1). If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks
a. the stock is experiencing supernormal growth.
b. the stock should be sold.
c. the stock is a good buy.
d. management is probably not trying to maximize the price per share.
e. dividends are not likely to be declared.
2). The preemptive right is important to shareholders because it
a. allows managers to buy additional shares below the current market price.
b. will result in higher dividends per share.
c. is included in every corporate charter.
d. protects the current shareholders against a dilution of their ownership interests.
e. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.
3). Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?
a. All common stocks fall into one of three classes: A, B, and C.
b. All common stocks, regardless of class, must have the same voting rights.
c. All firms have several classes of common stock.
d. All common stock, regardless of class, must pay the same dividend.
e. Some class or classes of common stock are entitled to more votes per share than other classes.
4). If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium.
a. The expected return on the stock is 5% a year.
b. The stock’s dividend yield is 5%.
c. The price of the stock is expected to decline in the future.
d. The stock’s required return must be equal to or less than 5%.
e. The stock’s price one year from now is expected to be 5% above the current price.
5). Which of the following statements is CORRECT?
a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital.
b. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital.
c. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital.
d. To implement the corporate valuation model, we discount projected free cash flows at the cost of equity capital.
e. The corporate valuation model requires the assumption of a constant growth rate in all years.
6). Which of the following statements is CORRECT?
a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.
b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm’s common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock.
c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock.
d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free.
e. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer.
7). If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock’s expected total return for the coming year?
8). Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.
9). When working with the CAPM, which of the following factors can be determined with the most precision?
a. The market risk premium (RPM).
b. The beta coefficient, bi, of a relatively safe stock.
c. The most appropriate risk-free rate, rRF.
d. The expected rate of return on the market, rM.
e. The beta coefficient of “the market,” which is the same as the beta of an average stock.
10). LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
11). O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?
12). Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings?
13). A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings?
14). You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC?
15). Which of the following statements is CORRECT?
a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.
16). Which of the following statements is CORRECT?
a. The component cost of preferred stock is expressed as rp(1 - T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.
c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are “free.”
d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years.
e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.
17). Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. A project’s NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.
b. The lower the WACC used to calculate it, the lower the calculated NPV will be.
c. If a project’s NPV is less than zero, then its IRR must be less than the WACC.
d. If a project’s NPV is greater than zero, then its IRR must be less than zero.
e. The NPV of a relatively low-risk project should be found using a relatively high WACC.
18). Which of the following statements is CORRECT?
a. One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
b. One defect of the IRR method is that it does not take account of the time value of money.
c. One defect of the IRR method is that it does not take account of the cost of capital.
d. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future.
e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.
19). Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects
20). Which of the following statements is CORRECT?
a. The NPV method assumes that cash flows will be reinvested at the WACC, 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 IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
21). Which of the following statements is CORRECT?
a. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides.
b. The discounted payback method eliminates all of the problems associated with the payback method.
c. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability.
d. To find the MIRR, we discount the TV at the IRR.
e. A project’s NPV profile must intersect the X-axis at the project’s WACC.
22). Which of the following statements is CORRECT? Assume that all projects being considered have normal cash flows and are equally risky.
a. If a project’s IRR is equal to its WACC, then, under all reasonable conditions, the project’s NPV must be negative.
b. If a project’s IRR is equal to its WACC, then under all reasonable conditions, the project’s IRR must be negative.
c. If a project’s IRR is equal to its WACC, then under all reasonable conditions the project’s NPV must be zero.
d. There is no necessary relationship between a project’s IRR, its WACC, and its NPV.
e. When evaluating mutually exclusive projects, those projects with relatively long lives will tend to have relatively high NPVs when the cost of capital is relatively high.
23). Which of the following statements is CORRECT?
a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the project’s NPV.
e. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.
24). Which of the following factors should be included in the cash flows used to estimate a project’s NPV?
a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
b. Interest on funds borrowed to help finance the project.
c. The end-of-project recovery of any additional net operating working capital required to operate the project.
d. Cannibalization effects, but only if those effects increase the project’s projected cash flows.
e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.
25). Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
a. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.
c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
d. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.
26). Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data:
Project X Project Y
Expected NPV $350,000 $350,000
Standard deviation (σNPV) $100,000 $150,000
Project beta (vs. market) 1.4 0.8
Correlation of the
project cash flows with
cash flows from currently
existing projects Cash flows are not
correlated with the
cash flows from
existing projects Cash flows are highly
correlated with the
cash flows from
Which of the following statements is CORRECT?
a. Project X has more stand-alone risk than Project Y.
b. Project X has more corporate (or within-firm) risk than Project Y.
c. Project X has more market risk than Project Y.
d. Project X has the same level of corporate risk as Project Y.
e. Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.
27). A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?
a. Increase the estimated IRR of the project to reflect its greater risk.
b. Increase the estimated NPV of the project to reflect its greater risk.
c. Reject the project, since its acceptance would increase the firm’s risk.
d. Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets.
e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
28). As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow?
