = Net income +

Depreciation), so depreciation is set forth on a separate line in the cash budget.

b. If cash inflows and cash outflows occur on a regular basis, such as the situation in

which inflows from collections occur in equal amounts each day and most payments

are made regularly on the 10th of each month, then it is not necessary to use a daily

cash budget. A cash budget prepared at the end of the month will suffice.

c. Sound working capital policy is designed to maximize the time between cash

expenditures on materials and the collection of cash on sales.



(21.9) Working capital financing policy Answer: b Diff: M


a. Net working capital may be defined as current assets minus current liabilities. Any

increase in the current ratio will automatically lead to an increase in net workingcapital.

b. Although short-term interest rates have historically averaged less than long-term

rates, the heavy use of short-term debt is considered to be an aggressive strategy

because of the inherent risks of using short-term financing.

c. If a company follows a policy of “matching maturities,” this means that it matches its

use of common stock with its use of long-term debt as opposed to short-term debt.





(21.9) Working capital financing policy Answer: c Diff: M


a. Accruals are an expensive way to finance working capital.

b. A conservative financing policy is one in which the firm finances all of its fixed

assets with long-term capital and part of its permanent net operating working capital

with short-term, nonspontaneous credit.

c. If a company receives trade credit under the terms 2/10, net 30 days, this implies the

company has 10 days of free trade credit.



(21.10) Marketable securities portfolio Answer: d Diff: M

32. Which of the following statement completions is most correct? If the yield curve is

upward sloping, then a firm’s marketable securities portfolio, assumed to be held for

liquidity purposes, should be

a. Weighted toward long-term securities because they pay higher rates.

b. Weighted toward short-term securities because they pay higher rates.

c. Weighted toward U.S. Treasury securities to avoid interest rate risk.

d. Weighted toward short-term securities to avoid interest rate risk.

e. Balanced between long- and short-term securities to minimize the effects of either an

upward or a downward trend in interest rates.



(21.11) Short-term financing Answer: a Diff: M


a. Under normal conditions, a firm’s expected ROE would probably be higher if it

financed with short-term rather than with long-term debt, but the use of short-termdebt would probably increase the firm’s risk.

b. Conservative firms generally use no short-term debt and thus have zero current

liabilities.

c. A short-term loan can usually be obtained more quickly than a long-term loan, but the

cost of short-term debt is likely to be higher than that of long-term debt.

d. If a firm that can borrow from its bank buys on terms of 2/10, net 30 days, and if it

must pay by Day 30 or else be cut off, then we would expect to see zero accounts

payable on its balance sheet.

e. If one of your firm’s customers is “stretching” its accounts payable, this may be a

nuisance but does not represent a real financial cost to your firm as long as the firm

periodically pays off its entire balance.



(21.11) Short-term versus long-term financing Answer: d Diff: M


a. Under normal conditions the shape of the yield curve implies that the interest cost of

short-term debt is greater than that of long-term debt, although short-term debt hasother advantages that make it desirable as a financing source.

b. Flexibility is an advantage of short-term credit but this is somewhat offset by the

higher flotation costs associated with the need to repeatedly renew short-term credit.

c. A short-term loan can usually be obtained more quickly than a long-term loan but the

penalty for early repayment of a short-term loan is significantly higher than for a

long-term loan.

d. Statements about the flexibility, cost, and riskiness of short-term versus long-term

credit are dependent on the type of credit that is actually used.

e. Short-term debt is often less costly than long-term debt and the major reason for this

is that short-term debt exposes the borrowing firm to much less risk than long-term

debt.


Easy:

(21.1) Cash conversion cycle Answer: d Diff: E35. Spartan Sporting Goods has $5 million in inventory and $2 million in accounts receivable. Its

average daily sales are $100,000. The company’s payables deferral period (accounts payable divided

by daily purchases) is 30 days. What is the length of the company’s cash conversion cycle?

a. 100 days

b. 60 days

c. 50 days

d. 40 days

e. 33 days



(21.1) Cash conversion cycle Answer: a Diff: E

36. For the Cook County Company, the average age of accounts receivable is 60 days, the

average age of accounts payable is 45 days, and the average age of inventory is 72 days.

Assuming a 365-day year, what is the length of the firm’s cash conversion cycle?

a. 87 days

b. 90 days

c. 65 days

d. 48 days

e. 66 days

(21.4) Sales collections Answer: d Diff: E

37. The Danser Company expects to have sales of $30,000 in January, $33,000 in February,

and $38,000 in March. If 20 percent of sales are for cash, 40 percent are credit sales paid

in the month following the sale, and 40 percent are credit sales paid 2 months following

the sale, what are the cash receipts from sales in March?

a. $55,000

b. $47,400

c. $38,000

d. $32,800

e. $30,000



(21.5) Float Answer: d Diff: E

38. Jumpdisk Company writes checks averaging $15,000 a day, and it takes 5 days for these

checks to clear. The firm also receives checks in the amount of $17,000 per day, but the

firm loses three days while its receipts are being deposited and cleared. What is the

firm's net float in dollars?

a. $126,000

b. $ 75,000

c. $ 32,000

d. $ 24,000

e. $ 16,000

(21.6) Inventory turnover ratio and DSO Answer: a Diff: E

39. Bowa Construction’s days sales outstanding is 50 days (on a 365-day basis). The company’s

accounts receivable equal $100 million and its balance sheet shows inventory equal to $125

million. What is the company’s inventory turnover ratio?

a. 5.84

b. 4.25

c. 3.33

d. 2.75

e. 7.25



(21.8) Accounts receivable balance Answer: a Diff: E

40. If Hot Tubs Inc. had sales of $2,027,773 per year (all credit) and its days sales

outstanding was equal to 35 days, what was its average amount of accounts receivable

outstanding? (Assume a 365-day year.)

a. $194,444

b. $ 57,143

c. $ 5,556

d. $ 97,222

e. $212,541

(21.8) Cost of trade credit Answer: a Diff: E


discount, and it pays after 67 days. What is the nominal annual cost of not taking the


a. 21.71%

b. 22.07%

c. 22.95%

d. 23.48%

e. 24.52%



(21.8) Cost of trade credit Answer: d Diff: E42. Dixie Tours Inc. buys on terms of 2/15, net 30 days. It does not take discounts, and it


What is the nominal annual cost of its non-free trade credit? (Assume a 365-day year.)

a. 17.2%

b. 23.6%

c. 26.1%

d. 37.2%

e. 50.6%

(21.8) Cost of trade credit Answer: b Diff: E

43. Your company has been offered credit terms on its purchases of 4/30, net 90 days. What will

be the nominal annual cost of trade credit if your company pays on the 35th day after

receiving the invoice? (Assume a 365-day year.)

a. 30%

b. 304%

c. 3%

d. 87%

e. 156%



(21.12) Revolving credit agreement cost Answer: b Diff: E

46. Inland Oil arranged a $10,000,000 revolving credit agreement with a group of small

banks. The firm paid an annual commitment fee of one-half of one percent of the unused

balance of the loan commitment. On the used portion of the loan, Inland paid 1.5 percent

above prime for the funds actually borrowed on an annual, simple interest basis. The prime rate was at 9 percent for the year. If Inland borrowed $6,000,000 immediately

after the agreement was signed and repaid the loan at the end of one year, what was the

total dollar cost of the loan agreement for one year?

a. $560,000

b. $650,000

c. $540,000

d. $900,000

e. $675,000

Medium:

(21.1) Inventory conversion period Answer: d Diff: M

47. On average, a firm sells $2,000,000 in merchandise a month. It keeps inventory equal to

one-half of its monthly sales on hand at all times. If the firm analyzes its accounts using a

365-day year, what is the firm’s inventory conversion period?

a. 365.0 days

b. 182.5 days

c. 30.3 days

d. 15.2 days

e. 10.5 days



(21.1) Cash conversion cycle Answer: d Diff: M48. Porta Stadium Inc. has annual sales of $80,000,000 and keeps average inventory of

$20,000,000. On average, the firm has accounts receivable of $16,000,000. The firm

buys all raw materials on credit, its trade credit terms are net 35 days, and it pays on time.

