Final Exam Practice Questions

BUS 106

Final Exam Practice Questions

1. A bond's par value can also be called its: A. coupon payment. B. present value. C. default value. D. face value Learning Objective: 06-01 Distinguish among a bond's coupon rate; current yield; and yield to maturity. Topic: Bond Characteristics and Prices

2. The discount rate that makes the present value of a bond's payments equal to its price is termed the: A. rate of return. B. yield to maturity. C. current yield. D. coupon rate. Learning Objective: 06-01 Distinguish among a bond's coupon rate; current yield; and yield to maturity. Topic: Calculating Yields

3. How does a bond dealer generate profits when trading bonds? A. By maintaining bid prices lower than ask prices B. By maintaining bid prices higher than ask prices C. By retaining the bond's next coupon payment D. By lowering the bond's coupon rate Learning Objective: 06-01 Distinguish among a bond's coupon rate; current yield; and yield to maturity. Topic: Bond Characteristics and Prices

4. Which of the following identifies the distinction between a U.S. Treasury bond and a Treasury note? A. Bonds make coupon payments; notes do not. B. Bills have default risk; bonds do not. C. Bonds are priced in 32s; notes are not. D. Bonds initially have more than 10 years until maturity; notes have fewer than 10 years initially. Learning Objective: 06-01 Distinguish among a bond's coupon rate; current yield; and yield to maturity. Topic: Bond Characteristics and Prices

5. How much does the $1,000 to be received upon a bond's maturity in 4 years add to the bond's price if the appropriate discount rate is 6%? A. $209.91 B. $260.00 C. $760.00 D. $792.09 $1,000/(1.06)4 = $792.09 Learning Objective: 06-02 Find the market price of a bond given its yield to maturity; find a bond's yield given its price; and demonstrate why prices and yields move in opposite directions. Topic: Calculating Yields

6. How much should you pay for a $1,000 bond with 10% coupon, annual payments, and 5 years to maturity if the interest rate is 12%? A. $927.90 B. $981.40 C. $1,000.00 D. $1,075.82

Learning Objective: 06-02 Find the market price of a bond given its yield to maturity; find a bond's yield given its price; and demonstrate why prices and yields move in opposite directions. Topic: Bond Characteristics and Prices

7. The yield curve depicts the current relationship between: A. bond yields and default risk. B. bond maturity and bond ratings. C. bond yields and maturity. D. promised yields and default premiums. Learning Objective: 06-02 Find the market price of a bond given its yield to maturity; find a bond's yield given its price; and demonstrate why prices and yields move in opposite directions. Topic: The Yield Curve

8. Which of the following best characterizes the difference between growth stocks and income stocks? A. Growth stocks do not pay dividends. B. Income stocks offer higher rates of return. C. Income stocks are seasoned issues. D. Growth stocks have greater PVGO. Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper. Topic: Stocks and the Stock Market

9. Common stock can be valued using the perpetuity valuation formula if the: A. discount rate is expected to remain constant. B. dividends are not expected to grow. C. growth rate in dividends is not constant. D. investor does not intend to sell the stock. Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price. Topic: Valuing Common Stocks

10. What should be the price for a common stock paying $3.50 annually in dividends if the growth rate is zero and the discount rate is 8%? A. $22.86 B. $28.00 C. $42.00 D. $43.75

Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price. Topic: The Dividend Discount Model

11. What constant-growth rate in dividends is expected for a stock valued at $32.00 if next year's dividend is forecast at $2.00 and the appropriate discount rate is 13%? A. 5.00% B. 6.25% C. 6.75% D. 15.38%

Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price. Topic: The Dividend Discount Model

12. What is the plowback ratio for a firm that has earnings per share of $12.00 and pays out $4.00 per share as dividends? A. 25.00% B. 33.33% C. 66.67% D. 75.00%

Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price. Topic: Valuing Common Stocks

13. What should be the price of a stock that offers a $4 annual dividend with no prospects of growth, and has a required return of 12.5%? A. $8.50 B. $25.00 C. $32.00 D. $50.00 P = $4/.125 P = $32 Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price. Topic: The Dividend Discount Model

