Palawan State University COLLEGE OF BUSINESS & ACCOUNTANCY Puerto Princesa City FINANCE 12: FINANCIAL MANAGEMENT PART

I FINAL EXAMINATION 2nd Semester Academic Year 2011-2012

Name:____________________________________ Section (Days and Time): ________________

Score: ______________ Date: _______________

Multiple Choice. Identify the letter of the choice that best completes the statement or answers the question. Write the letter of your choice on the space provided for each item. ____ 1. Jane has randomly selected a portfolio of 20 stocks, and Dick has randomly selected a portfolio of two stocks. Which of the following statements is most correct? a. The required return on Jane's portfolio must be higher than the required return on Dick's portfolio because Jane is more diversified. b. If the two portfolios have the same beta, Jane's portfolio will have less market risk but the same amount of company-specific risk as Dick's portfolio. c. If the two portfolios have the same beta, their required returns will be the same but Jane's portfolio will have more company-specific risk than Dick's. d. All of the statements above are correct. e. None of the statements above is correct.

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2. Stock A and Stock B each have an expected return of 12 percent, a beta of 1.2, and a standard deviation of 25 percent. The returns on the two stocks have a correlation of 0.6. Portfolio P has half of its money invested in Stock A and half in Stock B. Which of the following statements is most correct? a. Portfolio P has an expected return of 12 percent. b. Portfolio P has a standard deviation of 25 percent. c. Portfolio P has a beta of 1.2. d. Statements a and c are correct. e. All of the statements above are correct.

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3. Stocks A, B, and C all have an expected return of 10 percent and a standard deviation of 25 percent. Stocks A and B have returns that are independent of one another. (Their correlation coefficient, r, equals zero.) Stocks A and C have returns that are negatively correlated with one another (that is, r < 0). Portfolio AB is a portfolio with half its money invested in Stock A and half invested in Stock B. Portfolio AC is a portfolio with half its money invested in Stock A and half invested in Stock C. Which of the following statements is most correct? a. Portfolio AB has an expected return of 10 percent. b. Portfolio AB has a standard deviation of 25 percent. c. Portfolio AC has a standard deviation that is less than 25 percent. d. Statements a and b are correct. e. Statements a and c are correct.

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4. Stock A and Stock B each have an expected return of 15 percent, a standard deviation of 20 percent, and a beta of 1.2. The returns of the two stocks are not perfectly correlated; the correlation coefficient is 0.6. You have put together a portfolio that consists of 50 percent Stock A and 50 percent Stock B. Which of the following statements is most correct? a. The portfolio's expected return is 15 percent. b. The portfolio's beta is less than 1.2. c. The portfolio's standard deviation is 20 percent. d. Statements a and b are correct. e. All of the statements above are correct.

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5. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25 percent. The returns of the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Which of the following statements is most correct? a. Portfolio P's expected return is less than the expected return of Stock C. b. Portfolio P's standard deviation is less than 25 percent. c. Portfolio P's realized return will always exceed the realized return of Stock A. d. Statements a and b are correct. e. Statements b and c are correct. 6. The risk-free rate is 6 percent. Stock A has a beta of 1.0, while Stock B has a beta of 2.0. The market risk premium (kM - kRF) is positive. Which of the following statements is most correct? a. Stock B's required rate of return is twice that of Stock A. b. If Stock A's required return is 11 percent, the market risk premium is 5 percent. c. If the risk-free rate increases (but the market risk premium stays unchanged), Stock B's required return will increase by more than Stock A's. d. Statements b and c are correct. e. All of the statements above are correct.

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7. In recent years, both expected inflation and the market risk premium (kM - kRF) have declined. Assume that all stocks have positive betas. Which of the following is likely to have occurred as a result of these changes? a. The average required return on the market, kM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. b. The required returns on all stocks have fallen by the same amount. c. The required returns on all stocks have fallen, but the decline has been greater for stocks with higher betas. d. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas. e. The required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.

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8. Stock X has a beta of 1.5 and Stock Y has a beta of 0.5. The market is in equilibrium (that is, required returns equal expected returns). Which of the following statements is most correct? a. Since the market is in equilibrium, the required returns of the two stocks should be the same. b. If both expected inflation and the market risk premium (kM - kRF) increase, the required returns of both stocks will increase by the same amount. c. If expected inflation remains constant but the market risk premium (kM - kRF) declines, the required return of Stock X will decline but the required return of Stock Y will increase. d. All of the statements above are correct. e. None of the statements above is correct.