The firm’s managers are searching for ways to shorten the cash conversion cycle. If sales

can be maintained at existing levels but inventory can be lowered by $4,000,000 and

accounts receivable lowered by $2,000,000, what will be the net change in the cash

conversion cycle? Use a 365-day year. Round to the closest whole day.

a. +105 days

b. -105 days

c. +27 days

d. -27 days

e. -3 days

(21.1) Cash conversion cycle Answer: e Diff: M

49. You have recently been hired to improve the performance of Multiplex Corporation,

which has been experiencing a severe cash shortage. As one part of your analysis, you

want to determine the firm’s cash conversion cycle. Using the following information

and a 365-day year, what is your estimate of the firm’s current cash conversion cycle?

Current inventory = $120,000. Annual sales = $600,000.

Accounts receivable = $157,808.

Accounts payable = $25,000.

Total annual purchases = $365,000.

Purchases credit terms: net 30 days.

Receivables credit terms: net 50 days.a. 49 days

b. 193 days

c. 100 days

d. 168 days

e. 144 days



(21.1) Cash conversion cycle Answer: b Diff: M50. Kolan Inc. has annual sales of $36,500,000 ($100,000 a day on a 365-day basis). On

average, the company has $12,000,000 in inventory and $8,000,000 in accounts

receivable. The company is looking for ways to shorten its cash conversion cycle, which

is calculated on a 365-day basis. Its CFO has proposed new policies that would result in

a 20 percent reduction in both average inventories and accounts receivables. The

company anticipates that these policies will also reduce sales by 10 percent. Accounts

payable will remain unchanged. What effect would these policies have on the company’s

cash conversion cycle? Round to the nearest whole day.

a. -40 days

b. -22 days

c. -13 days

d. +22 days

e. +40 days

(21.1) Cash conversion cycle Answer: e Diff: M

51. Gaston Piston Corp. has annual sales of $50,735,000 and maintains an average

inventory level of $15,012,000. The average accounts receivable balance outstanding

is $10,008,000. The company makes all purchases on credit and has always paid on the

30th day. The company is now going to take full advantage of trade credit and pay itssuppliers on the 40th day. If sales can be maintained at existing levels but inventory

can be lowered by $1,946,000 and accounts receivable lowered by $1,946,000, what

will be the net change in the cash conversion cycle? (Assume there are 365 days in the

year.)

a. -14.0 days

b. -18.8 days

c. -28.0 days

d. -25.6 days

e. -38.0 days



(21.2) ROE and working capital policy Answer: c Diff: M

52. Jarrett Enterprises is considering whether to pursue a restricted or relaxed current asset

investment policy. The firm’s annual sales are $400,000; its fixed assets are $100,000;

debt and equity are each 50 percent of total assets. EBIT is $36,000, the interest rate on

the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. With a restricted policy, current assets will be 15 percent of sales. Under a relaxed policy, current assets

will be 25 percent of sales. What is the difference in the projected ROEs between the

restricted and relaxed policies?

a. 0.0%

b. 6.2%

c. 5.4%

d. 1.6%

e. 3.8%



(21.4) Cash budget Answer: c Diff: M

53. Chadmark Corporation’s budgeted monthly sales are $3,000. Forty percent of its

customers pay in the first month and take the 2 percent discount. The remaining 60

percent pay in the month following the sale and don’t receive a discount. Chadmark’s

bad debts are very small and are excluded from this analysis. Purchases for next month’ssales are constant each month at $1,500. Other payments for wages, rent, and taxes are

constant at $700 per month. Construct a single month’s cash budget with the information

given. What is the average cash gain or (loss) during a typical month for Chadmark

Corporation?

a. $2,600

b. $ 800

c. $ 776

d. $ 740

e. $ 728

(21.5) Lockbox Answer: e Diff: M

54. Cross Collectibles currently fills mail orders from all over the U.S. and receipts come in

to headquarters in Little Rock, Arkansas. The firm's average accounts receivable (A/R) is

$2.5 million and is financed by a bank loan with 11 percent annual interest. Cross is

considering a regional lockbox system to speed up collections which it believes will

reduce A/R by 20 percent. The annual cost of the system is $15,000. What is theestimated net annual savings to the firm from implementing the lockbox system?

a. $500,000

b. $ 30,000

c. $ 60,000

d. $ 55,000

e. $ 40,000



(21.8) Accounts payable balance Answer: e Diff: M

55. Your firm buys on credit terms of 2/10, net 45 days, and it always pays on Day 45. If

you calculate that this policy effectively costs your firm $159,621 each year, what is the

firm’s average accounts payable balance? (Hint: Use the nominal cost of trade credit

and carry its cost out to 6 decimal places.)

a. $1,234,000

b. $ 75,000

c. $ 157,500

d. $ 625,000

e. $ 750,000

(21.8) EAR cost of trade credit Answer: e Diff: M56. Suppose the credit terms offered to your firm by your suppliers are 2/10, net 30 days.

Out of convenience, your firm is not taking discounts, but is paying after 20 days, instead

of waiting until Day 30. You point out that the nominal cost of not taking the discount

and paying on Day 30 is approximately 37 percent. But since your firm is not taking

discounts and is paying on Day 20, what is the effective annual cost of your firm’s

current practice, using a 365-day year?

a. 36.7%

b. 105.4%

c. 73.4%

d. 43.6%

e. 109.0%



(21.8) EAR cost of trade credit Answer: e Diff: M

57. Hayes Hypermarket purchases $4,562,500 in goods over a 1-year period from its sole

supplier. The supplier offers trade credit under the following terms: 2/15, net 50 days. If

Hayes chooses to pay on time but not to take the discount, what is the average level of the

company’s accounts payable, and what is the effective annual cost of its trade credit?(Assume a 365-day year.)

a. $208,333; 17.81%

b. $416,667; 17.54%

c. $416,667; 27.43%

d. $625,000; 17.54%

e. $625,000; 23.45%

(21.8) EAR cost of trade credit Answer: d Diff: M


discount, and it pays after 58 days. What is the effective annual cost of not taking this


a. 21.63%

b. 13.35%

c. 14.90%

d. 15.89%

e. 18.70%



(21.7) Accounts payable balance Answer: d Diff: T

59. Dalrymple Grocers buys on credit terms of 2/10, net 30 days, and it always pays on the 30th

day. Dalrymple calculates that its annual costly trade credit is $375,000. What is the firm’s

average accounts payable balance? Assume a 365-day year.

a. $187,475

b. $374,951

c. $223,333

d. $562,426

e. $457,443

(21.8) Financial statements and trade credit Answer: d Diff: T60. Quickbow Company currently uses maximum trade credit by not taking discounts on its

purchases. Quickbow is considering borrowing from its bank, using notes payable, in order

to take trade discounts. The firm wants to determine the effect of this policy change on its

net income. The standard industry credit terms offered by all its suppliers are 2/10, net 30

days, and Quickbow pays in 30 days. Its net purchases are $11,760 per day, using a 365-

day year. The interest rate on the notes payable is 10 percent and the firm’s tax rate is 40

percent. If the firm implements the plan, what is the expected change in Quickbow’s net

income?

a. -$23,520

b. -$31,440

c. +$23,520

d. +$38,448

e. +$69,888



Multiple Part:


Callison Airlines is deciding whether to pursue a restricted or relaxed working capital investment

policy. Callison’s annual sales are expected to total $3.6 million, its fixed assets turnover ratio equals

4.0, and its debt and common equity are each 50 percent of total assets. EBIT is $150,000, the

interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. If the company

follows a restricted policy, its total assets turnover will be 2.5.

Under a relaxed policy, its total assets turnover will be 2.2.

(21.2) Working capital investment policy Answer: c Diff: M

61. If the firm adopts a restricted policy, how much will it save in interest expense (relative to

what it would be if Callison were to adopt a relaxed policy)?

a. $ 3,233

b. $ 6,175

c. $ 9,818

d. $ 7,200

e. $10,136

(21.2) Working capital investment policy and ROE Answer: b Diff: M

62. What is the difference in the projected ROEs between the restricted and relaxed policies?

a. 2.24% b. 1.50% c. 1.00% d. 0.50% e. 0.33%



CHAPTER 21

1. (21.1) Cash conversion cycle Answer: b Diff: E

Statement a is false. If inventory increases, and sales do not, more cash is being “tied up” in

inventory so the cash conversion cycle is increased, not reduced. Statement b is true. If the company

reduces its DSO, it is collecting its accounts receivables more efficiently, so it reduces the cash

conversion cycle. Statement c is false. If the company pays its bills sooner, it uses its cash to pay off

accounts payable, and this increases its cash conversion cycle.

