RCA is considering two independent projects, X and Y. Both projects have a cost of capital of 14%. The cash flows that the projects will produce are:

Question 1

Year

Project X

$(9,000)

4,000

Project Y

$(10,334)

3,000

5,000

6,000

RCA uses the IRR method for project selection. Based on the above data, RCA should accept:

a. Both projects

b. Project X, but not Project Y

c. Project Y, but not Project X

d. Neither project

Question 2

Sibling Company’s common stock has a beta of 1.40. If the risk-free rate of return is 7% and the market offers a premium of 8% over the risk free rate, what is the expected return on Sibling’s stock?

a. 8.4%

b. 11.2%

c. 14.4%

d. 18.2%

Question 3

Which of the following investors incurs the least risk?

a. bondholders

b. preferred stockholders

c. common stockholders

d. all of the above bear equal risk

Question 4

Castle Corp. generated $2 million in operating profits. The firm’s corporate tax rate was 40%. If the WACC was 12%, what was the value of the firm?

a. $6.7 million

b. $10 million

c. $12.3 million

d. $16.7 million

Question 5

If the market price of a bond increases, then:

a. the yield to maturity decreases

b. the coupon rate decreases

c. the yield to maturity increases

d. none of the above

Question 6

The Acme Company is analyzing a project that has a cost of capital of 10%. The project’s estimated cost is $200,000. The cash flows that the project is expected to generate are as follows.

Year

Cash flow

$75,000

$85,000

$95,000

$65,000

$15,000

The discounted payback period for this project is:

a. 2.42 years

b. 2.86 years

c. 3 years

d. 3.72 years

Question 7

Metals, Inc. has $2,575,000 of debt, $550,000 of preferred stock, and $18,125,000 of common stock. The after-tax cost of debt is 5.25%, preferred stock has a required rate of return of 6.35%, and common stock has a required rate of return of 14.05%. What is Metals’ WACC?

a. 4.50%

b. 8.33%

c. 10.84%

d. 12.78%

Question 8

Wannabe a Brave, Inc. (WaB) is considering the purchase of a new machine which is expected to increase EBITDA by $5,000 annually. Due to this increase, WaB expects that its working capital will increase $3,000 for the project. The company will use the straight-line method to depreciate the $20,000 purchase price over the project’s 5 year economic life. The salvage value will be zero. The firm has a marginal tax rate of 34 percent and a cost of capital of 12 percent.

The machine’s after-tax operating cash flows for years 1-5 are _________.

a. $10,000

b. $4,660

c. $5,980

d. $1,980

Question 9

RRR Co. has a debt ratio of 45%. What is its Debt-to-Equity ratio?

a. 45%

b. 55%

c. 82%

d. 122%

Question 10

A stock dividend and a stock split are similar in that _____.

a. cash is paid out and the number of shares outstanding increases

b. no cash is paid out and the number of shares outstanding increases

c. both changes affect only the common stock account

d. cash is paid out and the only other effect is on the retained earnings account

e. they are totally dissimilar

Question 11

The machine’s initial cash outlay is ________.

a. $23,000

b. $21,000

c. $20,000

d. $17,000

Question 12

Katie’s Chocolates imports raw chocolate from Brazil. The current cost of chocolate in the spot market is $2.38 per pound. The company’s total imports are 200,000 pounds per year. What would the cost savings be to the company from hedging, at the current spot rate, this year’s purchases if chocolate goes up in price to $3.00 per pound?

a. $124,000

b. $200,000

c. $476,000

d. $600,000

Question 13

The intrinsic (exercise) value of a put option equals _____.

a. exercise price – stock price

b. stock price – exercise price

c. call premium – (exercise price – stock price)

d. put premium – (stock price – exercise price)

Question 14

A corporation with surplus cash flows may use the cash flows to:

a. pay special dividends

b. repurchase shares

c. pay interest

d. all of the above

Question 15

The optimal capital structure is

a. the mix of funds used by the firm in a manner that will maximize the firm’s common stock price

b. the mix of all items that appear on the right-hand side of the company’s balance sheet

c. the mix of funds that will minimize the firm’s beta

d. the mix of securities that will maximize the firm’s EPS

Question 16

An investor would buy a _____ if she believes that the price of the underlying stock will fall in the near future.

a. call option

b. convertible bond

c. put option

d. futures contract

Question 17

Last year, the sales for the Writing Room Stationery Company were $20 million. The ratios for several balance sheet items relative to sales were calculated as follows:

