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savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/quiz_3_review.htm
1.
unsecured bonds
b.
income bonds
c.
d.
debentures
ANSWER:
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2.
b.
c.
d.
ANSWER:
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3.
bankrupt
b.
in default
c.
profitable
d.
in registration
ANSWER:
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4.
2.
3.
default
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
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5.
b.
c.
d.
ANSWER:
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6.
convertible bonds
b.
income bonds
c.
d.
debentures
ANSWER:
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7.
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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8.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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9.
interest rates
b.
c.
d.
ANSWER:
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10.
b.
c.
d.
ANSWER:
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11.
management fees
2.
3.
4.
load charges
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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12.
b.
c.
d.
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13.
b.
c.
d.
ANSWER:
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14.
LLCs
b.
corporations
c.
sole proprietorships
d.
limited partnerships
ANSWER:
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15.
Variable costs
a.
b.
c.
d.
ANSWER:
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16.
variable
b.
fixed
c.
a non-cash expense
d.
undetermined
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17.
Retained earnings
a.
have no cost
b.
c.
d.
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18.
b.
c.
d.
ANSWER:
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19.
b.
c.
d.
ANSWER:
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20.
b.
c.
d.
ANSWER:
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21.
b.
c.
d.
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22.
b.
c.
d.
ANSWER:
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23.
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
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24.
b.
c.
d.
ANSWER:
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25.
b.
c.
d.
ANSWER:
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Problem
26.
$1,000
semi-annual interest
$50
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maturity
10 years
a.
b.
What would be the price if comparable debt yields 12% and the bond matures after five years?
c.
What are the current yields and yields to maturity in a. and b.?
d.
What would be the bond's price in a. and b. if interest rates declined to 8%?
e.
f.
What two generalizations may be drawn from the above price changes?
RESPONSE:
ANSWER:
a.
b.
c.
Current yield
Yield to maturity
in a:
$100/$885 =
11.3%
12%
in b:
$100/$926 =
10.8%
12%
15/37
Notice that the yield to maturity is the yield on the comparable debt. Students
may confirm this by calculating the yield to maturity.
d.
e.
f.
POINTS:
Current yields
Yield to maturity
a:
$100/$1,136
= 8.8%
8%
b:
$100/$1,082
= 9.2%
8%
(1)
(2)
The longer the term of the bond (ten versus five years), the greater is
the price fluctuation.
-- / 1
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27.
REF:
You purchase a bond for $875. It pays $80 a year (i.e., the semiannual coupon is 4 percent), and the bond
matures after ten years. What is the yield to maturity?
RESPONSE:
ANSWER:
The yield to maturity equates the present value of the interest payments and principal
repayment. In this problem, that rate is 10%:
($40)(12.462) + ($1,000)(0.377) = $875.48.
(PV = -875; I = ?; N = 20; PMT = 40, and FV = 1000, I = 5 per period or 10 annually.)
POINTS:
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REF:
28.
Determine the current market prices of the following $1,000 bonds if the comparable rate is 10 percent
and answer the following questions.
XY 5 1/4 percent (interest paid annually) for 20 years
AB 14 percent (interest paid annually) for 20 years
a.
Which bond has a current yield that exceeds the yield to maturity?
b.
c.
If CD, Inc. has a bond with a 5 1/4 percent coupon and a maturity of 20 years but which was lower
rated, what would be its price relative to the XY, Inc bond? Explain.
RESPONSE:
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ANSWER:
POINTS:
a.
The current yield of the AB, Inc. bond exceeds the yield to maturity (10.25%
versus 10%) because the current yield does not consider the loss of the
premium the investors will suffer over the lifetime of the bond.
b.
There is no reason to expect the firm to call the XY bond, because the firm
could repurchase the bonds at a discount. The AB bond, however, may be
called. Current interest rates are lower (10% versus the 14% coupon on that
bond), so the firm could refund the debt. (The instructor should ask what
impact the expectation of such refunding may have on the price of the bond.)
c.
Since the CD and XY bonds are identical with regard to interest paid and term
to maturity, the factor that differentiates them is the credit rating. The CD bond
has a lower credit rating, so its value relative to the XY bond should be less.
Such a lower price will increase the yield to the investor and presumably
would be necessary to induce the investor to purchase the riskier bond.
-- / 1
REF:
29.
An investor buys a $1,000, 20 year 7 percent (interest paid semiannually) bond at par. After five years have
passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond?
RESPONSE:
ANSWER:
POINTS:
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REF:
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30.
PFD B:
If comparable yields are 9 percent, what should be the price of each preferred stock?