2. (21.2) Working capital Answer: c Diff: E

3. (21.4) Cash budget Answer: e Diff: E

4. (21.4) Cash budget Answer: a Diff: E

5. (21.4) Cash budget Answer: d Diff: E

Statement a is false because depreciation is not a cash item. (Although depreciation will affect taxes,

depreciation itself will not be explicitly included in the cash budget. The question asks “explicitly.”)

Statement b is true because this is a cash transaction, so it should be included in the cash budget.

Statement c is true because this is a cash transaction and should be included in the cash budget. Since

statements b and c are true, statement d is the correct choice.

6. (21.5) Cash management Answer: a Diff: E

Net float = Disbursements float - Collections float; therefore the larger the disbursements float

and the lower the collections float the better the cash management system. A lockbox is usedto speed cash collections. If a firm's outflows come due early in the month rather than

uniformly this will necessitate a large line of credit.



7. (21.5) Cash management Answer: e Diff: E

A very efficient cash management system could allow a firm to operate with positive net float

where the firm has a negative checkbook balance at most times but still does not bounce its

checks. The other statements are false. A good cash management system maximizes

disbursement float and minimizes collections float. A well-designed lockbox system minimizescollections float which would increase a firm's net float. Increases in interest rates raise the

opportunity cost of idle cash. A firm prefers to write checks, maximizing its disbursement float

and increasing its net float.

8. (21.5) Lockbox Answer: d Diff: E

9. (21.6) Inventory management Answer: e Diff: E

10. (21.7) Monitoring receivables Answer: b Diff: E

11. (21.7) Credit policy Answer: e Diff: E

12. (21.7) Credit policy Answer: d Diff: E

13. (21.9) Working capital financing policy Answer: a Diff: E14

. (21.9) Working capital financing Answer: e Diff: E15

. (21.9) Working capital financing Answer: a Diff: E

Statement a is false, and therefore the appropriate answer. Commercial paper is a type of

unsecured promissory note issued by large, strong firms. Statements b, c, d, and e are all

accurate statements.

16. (21.10) Marketable securities Answer: a Diff: E

17. (21.13) Commercial paper Answer: d Diff: E

18. (21.1) Cash conversion cycle Answer: d Diff: M

19. (21.1) Cash conversion cycle Answer: d Diff: M

Statements a and b are true; therefore, statement d is the appropriate choice. Delaying payments to

suppliers increases the length of the cash conversion cycle.

20. (21.2) Working capital policy Answer: d Diff: M

Statements a, b, c, and e are all true statements. Statement d is false, and thus the appropriate

choice. Holding minimal levels of inventory may result in lost sales.

21. (21.3) Cash balances Answer: c Diff: M

22. (21.3) Compensating balances Answer: c Diff: M

23. (21.4) Cash budget Answer: e Diff: M

24. (21.5) Cash management Answer: e Diff: M

25. (21.5) Float Answer: a Diff: M



Step 3: Given data and information calculated above, determine the firm’s cash conversion cycle:

Cash conversion cycle = 50 + 20 - 30

= 40 days.

36. (21.1) Cash conversion cycle Answer: a Diff: E

cycleconvers onCash

=periodconvers onInv.

+periodcollect onRec.

– perioddeferralPay.

= 72 + 60 - 45 = 87 days.

37. (21.4) Sales collections Answer: d Diff: E

receiptsMarch

= (0.20)($38,000) + (0.40)($33,000) + (0.40)($30,000) = $32,800.

38. (21.5) Float Answer: d Diff: E

Positive disbursement float = $15,000(5) = $75,000.

Negative collections float = $17,000(3) = $51,000.

Net float = $75,000 - $51,000 = $24,000.

39. (21.6) Inventory turnover ratio and DSO Answer: a Diff: E

Step 1: Determine sales level using the DSO equation.

DSO =/365Sales

sRece vable

50 =/365Sales

000,000,100

$100,000,000 =365

)Sales(50

$36,500,000,000 = 50(Sales)

$730,000,000 = Sales.

Step 2: Calculate inventory turnover ratio.



Inv. turnover =.Inv

Sales

Inv. turnover =000,000,125$

000,000,730

Inv. turnover = 5.84.

40. (21.8) Accounts receivable balanceAnswer: a Diff: E

Accounts receivables = DSO Sales per day = 35($2,027,773/365) = $194,444.

41. (21.8) Cost of trade credit Answer: a Diff: E

Nominal percentage cost =97

3

52

536 = 21.71%.

42. (21.8) Cost of trade credit Answer: d Diff: E

Nominal percentage cost =98

2

15-35

536 = 37.24%.

43. (21.8) Cost of trade credit Answer: b Diff: E

Nominal percentage cost =

96

4

5

536 = 3.042 = 304.2%.

44. (21.8) Free trade credit Answer: a Diff: E

Daily purchases =365

000,730 = $2,000.

Free trade credit = $2,000 15 = $30,000.



45

. (21.9) Maturity matching Answer: e Diff: E

A maturity matching policy implies that fixed assets and permanent current assets are financed

with long-term sources. Thus, since the minimum balance that total assets approach is

$320,000, and $260,000 of that balance is fixed assets, permanent current assets equal $60,000.

The likely level of long-term financing is $320,000.

Long-term debt financing = Permanent cash assets + Fixed assets.

Permanent cash assets = Low end of total assets - Fixed assets

= $320,000 - $260,000 = $60,000.

Long-term debt financing = $60,000 + $260,000 = $320,000.

46. (21.12) Revolving credit agreement cost Answer: b Diff: E

Interest rate on borrowed funds = 0.09 + 0.015 = 10.5%.

Cost of unused portion: $4,000,000 0.005 = $ 20,000

Cost of used portion: $6,000,000 0.105 = 630,000

Total cost of loan agreement $650,000

47. Inventory conversion period Answer: d Diff: M

Inventory conversion period (ICP) =Inventory/Sales

days365.

Annual sales = 12 $2 million = $24 million.

Inventory = 0.5 $2 million = $1 million.

ICP =1$/24$

365 = 15.2 days.



48

. (21.1) Cash conversion cycle Answer: d Diff: M

Old With Change

ICP =

20$

80$

365 =

4

365 = 91.25

16$

80$

365 =

5

365 = 73.000

+ +

DSO =

365

80$

16 = 73.00

365

80$

14 = 63.875

DP = 35 days -35.00 DP -35.000

CCC = 129.25 days New CCC = 101.875 days

Change in CCC = 101.875 – 129.25 = -27.375 days -27 days.

Net change is –27 days (CCC is 27 days shorter).

49. (21.1) Cash conversion cycle Answer: e Diff: M

Calculate each of the three main components of the cash conversion cycle:

Inventory Conversion period (ICP):

ICP =65$600,000/3

, =

6$1,643.835

, = 73 days.

Days sales outstanding (DSO):

DSO =65$600,000/3

157,808 =

6$1,643.835

157,808 = 96 days.

Payables deferral period (PDP):

PDP =65$365,000/3

25,000 =

$1,000

25,000 = 25 days.

Cash conversion cycle (CCC):

CCC = ICP + DSO – PDP = 73 + 96 – 25 = 144 days.



50

. (21.1) Cash conversion cycle Answer: b Diff: M

cycleconvers onCash

=periodconvers onInv.

+periodcollect onRec.

– perioddeferralPay.

.

For this problem we are only interested in the change in the CCC. We may therefore ignore the Payables

Deferral Period since it is assumed to remain unchanged.

Old CCC (ignore payables) = $12,000,000/$100,000 + $8,000,000/$100,000

= 120 + 80 = 200 days.

New CCC = $9,600,000/$90,000 + $6,400,000/$90,000

= 106.67 + 71.11 = 177.78 days.

Change in CCC = New CCC – Old CCC

= 177.78 – 200

= -22.22 days. Round to 22 days shorter.