Cash

Accounts Receivable

Inventory

Net Fixed Assets

Accounts Payable

Notes Payable

Other Accruals

Net Income

15%

20%

50%

20%

10%

8.5%

The firm wishes to maintain its 25% payout ratio. If sales were to increase 5%, what would the Additional Funds Needed be?

a. $203,750

b. -$725,000

c. -$788,750

d. -$688,750

Question 18

Villa Pizza had sales in 2012 of $850,000. It expects sales to increase 10% this next year. The firm is operating at full capacity. If Asset/Sales = 55%, Liabilities/Sales = 20%, Profit Margin = 12% and the POR = 50%, what would be the Additional Funds Needed?

a. -$26,350

b. $24,650

c. $58,650

d. $246,500

Question 19

Target-Mart is planning a new store in Greenwich. The company will lease the needed space for 15 years. Equipment and fixtures for the store will cost $2,500,000 and will be depreciated totally using the straight-line depreciation method. In addition, inventories valued at $500,000 will also be needed to stock the store at the current time (before opening). Sales are expected to be $5 million each year. Operating expenses, ignoring depreciation, will be $2,500,000 each year. The firm will maintain the same inventory levels, and liquidate the inventory at the end of the 15-year period. The corporate tax rate is 34%. The WACC for Target-Mart is 11.75%.

What is the MIRR of this project?

a. 22.5%

b. 30.9%

c. 35.7%

d. 56.8%

Question 20

Speedy Growth Profitable Tech Company’s zero dividend policy may be explained by _____.

a. a dividend payment would indicate no more positive investment opportunities

b. Speedy has generated a greater return to shareholders than they can earn on the dividend

c. shareholders prefer growth and capital gains over dividends

d. all of the above

e. none of the above

Question 21

Which of the following statements regarding capital budgeting is most accurate?

a. The higher the discounted payback period, the higher a project should be ranked.

b. A project that is expected to generate a negative NPV will produce an IRR that is greater than the cost of capital required to justify the investment.

c. When analyzing two independent projects, the IRR method will produce the same decision that is obtained from evaluating projects using the NPV method.

d. The Profitability Index (PI) is a better method for ranking projects than the Payback Period (PBP) because PI used cash flows and PBP doesn’t.

Question 22

Healy, Inc. currently has a beta of 1.25 and a debt-equity ratio of 1. The corporate tax rate is 35%. If the company increases debt so that its debt-equity ratio is 1.75, what would the resulting beta be?

a. 0.76

b. 1.25

c. 1.62

d. 1.75

Question 23

A project with a WACC of 10% has a net present value of -$175. The internal rate of return for this project will be:

a. Lower than 10%

b. Higher than 10%

c. Equal to 10%

d. Cannot be determined with the information given

Question 24

The South Bay Company manufactures computer chips for use in consumer electronics that are built to the specifications of major brand manufacturers. Company management is considering investing in a project to develop and produce its own line of electronic music storage and playback devices based on its own revolutionary and untested chip design. In analyzing the NPV of this project, a financial analyst should use ___.

a. the firm’s weighted average cost of capital as the discount rate

b. a discount rate that is higher than the firm’s WACC to reflect the additional risk of this project

c. very conservative estimates for the estimated cash flows and discount them at a rate that is lower than the firm’s WACC to reflect the additional risk of this project

d. the leveraged free cash flows of the project discounted at a higher risk-adjusted WACC

Question 25

If dividends are taxed, then investors in _____ tax brackets will tend to prefer high dividend payout stocks.

a. high

b. average

c. low

d. cannot tell from the information provided

Question 26

A company estimates that an average-risk project has a WACC of 9%, a below-average risk project has a 7% cost of capital, and an above-average risk project has an 11% cost of capital. Which of the following projects should the company accept?

a. Project A which has average risk and an IRR of 9.5%

b. Project B which has below-average risk and an IRR of 6.35%

c. Project C which has above-average risk and an IRR of 10.5%

d. All of the projects are acceptable

Question 27

What is the NPV of this project?

a. $8,256,937

b. $8,829,179

c. $8,389,579

d. $8,875,198

Question 28

Treasury bonds currently earn 5.8%. The expected market rate of return is 13.4%. The corporate tax rate is 40%. Given the following information for PDG Corporation, what is the debt ratio that maximizes the firm’s value?