14. Which of the following values treats the firm as a going concern? A. Market value B. Book value C. Liquidation value D. None of these Learning Objective: 07-03 Use stock valuation formulas to infer the expected rate of return on a common stock. Topic: Market, Book, and Liquidation Values

15. . If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year, what is the stock's current price? A. $4.50 B. $18.00 C. $22.22 D. $40.50 P/E = 13.5x Then P = 13.5  $3 Price = $40.50 Learning Objective: 07-04 Interpret price-earnings ratios. Topic: Valuing Common Stocks

16. Under which of the following forms of market efficiency would stock prices always reflect fair value? A. Weak-form efficiency. B. Semistrong-form efficiency. C. Strong-form efficiency. D. All of these are correct due to capital market efficiency. Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market Analysis

17. A fundamental analyst: A. relies on the same information as the technical analyst, but believes in the random walk. B. studies a firm's financial statements to determine pricing inefficiencies. C. believes that the market is strong-form efficient. D. performs an unnecessary function, since markets are efficient. Learning Objective: 07-05 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market Analysis

18. Capital structure decisions refer to the: A. dividend yield of the firm's stock. B. blend of equity and debt used by the firm. C. capital gains available on the firm's stock. D. maturity date for the firm's securities. Learning Objective: 13-03 Calculate the weighted-average cost of capital. Topic: Understanding Capital Structure

19. What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 40% tax rate? A. 9.6% B. 12.0% C. 13.6% D. 16.0% WACC = [.5  (.12  .6)] + (.5  .2) = 3.6% + 10% = 13.60% Learning Objective: 13-03 Calculate the weighted-average cost of capital. Topic: Weighted-Average Cost of Capital

20. What is the WACC for a firm using 55% equity with a required return of 15%, 35% debt with a required return of 8%, 10% preferred stock with a required return of 10%, and a tax rate of 35%? A. 10.72% B. 11.07% C. 11.70% D. 12.05% WACC = [.35  (1 - .35).08] + (.1  .1) + (.55  .15) = 1.82% + 1.0% + 8.25% = 11.07% Learning Objective: 13-03 Calculate the weighted-average cost of capital. Topic: Weighted-Average Cost of Capital

21. What would you estimate to be the required rate of return for equity investors if a stock sells for $40.00 and will pay a $4.40 dividend that is expected to grow at a constant rate of 5%? A. 7.6% B. 12.0% C. 12.6% D. 16.0%

Learning Objective: 13-03 Calculate the weighted-average cost of capital. Topic: Rates of Return

22. A project will generate $1 million net cash flow annually in perpetuity. If the project costs $7 million, what is the lowest WACC shown below that will make the NPV negative? A. 10% B. 12% C. 14% D. 16% $1 million/.16 = $6.25 million < $7 million Therefore, NPV < $0 At 14%, the NPV is still positive by $142,857. Learning Objective: 13-03 Calculate the weighted-average cost of capital. Topic: Weighted-Average Cost of Capital

23. The stability of a firm's operating income is the focus of: A. financial leverage. B. weighted-average cost of capital. C. capital structure. D. business risk. Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital Structure and Corporate Taxes

24. What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes. A. 54.0% B. 60.0% C. 66.7% D. 75.0%

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital Structure and Corporate Taxes

25. According to MM II, as a firm's debt-equity ratio decreases: A. its financial risk increases. B. its operating risk increases. C. the required rate of return on equity increases. D. the required rate of return on equity decreases. Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Understanding MM

26. An implicit cost of adding debt to the capital structure is that it: A. adds interest expense to the operating statement. B. increases the required return on equity. C. reduces the expected return on assets. D. decreases the firm's beta. Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital Structure and Corporate Taxes

27. What is the return on equity for a firm with 15% return on assets, 10% return on debt, and a .75 debt-equity ratio? A. 18.75% B. 20.00% C. 23.75% D. 26.25%

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital Structure and Corporate Taxes