51. (21.1) Cash conversion cycle Answer: e Diff: M

First, calculate Sales/Day = $50,735,000/365 = $139,000.

Then, calculate the old inventory conversion period:

Inventory/Sales per day = $15,012,000/$139,000 = 108 days.

Then, find the new inventory conversion period:

$13,066,000/$139,000 = 94 days.

We have cut the inventory conversion period by 108 – 94 = 14 days.

Then, calculate the old DSO:

Accts. Rec./Sales per day = $10,008,000/$139,000 = 72 days.

Then, find the new DSO = $8,062,000/$139,000 = 58 days.

We have cut the DSO by 72 – 58 = 14 days.

Finally, find the total net change = -14 + (-14) – 10

= -38 days.

52. (21.2) ROE and working capital policy Answer: c Diff: M

Construct simplified comparative balance sheets and income statements for the restricted and

relaxed policies (In thousands of dollars):

15% of Sales 25% of Sales

Balance sheet: Restricted Relaxed

Current assets $ 60.0 $100.0



Fixed assets 100.0 100.0

Total assets $160.0 $200.0

Debt $ 80.0 $100.0

Equity 80.0 100.0

Total liabilities and equity $160.0 $200.0

Income statement:

EBIT $ 36.0 $ 36.0

Interest (10%) (8.0) (10.0)

EBT $ 28.0 $ 26.0

Taxes (40%) (11.2) (10.4)

Net income $ 16.8 $ 15.6

ROE = NI/Equity $16.8/$80 = 0.21 $15.6/$100 = 0.156.

Difference in ROEs = 0.21 - 0.156 = 0.054 = 5.4%.



53

. (21.4) Cash budget Answer: c Diff: M

Construct a simplified cash budget:

Sales $3,000

Collections (same month’s sales) 1,176 (0.98 0.40 $3,000)

Collections (last month’s sales) 1,800 (1.00 0.60 $3,000)

Total collections 2,976

Purchases payments 1,500

Other payments 700

Total payments 2,200

Net cash gain (loss) $ 776

54. (21.5) Lockbox Answer: e Diff: M

Calculate the net reduction in A/R:

Current A/R = $2,500,000. New A/R with 20% reduction:

$2,500,000 - 0.20($2,500,000) = $2,000,000.

Net reduction in A/R = $500,000.

Calculate the interest savings and net savings:

Interest savings = $500,000(0.11) = $55,000.

Net savings = Interest savings - Annual lockbox cost

= $55,000 - $15,000 = $40,000.

55. (21.8) Accounts payable balance Answer: e Diff: M

Approximate percentage cost =98

2

35

365 = 0.212828.

Accounts payable =212828.0

621,915 = $750,000.



56. (21.8) EAR cost of trade credit Answer: e Diff: M

Calculate the nominal percentage, which is the nominal annual cost:

Nominal cost =2100

2

1020

days365

= 0.0204 36.5 = 0.7449 74.5%.

Calculate the effective annual rate (EAR):

Numerical solution:

EAR = (1.0204)36.5 - 1.0 = 2.0905 - 1.0 = 109.05% 109%.

Financial calculator solution: (EAR)

Inputs: P/YR = 36.5; NOM% = 74.49. Output: EFF% = 109%.

57. (21.8) EAR cost of trade credit Answer: e Diff: M

The company pays every 50 days or 365/50 = 7.3 times per year. Thus, the average accounts

payable are $4,562,500/7.3 = $625,000. The effective cost of trade credit can be found as

follows:

EAR = (1 + 2/98)365/35 - 1 = 1.2345 - 1 = 0.2345 = 23.45%.



58

. (21.8) EAR cost of trade credit Answer: d Diff: M

Calculate the interest rate per period

Periodic rate = 2/98 = 2.04%.

Calculate the number of compounding periods

Number of compounding periods = 365/50 = 7.30.

Use periodic rate and compounding periods to determine the annual nominal rate

2.04% 7.3 = 14.90%.

Calculate EAR

EAR = (1 + 2/98)365/50 – 1 = (1.0204)7.3 – 1 = 1.1589 – 1 = 0.1589 = 15.89%.



59

. (21.7) Accounts payable balance Answer: d Diff: T

Step 1: Calculate the nominal annual cost of trade credit.

Nominal annual cost =1030

365

98

2

= 0.0204 18.25

= 37.24%.

Step 2: Using the nominal annual cost from Step 1 determine the amount of free trade credit.

37.24% =credittradeCostly

cred ttradeFree

37.24% =000,375$

cred ttradeFree

Free trade credit = $139,650.

Step 3: Determine gross and net sales.

$139,650 = Discount, which represents 2% of sales.

.02Sales = $139,650

Sales = $6,982,500.

Net sales = 0.98Sales

= 0.98($6,982,500)

= $6,842,850.

Step 4: Since accounts payable are shown net of discounts, determine daily sales based on net sales

figure. Then multiply this amount by 30 days.



Daily net sales =365

850,842,6

= $18,747.53.

Accounts payable balance = $18,747.53 30 = $562,426.03 $562,426.



60

. (21.8) Financial statements and trade credit Answer: d Diff: T

Calculate A/P with and without taking discounts:

A/PNo discount = $11,760 30 days = $352,800.

A/PDiscount = $11,760 10 days = $117,600.

Calculate financing amount in notes payable and interest cost. The firm will need to borrow the

difference in notes payable.

$352,800 - $117,600 = $235,200.

The additional interest cost is $235,200 0.10 = $23,520.

Calculate total purchases and discounts lost:

Total purchases = 365 days 12,000 gross purchases = $4,380,000.

Discounts lost = $4,380,000 0.02 = $87,600.

Construct comparative financial statements:

I. Partial balance sheet:

Take Discounts Don’t Take Discounts

(Borrow N/P) (Use Max. Trade Cdt) Difference

Accounts payable $117,600 $352,800 -$235,200

Notes payable (10%) 235,200 - +235,200

Total current liab. $352,800 $352,800 $ 0

II. Partial income statement:

EBIT* $140,000 $140,000 $ 0

Less: Interest 23,520 0 +23,520

Discounts lost 0 87,600 -87,600

EBT $116,480 $ 52,400 +$ 64,080



Less: Taxes (at 40%) 46,592 20,960 +25,632

Net income $ 69,888 $ 31,440 +$ 38,448

*Any EBIT can be used, since the difference in EBIT from the two policies is zero.

61. (21.2) Working capital investment policy Answer: c Diff: M

Step 1: Calculate net fixed assets, which will be the same under either policy.

FA turnover =NFA

S

4.0 =NFA

000,600,3

NFA = $900,000.

Step 2: Determine total assets under each policy, given the total assets turnover ratio for each one.

Restricted: Total assets turnover =TA

S

2.5 =TA

000,600,3

TA = $1,440,000.

Relaxed: 2.2 =TA

000,600,3$

TA = $1,636,364.

Step 3: Develop balance sheets for each policy to determine the debt level.Restricted Relaxed

Current assets $ 540,000 $ 736,364

Fixed assets 900,000 900,000

Total assets $1,440,000 $1,636,364

Debt $ 720,000 $ 818,182

Equity 720,000 818,182

Total liabilities & equity $1,440,000 $1,636,364

Step 4: Determine interest under each policy:

Restricted: $720,000 0.10 = $72,000.

Relaxed: $818,182 0.10 = $81,818.

Step 5: Calculate the difference in interest expense (the savings) between the 2 policies:

$81,818 - $72,000 = $9,818.



62

. (21.2) Working capital investment policy and ROE Answer: b Diff: M

Step 1: From the previous problem we can now set up an income statement for each policy.

Restricted Relaxed

EBIT $150,000 $150,000

Interest (10%) 72,000 81,818

EBT $ 78,000 $ 68,182

Taxes 31,200 27,273

Net income $ 46,800 $ 40,909

Step 2: Calculate ROE using common equity as calculated in the prior problem for each

policy.

Restricted: ROE =000,720$

800,46 Relaxed: ROE =

182,818$

909,40

= 6.5%. = 5.0%.

Step 3: Calculate the difference in ROEs.

ROE = 6.5% - 5.0% = 1.5%.