D/E

WACC

.20

.80

1.2

14.92%

12.9%

.40

.60

.40

10%

.80

.20

12%

a. 20%

b. 40%

c. 60%

d. 80%

Question 29

Why do common stocks tend to grow in value over long periods of time?

a. the fact that almost all shares of common stock are convertible

b. the growth rate in earnings per share

c. the growth in the number of shareholders

d. all of the above

Question 30

An analyst is interested in using the Black-Scholes model to value call options on the stock of QU, Inc. The analyst has accumulated the following information:

Stock price

$15

Exercise price

$18

Time until maturity

6 months

Standard deviation of the stock

20%

Risk free rate of return

What is the value of the call option?

a. $0.43

b. $0.14

c. $3.38

d. $3.00

Question 31

What type of risk is a direct result of a firm’s capital structure decision?

a. business risk

b. financial risk

c. systematic risk

d. interest rate risk

Question 32

An analyst is interested in using the Black-Scholes model to value put options on the stock of QU, Inc. The analyst has accumulated the following information:

Stock price

$40

Strike price

$40

Time until maturity

6 months

Standard deviation of the stock

12%

Risk free rate of return

16%

Using the Black-Scholes model, what is the value of a put option?

a. $1.94

b. $0.30

c. $3.76

d. $3.38

e. $2.12

Question 33

A discretionary form of financing would be:

a. Notes payable

b. Accounts payable

c. Accrued expenses

d. None of the above

Suppose a stock had an initial price of $83 per share, paid a dividend of $1.40 per share during the year, and had an ending share price of $76. Compute the dividend yield, the capital gains yield and the percentage total return.

1. Suppose a stock had an initial price of $83 per share, paid a dividend of $1.40 per share during the year, and had an ending share price of $76. Compute the dividend yield, the capital gains yield and the percentage total return.

A) 2.00%, –8.00%, –6.00%

B) 1.69%, 8.43%, 10.12%

C) 1.69%, –8.43%, –6.75%

D) -1.69%, 8.43%, 6.75%

2. You’ve observed the following returns on Kelley Corporation’s stock over the past five years: –16 percent, 21 percent, 4 percent, 16 percent, and 19 percent. What was the arithmetic average return on the stock over this five-year period? What was the variance of returns over this period? The standard deviation?

A) 8.80%, 0.023570, 15.35%

B) 11.80%, 0.023570, 15.35%

C) 8.80%, 0.034056, 18.45%

D) None of the above

3. The geometric average return answers the question, “What was your average compound return per year over a particular period?” The arithmetic average return answers the question, “What was your return in an average year over a particular period?”

A) True

B) False

4. A stock has had returns of 29 percent, 14 percent, 23 percent, –8 percent, 9 percent, and –14 percent over the last six years. What are the arithmetic (AAR) and geometric (GAR) average returns for the stock?

A) AAR = 8.83%, GAR = 7.69%

B) AAR = 7.69%, GAR = 8.83%

C) AAR = 8.83%, GAR = 8.83%

D) AAR = 16.17%%, GAR = 15.52%

5. Eight months ago, you purchased 400 shares of Winston, Inc. stock at a price of $56.90 a share. To date the company has paid quarterly dividends of $.55 a share twice. Today, you sold all of your shares for $49.40 a share. What is your total percentage return on this investment?

A) -11.2%

B) -9.3%

C) -8.4%

D) 12.0%

6. Over the past 75 years, the total annual returns on large company common stocks averaged 11.8%, small company stocks averaged 16.6%, long-term government bonds averaged 5.8%, while Treasury Bills averaged 3.7%. What was the average risk premium earned by long-term government bonds and small company stocks, respectively?

A) 1.8%; 11.9%

B) 2.1%; 12.9%

C) 4.4%; 13.9%

D) None of the above.

7. For given variances of the individual securities, a negative covariance between the two securities increases the variance of the entire portfolio. A positive covariance between the two securities decreases the variance of the entire portfolio.

A) True

B) False

8. The efficient set of securities represents those securities and portfolios of securities that have the highest expected return per unit of total risk (standard deviation of return).

A) True

B) False

9. A systematic risk is one that influences a large number of assets, each to a greater or lesser extent. Because systematic risks have marketwide effects, they are sometimes called market risks. An unsystematic risk is one that affects a single asset or a small group of assets. Because these risks are unique to individual companies or assets, they are sometimes called unique or asset specific risks.

A) True

B) False

10. The capital asset pricing model (or CAPM for short), implies that the expected return on a security is linearly related to its beta. In practice, financial economists generally use a broad-based value weighted index such as the Standard & Poor’s (S&P) 500 as a proxy for the market portfolio in order to estimate the beta for a security.