28. What is the maximum rate that can be paid on debt and maintain a 14% WACC with a 19% expected return on equity in a firm with a 60% debt-to-asset ratio? Ignore taxes. A. 6.50% B. 9.90% C. 10.67% D. 11.14%

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital Structure and Corporate Taxes

29. The WACC is used to value: A. projects with any risk. B. projects with the same risk as the firm's current business. C. projects with the same risk as the firm's debt. D. projects with the same risk as the firm's equity. Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital Structure and Corporate Taxes

30. A corporation's dividend payout ratio is the percentage of _____ paid out as dividends. A. cash B. earnings C. earnings before interest and taxes D. retained earnings Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay. Topic: Payout Policy

31. An increase in share price following an increase in dividends is logical if the: A. firm borrows to obtain cash for the dividend. B. increased dividend signals higher future earnings. C. dividend is believed to be temporary. D. clientele effect is not important. Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay. Topic: Dividend Policy

32. Capital gains may be preferred by investors over dividends even if their tax rates are equal because: A. taxes on dividends are withheld from paychecks. B. taxes on capital gains are paid annually. C. taxes on capital gains can be timed. D. after-tax dividends are less certain than capital gains. Learning Objective: 17-05 Show how market imperfections; especially the different tax treatment of dividends and capital gains; can affect payout policy. Topic: Payout Policy

33. You now own 84 shares of XYZ stock which is selling for $40 each, 4 of which you just received from the XYZ corporation. XYZ has declared a: A. stock dividend of 5%. B. cash dividend of $4. C. stock dividend of 4.76%. D. cash dividend of $160. (4 shares/80) = 5% Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay. Topic: Dividend Policy

34. The Beta corporation had 1,000 shares outstanding and a market value of $90,000 prior to the declaration of a $5 per share dividend. To finance a new project they will issue equity and the end result will be that the market value of the firm: A. drops by $1,000. B. drops to $85,000. C. increases by $1,000. D. increases to $95,000. Share price prior to declaration: = ($90,000/1,000) = $90 Share price after declaration: = $90 - $5 = $85 Market value of firm = $85 (1,000) = $85,000 Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay. Topic: Payout Policy

35. When an outside group acquires a firm, primarily through the use of borrowed funds, the acquisition is known as a: A. management buyout. B. tender offer. C. leveraged buyout. D. successful proxy fight. Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: The Mechanics of a Merger

36. The cost of a merger equals the: A. cash paid for the target firm. B. increase in total earnings less price paid. C. premium paid over the target's value as a separate entity. D. sum of cash and stock paid for the target firm. Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Evaluating Mergers

37. If Georgia Pacific (lumber products) were to acquire a national homebuilding firm, the combination would be termed a: A. horizontal merger. B. vertical merger. C. conglomerate merger. D. spin-off by the national homebuilding firm. Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: The Mechanics of a Merger

38. Shares of a corporation can, under certain circumstances, be priced at different amounts to different investors under the terms of a: A. proxy agreement. B. public tender offer. C. poison pill. D. shark repellent. Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Corporate Control

39. One of the reasons why proxy fights are rarely successful is that: A. management is always viewed as performing its job well. B. management can use corporate resources to defend against the fight. C. mergers are a cheaper form of changing management. D. shareholders are unconcerned with corporate management. Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Corporate Control

40. What does empirical evidence suggest about the distribution of gains from mergers? A. Shareholders of the acquired firm gain the most. B. Shareholders of the acquiring firm gain the most. C. Neither group of shareholders is likely to gain. D. Both groups of shareholders gain equally. Learning Objective: 21-05 Explain some of the motivations for leveraged and management buyouts of the firm. Topic: Evaluating Mergers

Short Answers:

1. One-year Treasury bonds yield 5% while 2-year bonds yield 6%. You are quite confident that in 1 year's time 1-year bonds will yield 8%. Would the higher yield on 2year bonds cause you to prefer them? If you invest in a 2-year bond, you will have $1,000  1.06 2 = $1,123.60. If you are right in your forecast about 1-year rates, then an investment in 1-year bonds will produce $1,000  1.05  1.08 = $1,134.00 by the end of 2 years. You would do better to invest in the 1-year bond. Learning Objective: 06-02 Find the market price of a bond given its yield to maturity; find a bond's yield given its price; and demonstrate why prices and yields move in opposite directions. Topic: Calculating Yields