Chapter 22: Provid ing and Obtaining Credit Page 1



Providing and Obtaining Credit

1. Multiple Choice: Conceptual

Medium:


1. A firm’s credit policy consists of which of the following items?

a. Credit period, cash discounts, credit standards, receivables monitoring.

b. Credit period, cash discounts, credit standards, collection policy.

c. Credit period, cash discounts, receivables monitoring, collection policy.

d. Cash discounts, credit standards, receivables monitoring, collection policy.

e. Credit period, receivables monitoring, credit standards, collection policy.

(22.3) Collection policy

2. Which of the following is not correct?

a. Collection policy is how a firm goes about collecting past-due accounts.

b. A more aggressive collection policy will reduce bad debt expenses, but may also

decrease sales.

c. Collection policy usually has little impact on sales since collecting past-due accounts

occurs only after the customer has already purchased.

d. Typically a firm will turn over an account to a collection agency only after it has tried

several times on its own to collect the account.

e. A lax collection policy will frequently lead to an increase in accounts receivable.





(22.4) Credit policy and seasonal dating


a. If credit sales as a percentage of a firm's total sales increases, and the volume of credit

sales also increases, then the firm's accounts receivable will automatically increase.

b. It is possible for a firm to overstate profits by offering very lenient credit terms which

encourage additional sales to financially "weak" firms. A major disadvantage of such

a policy is that it is likely to increase uncollectible accounts.

c. A firm with excess production capacity and relatively low variable costs would not be

inclined to extend more liberal credit terms to its customers than a firm with similar

costs that is operating close to capacity.

d. Firms use seasonal dating primarily to decrease their DSO.

e. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the

original sale took place on February 1st, the customer can take the discount up until

March 15th, but must pay the net invoice amount by April 1st.

(22.6) Payments pattern approach

4. Which of the following is not correct for a firm with seasonal sales and customers who

all pay promptly at the end of 30 days?

a. DSO will vary from month to month.

b. The quarterly uncollected balances schedule will be the same in each quarter.

c. The level of accounts receivable will be constant from month to month.

d. The ratio of accounts receivable to sales will vary from month to month.

e. The level of accounts receivable at the end of each quarter will be the same.





(22.6) Payments pattern approach

5. Seligstine, Inc.’s DSO was 31 days in March, and 45 days in April. Which of the

following is NOT possible?

a. Sales increased from March to April.

b. Sales decreased from March to April.

c. May’s quarterly uncollected balances schedule showed a higher percent of April’s

sales as uncollected than for March.

d. May’s quarterly uncollected balances schedule showed a lower percent of April’s


e. All of the above are possible.

(22.10) Choosing a bank

6. Which one of the following aspects of banks is considered most relevant to businesses

when choosing a bank?

a. Convenience of location.

b. Competitive cost of services provided.

c. Size of the bank's deposits.

d. Experience of personnel.

e. Loyalty and willingness to assume lending risks.






Easy:

Multiple part:

(The following information applies to the next two problems.)

You have just taken out a loan for $75,000. The stated (simple) interest rate on this loan is 10 percent, and the bank requires you to maintain a compensating balance equal to 15 percent of theinitial face amount of the loan. You currently have $20,000 in your checking account, and you plan to maintain this balance. The loan is an add-on installment loan which you will repay in 12equal monthly installments, beginning at the end of the first month.

(22.9) Loan payments

7. How large are your monthly payments?

a. $6,250

b. $7,000

c. $7,500

d. $5,250

e. $6,875

(22.9) Add-on installment loan

8

. What is the nominal annual add-on interest rate on this loan?

a. 10.00%

b. 16.47%

c. 18.83%

d. 20.00%

e. 24.00%





(22.9) EAR discount/compensating balance loan

9. Suppose you borrow $2,000 from a bank for one year at a stated annual interest rate of 14

percent, with interest prepaid (a discounted loan). Also, assume that the bank requiresyou to maintain a compensating balance equal to 20 percent of the initial loan value.

What effective annual interest rate are you being charged?

a. 14.00%

b. 8.57%

c. 16.28%

d. 21.21%

e. 28.00%

(22.9) EAR discount/compensating balance loan

10. Wentworth Greenery harvests its crops four times annually and receives payment for its

crop 90 days after it is picked and shipped. However, the firm must plant, irrigate, and

harvest on a near continual schedule. The firm uses 90-day bank notes to finance its

operations. The firm arranges an 11 percent discount interest loan with a 20 percent

compensating balance four times annually. What is the effective annual interest rate of

these discount loans?

a. 11.00%

b. 15.94%

c. 11.46%

d. 13.75%

e. 12.72%





(22.9) Effective annual rate

11. Assume you borrow $12,000 from the bank using a 10.19 percent “add-on”, one-year

installment loan, payable in four equal quarterly payments. What is the effective annual

rate of interest?

a. 9.50%

b. 10.19%

c. 15.99%

d. 16.98%

e. 20.38%


12. XYZ Company needs to borrow $200,000 from its bank. The bank has offered the

company a 12-month installment loan (monthly payments) with 9 percent add-on interest.

What is the effective annual rate (EAR) of this loan?

a. 16.22%

b. 17.97%

c. 17.48%

d. 18.67%

e. 18.00%






13. First National Bank of Micanopy has offered you the following loan alternatives in

response to your request for a $75,000, 1-year loan.

Alternative 1: 7 percent discount interest, with a 10 percent compensating balance.Alternative 2: 8 percent simple interest, with interest paid monthly.What is the effective annual rate on the cheaper loan?

a. 8.00%

b. 7.23%

c. 7.67%

d. 8.43%

e. 8.30%

(22.9) EAR discounted loan

14. Coverall Carpets Inc. is planning to borrow $12,000 from the bank. The bank offers the

choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year

installment loan, payable in 4 equal quarterly payments. What is the effective rate of

interest on the 12 percent discounted loan?

a. 10.7%

b. 12.0%

c. 12.5%

d. 13.6%

e. 14.1%





(22.9) Discount interest face value

15. Picard Orchards requires a $100,000 annual loan in order to pay laborers to tend and

harvest its fruit crop. Picard borrows on a discount interest basis at a nominal annual rate

of 11 percent. If Picard must actually receive $100,000 net proceeds to finance its crop,

then what must be the face value of the note?

a. $111,000

b. $100,000

c. $112,360

d. $ 89,000

e. $108,840

(22.9) Discount interest face value

16. Viking Farms harvests crops in roughly 90-day cycles based on a 360-day year. The firm

receives payment from its harvests sometime after shipment. Due in part to the firm's

rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on

which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds

from each note, what must be the face value of each note?

a. $61,856

b. $67,531

c. $60,000

d. $68,182

e. $67,423





Medium:


East Lansing Appliances (ELA) expects to have sales this year of $15 million under its current

credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Since ELA wants to improve its profitability, the treasurer

has proposed that the credit period be shortened to 15 days. This change would reduce expected

sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days. Expected

bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60

percent, and the cost of capital is 15 percent.

(22.8) Bad debt losses

17. What would be the incremental bad losses if the change were made?

a. $315,000

b. $260,500

c. -$260,500 (bad debt losses would decline)

d. -$315,000 (Bad debt losses would decline)

e. $ 0 (no change would occur)

(22.8) Cost of carrying receivables

18. What would be the incremental cost of carrying receivables if this change were made?

a. $108,750

b. -$116,250 (carrying costs would decline)

c. $157,900

d. -$225,000 (carrying costs would decline)

e. $260,500





(22.8) Incremental profits

19. What are the incremental pre-tax profits from this proposal?

a. $181,250

b. $271,750

c. $256,250

d. $206,500

e. $231,250





(The following information applies to the next four problems.)

Berkeley Prints expects to have sales this year of $15 million under its current credit policy. The

present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss

percentage is 5 percent. Also, Berkeley’s cost of capital is 15 percent, and its variable costs total 60

percent of sales. Since Berkeley wants to improve its profitability, a proposal has been made tooffer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net

30. The consultants predict that sales would increase by $500,000, and that 50 percent of all

customers would take the discount. The new DSO would be 30 days, and the bad debt loss

percentage on all sales would fall to 4 percent.