Of course, all investors do not hold the same portfolio. However, we know that a large number of investors hold diversified portfolios, particularly when mutual funds or pension funds are included. A broad-based value weighted index such as the S&P 500, therefore, is a good proxy for the highly diversified portfolios of many investors.

Since the average return on the S&P 500 proxy for the market portfolio has been higher than the average risk-free rate over long periods of time, [E(RM) – RF] is presumably positive over long periods. Thus, the CAPM also implies that the expected return on a security is positively related to its beta.

A) True

B) False

11. Consider the following information on three stocks A, B and C:

State of Probability of Rate of Return if State Occurs

Economy State Occurring A B C

Boom .2 .20 .35 .60

Normal .6 .15 .12 .05

Bust .2 .01 -.25 -.50

If your portfolio is invested 30 percent each in A and B and 40 percent in C, what is the portfolio expected return? The variance? The standard deviation?

A) 9.16%, .08001, 28.29%

B) 4.30%, .08001, 28.29%

C) 9.16%, .03882, 19.70%

D) 8.72%, .04612, 21.48%

12. The principle of diversification tells us that:

A) concentrating an investment in three companies all within the same industry will greatly reduce your overall risk.

B) concentrating an investment in two or three large stocks will eliminate all of your risk.

C) spreading an investment across many diverse assets will eliminate some of the risk.

D) spreading an investment across many diverse assets will eliminate all of the risk.

13. The slope of an asset’s security market line is the:

A) reward-to-risk ratio.

B) beta coefficient.

C) risk-free interest rate.

D) market risk premium.

14. Which one of the following statements is correct concerning the expected rate of return on an individual stock given various states of the economy?

A) The expected return is a geometric average where the probabilities of the economic states are used as the exponential powers.

B) The expected return is an arithmetic average of the individual returns for each state of the economy.

C) The expected return is a weighted average where the probabilities of the economic states are used as the weights.

D) The expected return is equal to the summation of the values computed by dividing the expected return for each economic state by the probability of the state.

15. If investors possess homogeneous expectations over all assets in the market portfolio, when riskless lending and borrowing is allowed, the market portfolio is defined to:

A) be the same portfolio of risky assets chosen by all investors.

B) have the securities weighted by their market value proportions.

C) be a diversified portfolio.

D) All of the above.

16. Using the CAPM, a stock has a beta of 1.3, the expected return on the market is 9 percent, and the risk-free rate is 4 percent. What must the expected return on this stock be?

A) 11.70%

B) 10.50%

C) 14.00%

D) 25.70%

17. While beta is theoretically the best measure of risk for a security in a portfolio, not all betas are created equal. Some are computed using weekly returns and some using daily returns. Some are computed using 60 months of stock returns; some consider more or less returns. Some betas are computed by comparing the stock to the S&P 500 Index, while others use alternative indices. Finally, some reporting firms (including Value Line) make adjustments to raw betas to reflect information other than just the fluctuation in stock prices. Further, portfolio managers are interested in knowing what the beta of the stock will be in the future, but betas have to be estimated using historical data. Anytime we use the past to predict the future, there is the danger of making a poor estimate. This is often called forecast risk (estimation risk) or forecast error.

A) True

B) False

18. A stock with an actual return that lies above the security market line:

A) has less systematic risk than the overall market.

B) has more risk than warranted based on the realized rate of return.

C) has more systematic risk than the overall market.

D) has yielded a higher return than expected for the level of risk assumed.

19. The Capital Market Line is the relationship between the expected returns and standard deviations of portfolios formed by combinations of:

A) efficient portfolios.

B) the risk-free asset and any risky asset.

C) the risk-free asset and the optimal portfolio of risky assets.

D) the risk-free asset and any portfolio of risky assets.

20. When a project is financed with both debt and equity, the cost of capital is determined by the cost of both debt and equity. If a firm uses both debt and equity, the cost of capital is a weighted average of each or the weighted average cost of capital (WACC).

A) True

B) False

21. Kelley Corporation has a target capital structure of 55 percent common stock and 45 percent debt. Its cost of equity is 16 percent, and the cost of debt is 9 percent. The relevant tax rate is 35 percent. What is Kelley’s WACC?

A) 11.43%

B) 16.00%

C) 5.85%

D) 21.85%

22. Given the following information for Indiana Power Co., find the WACC.

The company’s tax rate is 35 percent;

Debt: 4,000 7 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 103 percent of par; the bonds make semiannual payments;

Common stock: 90,000 shares outstanding, selling for $57 per share;

The firm’s beta is 1.10;

Assume an 8 percent market risk premium

(Remember the risk premium = [E(RM) – Rf];

Rf = 6 percent risk-free rate.