2. What are the differences between the bond's coupon rate, current yield, and yield to maturity? A bond is a long-term debt of a government or corporation. When you own a bond, you receive a fixed interest payment each year until the bond matures. This payment is known as the coupon. The coupon rate is the annual coupon payment expressed as a fraction of the bond's face value. At maturity the bond's face value is repaid. In the United States most bonds have a face value of $1,000. The current yield is the annual coupon payment expressed as a fraction of the bond's price. The yield to maturity measures the average rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value. Learning Objective: 06-01 Distinguish among a bond's coupon rate; current yield; and yield to maturity. Topic: Calculating Yields

3. A stock offers an expected dividend of $3.50, has a required return of 14%, and has historically exhibited a growth rate of 6%. Its current price is $35.00 and shows no tendency to change. How can you explain this price based on the constant growth dividend discount model? The constant-growth dividend discount model would indicate that this stock should currently sell for $43.75, based on the following formula:

Although stocks can temporarily be out of equilibrium price, the fact that this stock price shows no tendency to change suggests that investors do not expect the past growth rate of 6% to continue into the future. Since there is no indication that the required rate of return has changed, it appears that the company many anticipate fewer positive growth opportunities than in the past. Therefore, the dividend yield has likely increased to its current 10% level, and the overall market seems to expect a growth rate of 4% rather than the historical 6%. At a growth rate of 4%, the stock would be correctly priced at $35.00. Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price. Topic: The Dividend Discount Model

4. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year, what is the stock's current price? P/E = 13.5x Then P = 13.5  $3 Price = $40.50 Learning Objective: 07-04 Interpret price-earnings ratios. Topic: Valuing Common Stocks

5. How do firms compute weighted-average costs of capital? WACC = rdebt  (1 - Tc)  D/V + requity  E/V The WACC is the expected rate of return on the portfolio of debt and equity securities issued by the firm. The required rate of return on each security is weighted by its proportion of the firm's total market value (not book value). Since interest payments reduce the firm's income tax bill, the required rate of return on debt is measured after tax, as rdebt  (1 - Tc). This WACC formula is usually written assuming the firm's capital structure includes just two classes of securities, debt and equity. If there is another class, say preferred stock, the formula expands to include it. In other words, we would estimate rpreferred, the rate of return demanded by preferred stockholders, determine P/V, the fraction of market value accounted for by preferred, and add rpreferred  P/V to the equation. Of course the weights in the WACC formula always add up to 1.0. In this case D/V + P/V + E/V = 1.0. Learning Objective: 13-03 Calculate the weighted-average cost of capital. Topic: Weighted-Average Cost of Capital

6. What is a firm's weighted-average cost of capital if the stock has a beta of 1.45, Treasury bills yield 5%, and the market portfolio offers an expected return of 14%? In addition to equity, the firm finances 30% of its assets with debt that has a yield to maturity of 9%. The firm is in the 35% marginal tax bracket. re= 5% + 1.45 (14% - 5%) = 5% + 13.05 = 18.05% rd= 9% (1 - .35) = 5.85% WACC = (.3  5.85%) + (.7  18.05%) = 1.755% + 12.635% = 14.39% Learning Objective: 13-03 Calculate the weighted-average cost of capital. Topic: Weighted-Average Cost of Capital

7. What is the goal of the capital structure decision? What is the financial manager trying to do? The goal is to maximize the overall market value of all the securities issued by the firm. Think of the financial manager as taking all the firm's real assets and selling them to investors as a package of securities. Some financial managers choose the simplest package possible: all-equity financing. Others end up issuing dozens of types of debt and equity securities. The financial manager must try to find the particular combination that maximizes the market value of the firm. If firm value increases, common stockholders will benefit. Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital Structure and Corporate Taxes

8. Calculate the WACC for a firm with a debt-equity ratio of 1.5. The debt pays 10% interest and the equity is expected to return 16%. Assume a 35% tax rate and risk-free debt.