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9. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25 percent. The returns of the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but that the risk-free rate remains unchanged. Which of the following statements is most correct? a. The required return of all three stocks will increase by the amount of the increase in the market risk premium. b. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium. c. The required return of all stocks will remain unchanged since there was no change in their betas. d. The required return of the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will decrease while the returns of safer stocks (such as Stock A) will increase. e. The required return of the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A)

will decrease. Burlees Inc. Burlees Inc.'s CFO is interested in calculating the cost of capital. In order to calculate the cost of capital, the company has collected the following information: The company's capital structure consists of 40 percent debt and 60 percent common stock. The company has bonds outstanding with 25 years to maturity. The bonds have a 12 percent annual coupon, a face value of $1,000, and a current price of $1,252. The company uses the CAPM to calculate the cost of common stock. Currently, the riskfree rate is 5 percent and the market risk premium, (kM - kRF), equals 6 percent. The company's common stock has a beta of 1.6. The company's tax rate is 40 percent.

____ 10. Refer to Burlees Inc. What is the company's after-tax cost of debt? a. 3.74% b. 4.80% c. 5.62% d. 7.20% e. 8.33%

____ 11. Refer to Burlees Inc. What is the company's cost of common equity? a. 9.65% b. 14.00% c. 14.60% d. 17.60% e. 18.91%

____ 12. Refer to Burlees Inc. What is the company's weighted average cost of capital (WACC)? a. 10.5% b. 11.0% c. 11.5% d. 12.0% e. 12.5%

____ 13. Sunshine Inc. has two divisions. 50 percent of the firm's capital is invested in Division A, which has a beta of 0.8. The other 50 percent of the firm's capital is invested in Division B, which has a beta of 1.2. The company has no debt, and it is 100 percent equity financed. The risk-free rate is 6 percent and the market risk premium is 5 percent. Sunshine assigns different hurdle rates to each division, and these hurdle rates are based on each division's market risk. Which of the following statements is most correct? a. Sunshine's composite WACC is 11 percent. b. Division B has a lower weighted average cost of capital than Division A. c. If Sunshine assigned the same hurdle rate to each division, this would lead the firm to select too many projects in Division A and reject too many projects in Division B. d. Statements a and b are correct. e. Statements a and c are correct.

____ 14. If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true? a. If the beta of the asset is larger than the firm's beta, then the required return on the asset is less than the required return on the firm. b. If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm. c. If the beta of the asset is greater than the firm's beta prior to the addition of that asset, then the firm's beta after the purchase of the asset will be smaller than the original firm's beta. d. If the beta of an asset is larger than the firm's beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.

e. None of the statements above is correct. ____ 15. Using the Security Market Line concept in capital budgeting, which of the following is correct? a. If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firm's average project. b. If a project's return lies below the SML, it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta. c. If two mutually exclusive projects' expected returns are both above the SML, the project with the lower risk should be accepted. d. If a project's expected rate of return is greater than the expected rate of return on an average project, it should be accepted. e. None of the statements above is correct.

____ 16. Louisiana Enterprises, an all-equity firm, is considering a new capital investment. Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7 percent. The firm currently has a required return of 10.75 percent and a beta of 1.25. The investment, if undertaken, will double the firm's total assets. If kRF is 7 percent and the market return is 10 percent, should the firm undertake the investment? (Choose the best answer.) a. Yes; the expected return of the asset (7%) exceeds the required return (6.5%). b. Yes; the beta of the asset will reduce the risk of the firm. c. No; the expected return of the asset (7%) is less than the required return (8.5%). d. No; the risk of the asset (beta) will increase the firm's beta. e. No; the expected return of the asset is less than the firm's required return, which is 10.75%.

____ 17. Assume you are the director of capital budgeting for an all-equity firm. The firm's current cost of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5 percent. You are considering a new project that has 50 percent more beta risk than your firm's assets currently have, that is, its beta is 50 percent larger than the firm's existing beta. The expected return on the new project is 18 percent. Should the project be accepted if beta risk is the appropriate risk measure? Choose the correct statement. a. Yes; its expected return is greater than the firm's cost of capital. b. Yes; the project's risk-adjusted required return is less than its expected return. c. No; a 50 percent increase in beta risk gives a risk-adjusted required return of 24 percent. d. No; the project's risk-adjusted required return is 2 percentage points above its expected return. e. No; the project's risk-adjusted required return is 1 percentage point above its expected return.