RESPONSE:
ANSWER:
POINTS:
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31.
a.
Principal
$1,000
Maturity date
20
years
Interest
$80
(8% coupon)
Call price
$1,050
Exercise price
$65
a share
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b.
If comparable non-convertible debt offered an annual yield of 12 percent, what would be the value
of this bond as debt?
c.
If the stock were selling for $52, what is the value of the bond in terms of stock?
d.
Would you expect the bond to sell for its value as debt (i.e., the value determined in b) if the price of
the stock were $52?
e.
If the price of the bond were $960, what are the premiums paid over the bond's value as stock and
its value as debt?
f.
If the price of the stock were $35, what would be the minimum price of the bond?
g.
What is the probability that the bond will be called when the price of the stock is $52?
h.
If the price of the stock rose to $73, what would happen to the price of the bond?
i.
If the price of the stock were $73, what would the investor receive if the bond were called?
RESPONSE:
ANSWER:
a.
b.
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c.
d.
The bond would not sell for $701.60 but for at least $800, its value as stock.
e.
POINTS:
f.
If the price of the stock were $35, the value of the bond as stock would be $35
15,385 = $538.48. The bond would sell for at least its value as debt
($701.60).
g.
The value of the bond as stock would be $800. No one would convert the
bond if it were called; they would accept the call price instead ($1,050). Thus
there is no reason to expect the firm to call the bond.
h.
The value of the bond as stock is $73 15.385 = $1,123.11; the bond's value
would rise to at least $1,123.11.
i.
Since the bond is worth $1,123.11 in terms of stock, the holders would convert
the bond. If they did not convert the bond, they would suffer a loss as they
would receive only the call price ($1,050).
-- / 1
REF:
32.
Using the corporate tax rates given in the text (p. 345), what is the corporate income tax paid on earnings
of (a) $1,000, (b) $10,000, (c) $100,000, (d) 1,000,000, and (e) 10,000,000?
RESPONSE:
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ANSWER:
a.
b.
c.
d.
for $1,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(235,000).39 + (665,000).34 = $340,000
e.
for $10,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(335,000).39 + (665,000).34 + (9,000,000)x.34 =
$3,400,000
POINTS:
-- / 1
REF:
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33.
b.
If the firm sells 1,300 units, what are its earnings or losses?
c.
If sales rise to 2,000 units, what are the firm's earnings or losses?
d.
RESPONSE:
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ANSWER:
a.
b.
Earnings
c.
Earnings
d.
POINTS:
-- / 1
REF:
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34.
Given the following information, what happens to operating income and net income if output is increased
by 10 percent? Verify your answer.
Total assets
$100,000
$80,000
Equity
$20,000
$27,000
Units sold
12,300
$19.75
RESPONSE:
ANSWER:
POINTS:
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REF:
35.
(This is a simple problem that replicates the example in the chapter.) A firm needs $100 to start and
expects
Sales
$200
Expenses
$185
Tax rate
33% of earnings
a.
b.
If the firm borrows $40 of the $100 at any interest rate of 10%, what are the firm's net earnings?
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c.
What is the return on the owners' investment in each case? Why do the returns differ?
d.
e.
f.
RESPONSE:
ANSWER:
a.
and b.
Sales
no financial
with financial
leverage
leverage
$200
$200
185
185
Expenses
EBIT
15
15
Interest
EBT
15
11
Taxes
c.
Net earnings
10
Return on equity
$10/$100 = 10%
3.63
$
7.37
$7.37/$60 = 12.28%
The return for b is higher because of the successful use of financial leverage.
(Point out that operating income is 15% of assets versus the 10% interest rate
and the reduction in taxes that results from the interest expense.)
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d.
Sales
no financial
with financial
leverage
leverage
$200
$200
194
194
Expenses
POINTS:
EBIT
Interest
EBT
Taxes
0.66
Net earnings
Return on equity
$4/$100 = 4%
1.34
$1.34/$60 = 2.23%
e.
The return on equity fell more for the firm that was financially leveraged.
f.
The generalization is that the use of financial leverage to increase the return
on equity works both ways. If revenues fall and/or expenses rise, the use of
financial leverage will magnify the swing in the firm's return on equity.
-- / 1
REF:
36.
a.
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cost of
cost of
debt/assets s
debt
equity
0%
7%
14%
10
14
20
14
30
14
40
16
50
10
18
60
12
20
What is firm's cost of capital at the various combinations of debt and equity?
b.
What is the firm's optimal capital structure? Construct a balance sheet showing that combination
of debt and equity financing.