(22.4) Cash discounts

20. What would be the cost to Berkeley of the discounts taken?

a. $116,750

b. -$108,750

c. $155,000

d. $225,000

e. $260,500

(22.8) Bad debt losses

21. What would be the incremental bad debt losses if the change were made?

a. $130,000

b. $250,000


d. -$130,000 (bad debt losses would decline)

e. $620,000





(22.8) Cost of carrying receivables

22. What would be the incremental cost of carrying receivables if the change were made?

a. -$108,750 (carrying costs would decline)

b. $116,250

c. $157,900


e. $260,000

(22.8) Incremental profits


a. $283,750

b. $250,500

c. $303,250

d. $493,750

e. $288,250





(22.9) Add-on interest loan



installment loan, payable in 4 equal quarterly payments. What is the approximate

(nominal) rate of interest on the 10.19 percent add-on loan?

a. 5.10% b. 10.19% c. 12.00% d. 20.38% e. 30.57%

(22.9) Cost of short-term financing

25. Judy's Fashions, Inc. purchases supplies from a single supplier on terms of 1/10, net 20.

Currently, Judy takes the discount, but she believes she could extend the payment to 40

days without any adverse effects if she decided not to take the discount. Judy needs an

additional $50,000 to support an expansion of fixed assets. This amount could be raised by

making greater use of trade credit or by arranging a bank loan. The banker has offered to

loan the money at 12 percent discount interest . Additionally, the bank requires an average

compensating balance of 20 percent of the loan amount. Judy already has a commercial

checking account at this bank which could be counted toward the compensating balance,

but the required compensating balance amount is twice the amount that Judy would

otherwise keep in the account. Which of the following statements is most correct?

a. The cost of using additional trade credit is approximately 36 percent.

b. Considering only the explicit costs, Judy should finance the expansion with the bank

loan.

c. The cost of expanding trade credit using the approximation formula is less than the cost

of the bank loan. However, the true cost of the trade credit when compounding is

considered is greater than the cost of the bank loan.

d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent

because Judy would hold a cash balance of one-half the compensating balance amount

even if the loan were not taken.

e. If Judy had transaction balances that exceeded the compensating balance requirement,

the effective cost of the bank loan would be 12.00 percent.





(22.9) Cost of short-term financing

26. You need to borrow $25,000 for one year. Your bank offers to make the loan, and it

offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13

percent nominal interest, daily compounding (360-day year); (3) 9 percent add-on

interest, 12 end-of-month payments. The first two loans would require a single paymentat the end of the year, the third would require 12 equal monthly payments beginning at

the end of the first month. What is the difference between the highest and lowest

effective annual rates?

a. 1.12%

b. 2.48%

c. 3.60%

d. 4.25%

e. 5.00%





Tough:

(22.8) Change in credit policy

27. Bass Boats Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days.

The financial manager estimates that offering longer credit terms would (1) increase the

days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt

losses, which were 2 percent on the old sales, would amount to 5 percent on the

incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs

are 80 percent of sales, and Bass has a 15 percent receivables financing cost. What would

the annual incremental pre-tax profit be if Bass extended its credit period?

a. -$20,000 b. -$10,000 c. $ 0 d. $10,000 e. $20,000

(22.9) Effective interest rate




interest on the 10.19 percent add-on loan?

a. 9.50%

b. 10.19%

c. 15.22%

d. 16.99%

e. 22.05%



Chapter 22: Providing and Obtaining Credit Page 1



Providing and Obtaining Credit

1. Multiple Choice: Conceptual

Medium:

(22.1) Credit policy Answer: b Diff: M

1. A firm’s credit policy consists of which of the following items?

a. Credit period, cash discounts, credit standards, receivables monitoring.

b. Credit period, cash discounts, credit standards, collection policy.

c. Credit period, cash discounts, receivables monitoring, collection policy.

d. Cash discounts, credit standards, receivables monitoring, collection policy.

e. Credit period, receivables monitoring, credit standards, collection policy.

(22.3) Collection policy Answer: b Diff: M

2. Which of the following is not correct?

a. Collection policy is how a firm goes about collecting past-due accounts.

b. A more aggressive collection policy will reduce bad debt expenses, but may also

decrease sales.

c. Collection policy usually has little impact on sales since collecting past-due accounts

occurs only after the customer has already purchased.

d. Typically a firm will turn over an account to a collection agency only after it has tried

several times on its own to collect the account.

e. A lax collection policy will frequently lead to an increase in accounts receivable.





(22.4) Credit policy and seasonal dating Answer: b Diff: M


a. If credit sales as a percentage of a firm's total sales increases, and the volume of credit

sales also increases, then the firm's accounts receivable will automatically increase.

b. It is possible for a firm to overstate profits by offering very lenient credit terms which

encourage additional sales to financially "weak" firms. A major disadvantage of such

a policy is that it is likely to increase uncollectible accounts.

c. A firm with excess production capacity and relatively low variable costs would not be

inclined to extend more liberal credit terms to its customers than a firm with similar

costs that is operating close to capacity.

d. Firms use seasonal dating primarily to decrease their DSO.

e. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the

original sale took place on February 1st, the customer can take the discount up until

March 15th, but must pay the net invoice amount by April 1st.

(22.6) Payments pattern approach Answer: c Diff: M

4. Which of the following is not correct for a firm with seasonal sales and customers who

all pay promptly at the end of 30 days?

a. DSO will vary from month to month.

b. The quarterly uncollected balances schedule will be the same in each quarter.

c. The level of accounts receivable will be constant from month to month.

d. The ratio of accounts receivable to sales will vary from month to month.

e. The level of accounts receivable at the end of each quarter will be the same.





(22.6) Payments pattern approach Answer: e Diff: M

5. Seligstine, Inc.’s DSO was 31 days in March, and 45 days in April. Which of the

following is NOT possible?

a. Sales increased from March to April.

b. Sales decreased from March to April.

c. May’s quarterly uncollected balances schedule showed a higher percent of April’s


d. May’s quarterly uncollected balances schedule showed a lower percent of April’s


e. All of the above are possible.

(22.10) Choosing a bank Answer: e Diff: M

6. Which one of the following aspects of banks is considered most relevant to businesses

when choosing a bank?

a. Convenience of location.

b. Competitive cost of services provided.

c. Size of the bank's deposits.

d. Experience of personnel.

e. Loyalty and willingness to assume lending risks.






Easy:

Multiple part:

(The following information applies to the next two problems.)

You have just taken out a loan for $75,000. The stated (simple) interest rate on this loan is 10 percent, and the bank requires you to maintain a compensating balance equal to 15 percent of theinitial face amount of the loan. You currently have $20,000 in your checking account, and you plan to maintain this balance. The loan is an add-on installment loan which you will repay in 12equal monthly installments, beginning at the end of the first month.

(22.9) Loan payments Answer: e Diff: E

7. How large are your monthly payments?

a. $6,250

b. $7,000

c. $7,500

d. $5,250

e. $6,875

(22.9) Add-on installment loan Answer: d Diff: E

8

. What is the nominal annual add-on interest rate on this loan?

a. 10.00%

b. 16.47%

c. 18.83%

d. 20.00%

e. 24.00%





(22.9) EAR discount/compensating balance loan Answer: d Diff: E

9. Suppose you borrow $2,000 from a bank for one year at a stated annual interest rate of 14

percent, with interest prepaid (a discounted loan). Also, assume that the bank requiresyou to maintain a compensating balance equal to 20 percent of the initial loan value.

What effective annual interest rate are you being charged?

a. 14.00%

b. 8.57%

c. 16.28%

d. 21.21%

e. 28.00%

(22.9) EAR discount/compensating balance loan Answer: b Diff: E

10. Wentworth Greenery harvests its crops four times annually and receives payment for its

crop 90 days after it is picked and shipped. However, the firm must plant, irrigate, and

harvest on a near continual schedule. The firm uses 90-day bank notes to finance its

operations. The firm arranges an 11 percent discount interest loan with a 20 percent

compensating balance four times annually. What is the effective annual interest rate of

these discount loans?

a. 11.00%

b. 15.94%

c. 11.46%

d. 13.75%

e. 12.72%





(22.9) Effective annual rate Answer: d Diff: E

11. Assume you borrow $12,000 from the bank using a 10.19 percent “add-on”, one-year

installment loan, payable in four equal quarterly payments. What is the effective annual

rate of interest?

a. 9.50%

b. 10.19%

c. 15.99%

d. 16.98%

e. 20.38%

(22.9) Effective annual rate Answer: c Diff: E

12. XYZ Company needs to borrow $200,000 from its bank. The bank has offered the

company a 12-month installment loan (monthly payments) with 9 percent add-on interest.