____ 18. Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine a project's beta? a. Risk premium method. b. Pure play method. c. Accounting beta method. d. CAPM method. e. Statements b and c are correct.

____ 19. Northern Conglomerate has two divisions, Division A and Division B. Northern looks at competing pure-play firms to estimate the betas of each of the two divisions. After this analysis, Northern concludes that Division A has a beta of 0.8 and Division B has a beta of 1.5. The two divisions are the same size. The risk-free rate is 5 percent and the market risk premium, kM - kRF, is 6 percent. Assume that Northern is 100 percent equity financed. What is the overall composite WACC for Northern Conglomerate? a. 9.8% b. 10.2% c. 11.9% d. 13.6% e. 14.0%

____ 20. Interstate Transport has a target capital structure of 50 percent debt and 50 percent common equity. The firm is considering a new independent project that has a return of 13 percent and is not related to transportation. However, a pure play proxy firm has been identified that is exclusively engaged in the new line of business. The proxy firm has a beta of 1.38. Both firms have a marginal tax rate of 40 percent, and Interstate's beforetax cost of debt is 12 percent. The risk-free rate is 10 percent and the market risk premium is 5 percent. The firm should a. Reject the project; its return is less than the firm's required rate of return on the project of 16.9 percent. b. Accept the project; its return is greater than the firm's required rate of return on the project of 12.05 percent. c. Reject the project; its return is only 13 percent. d. Accept the project; its return exceeds the risk-free rate and the before-tax cost of debt. e. Be indifferent between accepting or rejecting; the firm's required rate of return on the project equals its expected return.

Project A Project A has a 10 percent cost of capital and the following cash flows: Year 0 1 2 3 4 Project A Cash Flow -$300 100 150 200 50

____ 21. Refer to Project A. What is Project A's net present value (NPV)? a. $ 21.32 d. $ 99.29 b. $ 66.26 e. $112.31 c. $ 83.00

____ 22. Refer to Project A. What is Project A's internal rate of return (IRR)? a. 13.44% d. 24.79% b. 16.16% e. 26.54% c. 18.92%

____ 23. Refer to Project A. What is Project A's modified internal rate of return (MIRR)? a. 7.40% d. 15.54% b. 12.15% e. 18.15% c. 14.49%

____ 24. Refer to Project A. In addition to Project A, the firm has a chance to invest in Project B. Project B has the following cash flows: Year 0 1 2 3 4 Project B Cash Flow -$200 150 100 50 50

At what cost of capital would Project A and Project B have the same net present value (NPV)? a. 11.19% d. 13.03% b. 12.23% e. 13.27% c. 12.63%

Company A Company A is considering a project with the following cash flows: Year 0 1 2 3 Project Cash Flow -$5,000 5,000 3,000 -1,000

The project has a cost of capital of 10 percent. ____ 25. Refer to Company A. What is the project's net present value (NPV)? a. $1,157 d. $2,000 $1,273 e. $2,776 b. c. $1,818

____ 26. Refer to Company A. What is the project's modified internal rate of return (MIRR)? a. 16.6% d. 18.0% b. 17.0% e. 18.6% c. 17.6%

Bell Corporation Bell Corporation is considering two mutually exclusive projects, Project A and Project B. The projects have the following cash flows: Year 0 1 2 3 4 Project A Cash Flow -500 150 200 250 100 Project B Cash Flow -500 300 300 350 -300

Both projects have a 10 percent cost of capital. ____ 27. Refer to Bell Corporation. What is Project A's net present value (NPV)? a. 30.12 d. 57.78 b. 34.86 e. 62.01 c. 46.13

____ 28. Refer to Bell Corporation. What is Project A's internal rate of return (IRR)? a. 15.32% d. 16.68% b. 15.82% e. 17.01% c. 16.04%

____ 29. Refer to Bell Corporation. What is Project B's modified internal rate of return (MIRR)? a. 12.05% d. 14.01% e. 14.88% b. 12.95% c. 13.37%

____ 30. Refer to Bell Corporation. At what discount rate would the two projects have the same net present value? a. 4.50% d. 7.15% b. 5.72% e. 8.83% c. 6.36% End Of examination