Sales revenues $13,000
Other operating costs $6,000
Tax rate 35.0%
29). Which one of the following is an example of a “flexibility” option?
a. A company has an option to invest in a project today or to wait for a year before making the commitment.
b. A company has an option to close down an operation if it turns out to be unprofitable.
c. A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at a later date if conditions change.
d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.
e. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly a commercial airline.
30). Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12%
C High 11%
D Low 9%
E Low 6%
Which set of projects would maximize shareholder wealth?
a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.
(Comp.) Real options
31). Which one of the following will NOT increase the value of a real option?
a. Lengthening the time during which a real option must be exercised.
b. An increase in the volatility of the underlying source of risk.
c. An increase in the risk-free rate.
d. An increase in the cost of obtaining the real option.
e. A decrease in the probability that a competitor will enter the market of the project in question.
32). Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT?
a. The abandonment option tends to reduce a project's NPV.
b. The abandonment option tends to reduce a project's risk.
c. If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project.
d. A project can either have an abandonment option or an investment timing option, but never both.
e. Investment timing options always increase the value of a project.
33). Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue projections shown below. One of Tutor's larger competitors, Online Professor (OP), is expected to do one of two things in Year 5: (1) develop its own competing program, which will put Tutor's program out of business, or (2) offer to buy Tutor's program if it decides that this would be less expensive than developing its own program. Tutor thinks there is a 35% probability that its program will be purchased for $6 million and a 65% probability that it won't be bought, and thus the program will simply be closed down with no salvage value. What is the estimated net present value of the project (in thousands) at a WACC = 10%, giving consideration to the potential future purchase?
WACC = 10.0% 0 1 2 3 4 5
Original project: -$3,000 $500 $500 $500 $500 $500
Buys 35% $6,000
Doesn't buy 65% $0
34). An increase in the debt ratio will generally have no effect on which of these items?
a. Business risk.
b. Total risk.
c. Financial risk.
d. Market risk.
e. The firm's beta.
35). Based on the information below, what is the firm's optimal capital structure?
a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
36). Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
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. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company's stock price hits a new high.
37). The firm’s target capital structure should do which of the following?
a. Maximize the earnings per share (EPS).
b. Minimize the cost of debt (rd).
c. Obtain the highest possible bond rating.
d. Minimize the cost of equity (rs).
e. Minimize the weighted average cost of capital (WACC).
38). Which of the following statements is CORRECT, holding other things constant?
a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
d. An increase in the company’s degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged.
e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.
39). Which of the following statements is CORRECT?
a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions.
c. A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.
40). Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells for $4.00 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs?
41). Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs. What are the pre-tax profits from sales of course packs?
a. $ 72,900
b. $ 81,000
c. $ 90,000
42). Your uncle is considering investing in a new company that will produce high quality stereo speakers. The sales price would be set at 1.5 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,200,000. What sales volume would be required to break even, i.e., to have EBIT = zero?
43). In the real world, dividends
a. are usually more stable 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, and these changes are randomly higher to lower, depending on whether earnings increased or decreased.
e. are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS would equal $0.80. Once the percentage is set, then dividend policy is on “automatic pilot” and the dividend actually paid depends strictly on earnings.
44). You own 100 shares of Troll Brothers' stock, which currently sells for $120 a share. The company is about to declare a 2-for-1 stock split. Which of the following best describes your likely position after the split?
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 $600 a share.
45). Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is lowered. Their argument is based on the assumption that
a. investors are indifferent between dividends and capital gains.
b. investors require that the dividend yield plus the 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 prefer a dollar of expected capital gains to a dollar of expected dividends because of the lower tax rate on capital gains.
46). Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio?
a. Its earnings become more stable.
b. Its access to the capital markets increases.
c. Its research and development efforts pay off, and it now has more high-return investment opportunities.
d. Its accounts receivable decrease due to a change in its credit policy.
e. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.
47). Which of the following statements about dividend policies is CORRECT?
a. Miller and Modigliani argued that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the “bird-in-the-hand” effect.
b. One reason that companies tend to favor distributing excess cash as dividends rather than by repurchasing stock is that dividends are normally taxed at a lower rate than gains on repurchased stock.
c. One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest.
d. One key advantage of the residual dividend model 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.
48). Which of the following statements is CORRECT?
a. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their investment in the company.
b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account.
c. Stock repurchases can be used by a firm that wants to increase its debt ratio.
d. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities.
e. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.
49). Which of the following statements is CORRECT?
a. Historically, the tax code has encouraged companies to pay dividends rather than retain earnings.
b. If a company uses the residual dividend model to determine its dividend payments, dividend payout will tend to increase whenever its profitable investment opportunities increase relatively rapidly.
c. The more a firm's management believes in the clientele effect, the more likely the firm is to adhere strictly to the residual dividend model.
d. Large stock repurchases financed by debt tend to increase expected earnings per share, but they also tend to increase the firm's financial risk.
e. A dollar paid out to repurchase stock has the same tax benefit as a dollar paid out in dividends. Thus, both companies and investors should be indifferent between distributing cash through dividends and stock repurchase programs.
50). Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the stock sold for $80 per share. If the firm's total market value is unchanged by the split, what will the stock price be following the split?