What is the effective annual rate (EAR) of this loan?

a. 16.22%

b. 17.97%

c. 17.48%

d. 18.67%

e. 18.00%





(22.9) Effective annual rate Answer: e Diff: E

13. First National Bank of Micanopy has offered you the following loan alternatives in

response to your request for a $75,000, 1-year loan.

Alternative 1: 7 percent discount interest, with a 10 percent compensating balance.Alternative 2: 8 percent simple interest, with interest paid monthly.What is the effective annual rate on the cheaper loan?

a. 8.00%

b. 7.23%

c. 7.67%

d. 8.43%

e. 8.30%

(22.9) EAR discounted loan Answer: d Diff: E




interest on the 12 percent discounted loan?

a. 10.7%

b. 12.0%

c. 12.5%

d. 13.6%

e. 14.1%





(22.9) Discount interest face value Answer: c Diff: E

15. Picard Orchards requires a $100,000 annual loan in order to pay laborers to tend and

harvest its fruit crop. Picard borrows on a discount interest basis at a nominal annual rate

of 11 percent. If Picard must actually receive $100,000 net proceeds to finance its crop,

then what must be the face value of the note?

a. $111,000

b. $100,000

c. $112,360

d. $ 89,000

e. $108,840

(22.9) Discount interest face value Answer: a Diff: E

16. Viking Farms harvests crops in roughly 90-day cycles based on a 360-day year. The firm

receives payment from its harvests sometime after shipment. Due in part to the firm's

rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on

which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds

from each note, what must be the face value of each note?

a. $61,856

b. $67,531

c. $60,000

d. $68,182

e. $67,423





Medium:


East Lansing Appliances (ELA) expects to have sales this year of $15 million under its current

credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Since ELA wants to improve its profitability, the treasurer

has proposed that the credit period be shortened to 15 days. This change would reduce expected

sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days. Expected

bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60

percent, and the cost of capital is 15 percent.

(22.8) Bad debt losses Answer: d Diff: E

17. What would be the incremental bad losses if the change were made?

a. $315,000

b. $260,500


d. -$315,000 (Bad debt losses would decline)

e. $ 0 (no change would occur)

(22.8) Cost of carrying receivables Answer: b Diff: M

18. What would be the incremental cost of carrying receivables if this change were made?

a. $108,750

b. -$116,250 (carrying costs would decline)

c. $157,900


e. $260,500





(22.8) Incremental profits Answer: e Diff: M


a. $181,250

b. $271,750

c. $256,250

d. $206,500

e. $231,250





(The following information applies to the next four problems.)

Berkeley Prints expects to have sales this year of $15 million under its current credit policy. The

present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss

percentage is 5 percent. Also, Berkeley’s cost of capital is 15 percent, and its variable costs total 60

percent of sales. Since Berkeley wants to improve its profitability, a proposal has been made tooffer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net

30. The consultants predict that sales would increase by $500,000, and that 50 percent of all

customers would take the discount. The new DSO would be 30 days, and the bad debt loss

percentage on all sales would fall to 4 percent.

(22.4) Cash discounts Answer: c Diff: E

20. What would be the cost to Berkeley of the discounts taken?

a. $116,750

b. -$108,750

c. $155,000

d. $225,000

e. $260,500

(22.8) Bad debt losses Answer: d Diff: E

21. What would be the incremental bad debt losses if the change were made?

a. $130,000

b. $250,000


d. -$130,000 (bad debt losses would decline)

e. $620,000





(22.8) Cost of carrying receivables Answer: a Diff: M

22. What would be the incremental cost of carrying receivables if the change were made?

a. -$108,750 (carrying costs would decline)

b. $116,250

c. $157,900


e. $260,000

(22.8) Incremental profits Answer: a Diff: M


a. $283,750

b. $250,500

c. $303,250

d. $493,750

e. $288,250





(22.9) Add-on interest loan Answer: d Diff: M



installment loan, payable in 4 equal quarterly payments. What is the approximate

(nominal) rate of interest on the 10.19 percent add-on loan?

a. 5.10% b. 10.19% c. 12.00% d. 20.38% e. 30.57%

(22.9) Cost of short-term financing Answer: d Diff: M

25. Judy's Fashions, Inc. purchases supplies from a single supplier on terms of 1/10, net 20.

Currently, Judy takes the discount, but she believes she could extend the payment to 40

days without any adverse effects if she decided not to take the discount. Judy needs an

additional $50,000 to support an expansion of fixed assets. This amount could be raised by

making greater use of trade credit or by arranging a bank loan. The banker has offered to

loan the money at 12 percent discount interest . Additionally, the bank requires an average

compensating balance of 20 percent of the loan amount. Judy already has a commercial

checking account at this bank which could be counted toward the compensating balance,

but the required compensating balance amount is twice the amount that Judy would

otherwise keep in the account. Which of the following statements is most correct?

a. The cost of using additional trade credit is approximately 36 percent.

b. Considering only the explicit costs, Judy should finance the expansion with the bank

loan.

c. The cost of expanding trade credit using the approximation formula is less than the cost

of the bank loan. However, the true cost of the trade credit when compounding is

considered is greater than the cost of the bank loan.

d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent

because Judy would hold a cash balance of one-half the compensating balance amount

even if the loan were not taken.

e. If Judy had transaction balances that exceeded the compensating balance requirement,

the effective cost of the bank loan would be 12.00 percent.





Tough:

(22.8) Change in credit policy Answer: e Diff: T

27. Bass Boats Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days.

The financial manager estimates that offering longer credit terms would (1) increase the

days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt

losses, which were 2 percent on the old sales, would amount to 5 percent on the

incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs

are 80 percent of sales, and Bass has a 15 percent receivables financing cost. What would

the annual incremental pre-tax profit be if Bass extended its credit period?

a. -$20,000 b. -$10,000 c. $ 0 d. $10,000 e. $20,000

(22.9) Effective interest rate Answer: d Diff: T 28. Coverall Carpets Inc. is planning to borrow $12,000 from the bank. The bank offers the



interest on the 10.19 percent add-on loan?

a. 9.50%

b. 10.19%

c. 15.22%

d. 16.99%

e. 22.05%





CHAPTER 22

ANSWERS AND

1

. (22.1) Credit policy Answer: b Diff: M2

. (22.3) Collection policy Answer: b Diff: M3. (22.4) Credit policy and seasonal dating Answer: b Diff: M

4. (22.6) Payments pattern approach Answer: c Diff: M

5. (22.6) Payments pattern approach Answer: e Diff: M

6. (22.10) Choosing a bank Answer: e Diff: M

7. (22.9) Loan payments Answer: e Diff: E

The monthly payments would be:

Monthly payment =12

7,500+75,000 = $6,875.

8. (22.9) Add-on installment loan Answer: d Diff: E

Approximate rate =2/$75,000

7,500 = 20%.





9. (22.9) EAR discount/compensating balance loan Answer: d Diff: E

Will receive $2,000.

Face amount of loan = $2,000/(1 - 0.14 - 0.20) = $3,030.30.

Discount interest = 0.14($3,030.30) = $424.24.

Compensating balance = 0.20($3,030.30) = $606.06.

0I = ?

1

3,030.30 -3,030.30

- 424.24 discount interest + 606.06

- 606.06 comp. balance -2,424.24

2,000.00

With a financial calculator, enter N = 1, PV = 2,000, PMT = 0, FV = -2,424.24, and solve for I/YR

= 21.21%.

10. (22.9) EAR discount/compensating balance loan Answer: b Diff: E

Assume firm needs $10,000.

Face amount of loan = $10,000/(1 - 0.11 - 0.20) = $14,492.75.

Discount interest = 0.11($14,492.75) = $1,594.20.

Compensating balance = 0.20($14,492.75) = $2,898.55.





0I = ?