Learning Objective: 16-02 Show why the tax system encourages debt finance and calculate the value of interest tax shields. Topic: Capital Structure and Corporate Taxes

9. Discuss how agency problems can develop between shareholders and bondholders when the firm is experiencing financial distress. Managers/owners may not have the proper incentives to accept/reject projects when the firm is under severe financial distress. Normally, managers will accept projects when the NPV is positive after being discounted with the appropriate rate for the project's risk. However, in the case of financial distress and when a lender will still advance funds, it may appear to be in the best interest of managers/owners to invest those funds in longshot projects that will offer high rates of return under perfect conditions. Of course, when probability is factored in, the project's NPV is likely to be negative. The key is that the rewards of the project will be retained by the owners while the costs of failure will be borne entirely by the lender. Similarly, when financial distress has decreased the value of debt below its book value, managers/owners may be reluctant to accept projects even when they offer a positive NPV. In this case the reasoning is that the rewards of the project will be "seized" by the bondholders in the way of increasing the market value of the debt. Thus, little if any benefit may accrue to equityholders, and they are not properly motivated to accept the project. Learning Objective: 16-03 Show how costs of financial distress can lead to an optimal capital structure. Topic: Costs of Financial Distress

10. Why would payout decisions be used by management to signal the prospects of the firm? A firm that chooses a high-dividend policy without the cash flow to back it up will find that it ultimately has to either cut back on investments or turn to capital markets for additional debt or equity financing. Because this is costly, managers do not increase dividends unless they are confident that the firm is generating enough cash to pay them. This is the principal reason that we say that there is an information content of dividends —that is, dividend changes are liable to be interpreted as signals of a change in the firm's prospects. Investors also seem to welcome the announcement that a company plans to repurchase its stock. If they are worried that the company has more cash than it can profitably employ, they may be pleased to see the cash given back to the shareholders. Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay. Topic: Payout Policy

11. Discuss the concept of dividend "smoothing." Managers are quite concerned with the message that may be "signaled" with each change in the level of dividends. Thus, if management held the notion of adhering to a fixed dividend payout, they would find themselves declaring a dividend of a different amount each quarter, as the firm goes through the normal gyrations of business cycles and various growth phases. The managers are especially sensitive to dividend reductions, as it signals that the future prospects of the firm are less attractive. Therefore, management is more likely to "smooth" the dividend, and hopefully show a stable pattern of continual growth. In periods of high earnings, then, management may raise the dividend only a portion of the way, so as to not be required to later reduce the regular dividend. Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay. Topic: Dividend Policy

12. How should the gains and costs of mergers to the acquiring firm be measured? A merger generates an economic gain if the two firms are worth more together than apart. The gain is the difference between the value of the merged firm and the value of the two firms run independently. The cost is the premium that the buyer pays for the selling firm over its value as a separate entity. When payment is in the form of shares, the value of this payment naturally depends on what those shares are worth after the merger is complete. The merger should proceed if the gain exceeds the cost. Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Evaluating Mergers

13. Why is it stated that the safest way of evaluating the potential gains from a merger is to focus on the changes in cash flow that will transpire as a result of the merger? The alternative to this approach is to determine the present value of the target and subtract from that the price paid for acquisition. In most cases it should be assumed that the market has already done this accurately, and thus the only item remaining to value is the change in value that occurs as a result of acquiring the target. In other words, what will change as a result of the acquisition? This forces the acquiring firm to realize that mergers are not valuable unless they create economic benefits that were previously not in existence. Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Evaluating Mergers

14. How are the gains from mergers distributed between the shareholders of the acquired and acquiring firms? We observed that when the target firm is acquired, its shareholders typically win: target firms' shareholders earn abnormally large returns. The bidding firm's shareholders roughly break even. This suggests that the typical merger generates positive net benefits, but competition among bidders and active defense by the management of the target firm pushes most of the gains toward the selling shareholders. Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how the gains from mergers are distributed between shareholders of the acquired and acquiring firms. Topic: The Mechanics of a Merger