$100
Debt
Equity
$100
c.
If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their
required rate of return if the firm uses its optimal combination of debt and equity financing?
d.
If the above cost of equity is the cost of retained earnings, what happens to the cost of capital if
the cost of new shares is one percentage point higher at the firm's optimal capital structure?
e.
If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital
structure if the firm needs $2,000,000?
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RESPONSE:
ANSWER:
a.
b.
$100
Liabilities
Equity
$ 30
70
$100
c.
If the firm earns $10 on every $100 of assets (i.e., 10% on assets), the
stockholders will not receive their required return of 14%. With 30% debt
financing, $2.40 must go to creditors ($30 .08 = $2.40), which leaves $7.60
for stockholders ($10 - 2.40). Since the stockholders have invested $70, they
earn a return of 10.86% ($7.60/$70).
For the stockholders to earn their required return, the firm must earn at 12.2%.
Then the firm can pay the creditors $2.40 and have sufficient left over ($9.80)
so that the stockholders earn the 14% required rate of return (i.e., $9.80/$70 =
14%).
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d.
If the cost of new equity rises to 15 percent, the cost of capital at the optimal
capital structure becomes:
.3(.08) + .7(.15) = 12.90.
e.
If the firm has retained earnings of $1,500,000, the breakpoint in the marginal
cost of capital schedule is
$1,500,000/.7 = $2,142,857.
The cost of $2,000,000 is 12.2 percent. The cost of the next $2,000,000 is
$142,857 at 12.2 percent and $1,857,143 at 12.7 percent.
POINTS:
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REF:
37.
The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm
exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management
believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital
structure.
a.
b.
c.
How much total financing may the firm have before the marginal cost of capital rises?
RESPONSE:
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ANSWER:
a.
b.
Notice that the marginal cost of capital rises after the firm exhausts its
retained earnings and must start using more expensive new equity.
c.
The retained earnings can support up to $36,428 in total financing and still
maintain the optimal combination of debt and equity financing. However, after
$36,428 of total financing, the retained earnings are exhausted, and the firm
must start using more expensive new equity.
POINTS:
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REF:
38.
An investment costs $10,000 and will generate annual cash inflows of $1,770 for ten years. According to
the net present value and internal rate of return methods of capital budgeting, should the firm make this
investment if its cost of capital is (a) 10% or (b) 14%?
RESPONSE:
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ANSWER:
POINTS:
39.
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REF:
A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The cost
of capital is 6 percent.
Year
Cash Inflow
A
$175
$1,100
175
175
175
175
175
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175
175
a.
What is the internal rate of return on each investment? Which investment should the firm make?
b.
What is the net present value of each investment? Which investment should the firm make?
c.
If the cash inflows can be reinvested at 8 percent, which investment should be made?
RESPONSE:
ANSWER:
a.
B:
$1,100/(1 + r B) = $1,000
Interest factor = $1,000/$1,100 = .909
rB = 10%
Since the investments are mutually exclusive, the firm should select B
because it has the higher internal rate of return.
b.
A:
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B:
Since the investments are mutually exclusive, the firm should select A
because it has the higher net present value.(This contradicts part a, which
selected investment B.)
c.
If the firm is able to reinvest the annual payments of $175, the terminal value
of A is $175(10.637) = $1,861.48
(10.637 is the interest factor for the future value of an ordinary annuity at 8%
for eight years.)
POINTS:
-- / 1
REF:
40.
$400
$ ---
$ ---
400
400
---
400
800
---
400
800
1,800
34/37
Each investment costs $1,400 and the firm's cost of capital is 10 percent.
a.
b.
c.
d.
RESPONSE:
ANSWER:
a.
Investment B:
$1,400 = $400/(1 + r B)2 + $800/(1 + r B)3 + $800/(1 + r B)4
Use 12%:
$400(.780) + $800(.712) + $800(.634) = $1,389
rB = approximately 12% (11.9%)
Investment C:
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b.
c.
Investment A:
$400(PVAIF 10%, 4y) $1,400 = $400(3.170) - $1,400 = ($132)
Investment B:
$400/(1 + .1) 2 + $800/(1 + .1) 3 + $800/(1 + .1) 4 - 1,400
= $400(.826) + $800(.751) + $800(.683) - $1,400
= $1,477.60 - $1,400 = $77.60
Investment C:
$1,800/(1 + .1) 4 - $1,400 = $1,800(.683) - $1,400
= ($170.60)
d.
POINTS:
According to the net present value, only investment B should be made. (This
confirms the answer to part b.)
-- / 1
REF:
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