1

14,492.75 -14,492.75

- 1,594.20 discount interest + 2,898.55

- 2,898.55 comp. balance -11,594.20

10,000.00

With a financial calculator, enter N = 1, PV = 10,000, PMT = 0, FV =

-11,594.20, and solve for I/YR = 15.94%.

11. (22.9) Effective annual rate Answer: d Diff: E

First, calculate the amount of "add-on" interest. Interest = 0.1019($12,000)= $1,222.80. The

total amount to be repaid is $1,222.80 + $12,000 = $13,222.80. The quarterly payments are$13,222.80/4 = $3,305.70. Find the periodic rate, where N = 4, PV = 12,000, PMT =

-3,305.70, FV = 0, so the quarterly rate = 3.9977%. Finally, enter the nominal rate into your

calculator, 4 3.9977% = 15.99% = NOM%. Enter P/YR = 4. Now, solve for EFF% = 16.98%.

12. (22.9) Effective annual rate Answer: c Diff: E

Interest is 9%($200,000) = $18,000. Thus, the face value of the loan is $200,000 + $18,000 =

$218,000. Monthly payments are $218,000/12 = $18,166.67.

Calculate the periodic rate as follows:

N = 12, PV = 200,000, FV = 0, PMT = -18,166.67, I/YR = ? = 1.3514%. Convert this to an annual

rate: 1.3514% 12 = 16.2168%. Applying the EAR formula, solve for EAR = (1 + 0.162168/12)12 -

1 = 17.48%.





13. (22.9) Effective annual rate Answer: e Diff: E

Alternative 1:

Face amount of loan = $75,000/(1 - 0.07 - 0.10) = $90,361.45 $90,361.

0I = ?

1

90,361 -90,361

- 6,325 discount interest + 9,036

- 9,036 comp. balance -81,325

75,000

To solve for the loan’s effective rate enter N = 1, PV = 75,000, PMT = 0, FV = -81,325, and solve

for I/YR = 8.43%.

Alternative 2:

EAR = (1 + 0.08/12)12 - 1 = 8.30%.

14. (22.9) EAR discounted loan Answer: d Diff: E

Will receive $12,000.

Face amount of loan = $12,000/(1 - 0.12) = $13,636.36.

Discount interest = 0.12($13,636.36) = $1,636.36.

0I = ?

1

13,636.36 -13,636.36

- 1,636.36 discount interest

12,000.00





With a financial calculator, enter N = 1, PV = 12,000, PMT = 0, FV = -13,636.36 , and solve for

I/YR = 13.64% 13.6%.

15. (22.9) Discount interest face value Answer: c Diff: E

Face value =(decimal)rateNominal-1.0

requ redFunds

=0.11-1.0

100,000 =

0.89

100,000 = $112,359.55 $112,360.

16

. (22.9) Discount interest face value Answer: a Diff: EConvert the annual rate to a periodic rate (quarterly) in the denominator of the face value

formula:

Face value =360/90rateNominal-1.0

requ redFunds

=0.12(0.25)-1.0

60,000 =

0.97

60,000 = $61,855.67 $61,856.

17. (22.8) Bad debt losses Answer: d Diff: EBad debt losses old: (.05)($15,000,000) = $750,000.

Bad debt losses new: (.03)($14,500,000) = $435,000.

Change in bad debt losses = $435,000 - $750,000 = -$315,000.





18. (22.8) Cost of carrying receivables Answer: b Diff: M

DSO0 = 60 days; DSON = 30 days. No discounts.

Calculate cost of carrying receivables at current and new sales levels:

sreceivablecarry ngofCost

= DSO(Sales/Day)(Variable cost ratio)(Cost of funds)

Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000.

Sales at $14,500,000: 30($14,500,000/360)(0.6)(0.15) = $108,750.

Change = $108,750 - $225,000 = -$116,250.

19. (22.8) Incremental profits Answer: e Diff: M

Analysis of policy change:

Current Effect of Credit New

Projections Policy Change Projections

Net sales $15,000,000 -$500,000 $14,500,000

Production costs 9,000,000 + 300,000 8,700,000

Profit before

credit costs $ 6,000,000 -$200,000 $ 5,800,000

Cost of carrying

receivables 225,000 + 116,250 108,750





Bad debt losses 750,000 + 315,000 435,000

Pre-tax profits $ 5,025,000 +$231,250 $ 5,256,250

Change in incremental pre-tax profits = $231,250.

20. (22.4) Cash discounts Answer: c Diff: E

No discounts with old policy; 2% discount with new policy (2/10, net 30).

Discount = $15,500,000(0.5)(0.02) = $155,000.

21. (22.8) Bad debt losses Answer: d Diff: E

Bad debt losses old: (0.05)($15,000,000) = $750,000.

Bad debt losses new: (0.04)($15,500,000) = $620,000.

Changes in bad debt losses = $620,000 - $750,000 = -$130,000.

22. (22.8) Cost of carrying receivables Answer: a Diff: M

DSO0 = 60 days; DSON = 30 days.



Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000.

Sales at $15,500,000: 30($15,500,000/360)(0.6)(0.15) = $116,250.

Change = $116,250 - $225,000 = -$108,750.





23. (22.8) Incremental profits Answer: a Diff: M

Analysis of policy change:



Sales $15,000,000 +$500,000 $15,500,000

Discounts 0 - 155,000 155,000

Net sales $15,000,000 +$345,000 $15,345,000

Production costs 9,000,000 - 300,000 9,300,000

Profit before

credit costs $ 6,000,000 +$ 45,000 $ 6,045,000

Cost of carrying

receivables 225,000 + 108,750 116,250

Bad debt losses 750,000 + 130,000 620,000

Pre-tax profits $ 5,025,000 +$283,750 $ 5,308,750

Change in incremental pre-tax profits = +$283,750.

24. (22.9) Add-on interest loan Answer: d Diff: M

Total to be repaid = $12,000(1.1019) = $13,222.80.

Interest = $13,222.80 - $12,000 = $1,222.80.

Approximate rateAdd-on =2/$12,000

1,222.80 = 0.2038 = 20.38%.





25. (22.9) Cost of short-term financing Answer: d Diff: M

Bank loan:

With account: 12%/(1 - 0.12 - 0.10) = 15.38%.

Without account: 12%/(1 - 0.12 - 0.20) = 17.65%.

Trade credit:

Approximately: (1%/99%)[360/(40 - 10)] = 12.12%.

Effective rate: (1.0101)12

- 1.0 = 12.82%.





26. (22.9) Cost of short-term financing Answer: c Diff: M

Simple interest: EAR = 15%.

Nominal interest, daily compounding:

EAR =360

1 +0.13

360 - 1

= 13.88%.

9% add-on, 12 mos. payments:

a. Total amount to be repaid is $25,000 principal, plus 0.09($25,000) = $2,250 of interest,

or $27,250.

b. The monthly payment = $27,250/12 = $2,270.83.

c.0 I = ? 1 12

| | ... |25,000 -2,270.83 -2,270.83

With a financial calculator, enter N = 12; PV = 25,000; PMT =

-2,270.83; and FV = 0 to solve for I = 1.3514%. However, this is a monthly rate.

d. EARAdd-on = (1.013514)12 - 1 = 17.48%.

The difference between the highest and lowest EAR is 17.48% - 13.88% = 3.60%.





27. (22.8) Change in credit policy Answer: e Diff: T

DSO0 = 30 days; DSON = 50 days; no discounts.

Calculate cost of carrying receivables at current and new sales levels:



Sales at $1,000,000: 30($1,000,000/360)(0.8)(0.15) = $10,000.

Sales at $1,200,000: 50($1,200,000/360)(0.8)(0.15) = $20,000.

Analysis of policy changes:



Net sales $1,000,000 +$200,000 $1,200,000

Production costs 800,000 - 160,000 960,000

Profit before

credit costs $ 200,000 +$ 40,000 $ 240,000

Cost of carrying

receivables 10,000 - 10,000 20,000

Bad debt losses* 20,000 - 10,000 30,000



Pre-tax profits $ 710,000 +$ 20,000 $ 190,000

*Bad debt losses old: $1,000,000(0.02) = $20,000.

Bad debt losses new: $1,000,000(0.02) + $200,000(0.05) = $30,000.

The annual incremental pre tax profit with the change in policy is $20,000.

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