A) 14.80%

B) 8.00%

C) 6.72%

D) 10.15%

23. The three forms of the efficient markets hypothesis (EMH) are: 1) Weak form. Market prices reflect all information, public or private. Investors are unable to earn abnormal returns using insider information or historical prices to predict future price movements. 2) Semi-strong form. In addition to historical data, market prices reflect all publicly-available information. Investors with insider, or private information, are able to earn abnormal returns. 3) Strong form. Market prices reflect information contained in historical prices. Investors are unable to earn abnormal returns using historical prices to predict future price movements.

A) True

B) False

24. During a trading day, American Air Inc. announces that it has lost a contract for a large transport plane project, which, prior to the news, it was widely believed to have secured. If the market is semistrong form efficient, how should the stock price react to this information if no additional information is released?

A) At the time of the announcement, the price of the stock should immediately increase.

B) At the time of the announcement, the price of the stock should not change.

C) At the time of the announcement, the price of the stock should immediately decrease.

D) At the time of the announcement, there is a 50 percent chance that the price of the stock could increase or decrease since stock price movement is random.

25. The EMH only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon.

A) True

B) False

26. A basic premise of portfolio theory is that investors tend to be risk averse. In selecting their investments, investors seek out investments with the characteristic of providing the maximum expected rate of return for a given level of risk, or the minimum anticipated volatility (risk) for a given expected rate of return.

A) True

B) False

27. Assume an investor formed a portfolio comprised of 30% in the common stock of AT&T, Inc., (T) and 70% in the common stock of Apple, Inc. (AAPL). Use the data provided below to calculate the portfolio’s monthly expected return, standard deviation, and coefficient of variation.

Spreadsheet estimates of average monthly return, standard deviation and covariance for each of these two stocks are as follows: (to convert to decimal format, move the decimal point two places to the left for both the average return and standard deviation; move the decimal point four places to the left for the covariance):

T AAPL

Average Monthly Return 2.28% 5.64%

Standard Deviation of Return 5.56% 12.01%

Covariance (T, AAPL) = -33

A) 4.63%, 55.85%, 12.06

B) 4.63%, 7.72%, 1.67

C) 3.39%, 4.49%, 1.33

D) None of the above

28. Consider a portfolio comprised of two stocks A and B:

The estimates shown below are given in percentage format for the expected return, E(R), and standard deviation of returns (SD). Note: to convert to decimal format, move the decimal point two places to the left for both the E(R) and SD).

Stock Weight E(R) SD

A 0.40 16% 45%

B 0.60 12% 30%

The correlation between stocks A and B is .75.

Calculate the portfolio expected return and standard deviation.

A) 13.6%, 33.67%

B) 13.6%, 12.73%

C) 12.1%, 18.62%

D) None of the above

29. An all-equity financed firm that has an 11 percent cost of capital is considering the following projects:

Project Beta Expected Return

W .75 11%

X .95 13%

Y 1.15 14%

Z 1.50 15%

The T-bill rate is 5 percent and the expected return on the market is 12 percent. Assuming the CAPM is the true return generating model, which projects should be accepted? Which projects would be incorrectly rejected if the firm’s cost of capital were used as a hurdle rate?

A) Accept X, Y and Z; Reject W

B) Accept W, Y and Z; Reject X

C) Accept W, X and Z; Reject Y

D) Accept W, X and Y; Reject Z

30. On-line Text Co. has four new text publishing products that it must decide on publishing to expand its services. The firm’s WACC has been 17%. The projects are of equal risk, Beta of 1.6. The risk-free rate is 7% and the market rate is expected to be 12%. The projects expected IRRs are as follows:

Project W = 14%

Project X = 18%

Project Y = 17%

Project Z = 15%

What project(s) should be clearly rejected?

A) Reject X and Y

B) Reject Y and Z

C) Reject W

D) Reject Z

31. In calculating the WACC, you must always use the book values for both debt and equity.

A. True

B. False

32. Financial markets continually fluctuate because they:

A) are completely inefficient.

B) are continually reacting to new information.

C) take weeks to react to new information.

D) only reflect historical information.

33. Suppose that firms with unexpectedly high earnings earn abnormally high returns for several months after the announcement. This would be evidence of:

A) efficient markets in the weak form.

B) inefficient markets in the weak form.

C) inefficient markets in the semistrong form.

D) inefficient markets in the all forms.

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