Finance Exam

Finance is

The study of the capitol market and its many players

Which of the following is NOT a financial Intermediary?

the U.S. treasury department

Money Markets are markets for

short term debt securities

Which of the following is NOT considered a capital market security?

Foreign Currencies

The over-the-counter market is

An intangible market for unlisted securities

Which of the following is a role of the secondary market?

Establishing security prices

Which of the following statements about risk is FALSE?

High risk should require low return

The ________ is a financial relationship created by several institutions with arrangements that allow the suppliers and demanders of long-term funds to make transactions.

Capital Market

what is the Maximum Maturity of securities that trade on the money markets?

1 year

A firm raises capital to finance new equipment by selling bonds in the?

Primary Market

The ________ is the financial market in which securities are initially issued

Primary Market

________ are further divided into two groups: auctions and dealer markets.

secondary markets

The primary market is facilitated by _____________ banks, which buy securities from the issuer and sell them to individuals and funds.

Investment

When you buy from a dealer, you pay the ________ price.

Asking

Is the foreign exchange market an auction or a dealer market?

dealer

what is an important dimension of the liquidity of a market?

Daily number of trades on the market

The purchase and sale of securities after the original issuance occurs in the:

Secondary Market

As the risk of a stock investment increases:

the required rate of return will increase

The efficient market hypothesis states that:

Markets price securities fairly at all times, and new information is rapidly reflected in the price.

Information asymmetry:

When some know more than others

T or F: The higher the probability that the return on an investment will not pay off its average promised value, the higher the expected return must be to induce an investor to invest in it.

True

T or F:) Money market securities have maturities of one year or less.

True

In cross sectional analysis a firms finacial ratios are

judged against performance of firms in the same industry

What is the connection between the income statement and the balance sheet?

Net income (minus dividends) is added to retained earnings in the balance sheet.

Find the return on assets if net income was $55,000, total assets are $115,000, EBIT was $100,000, and equity is $75,000.

47.8%

What is the return on equity if net income was $55,000, total assets are $115,000, EBIT was $100,000, and equity is $75,000?

73.3%

What is the quick ratio if cash is $10,000, accounts receivable are $25,000, inventories are $30,000, accounts payable are $40,000, and accrued payroll is $15,000?

0.09

What is the current ratio if cash is $10,000, accounts receivable are $25,000, inventories are $30,000, accounts payable are $40,000, and accrued payroll is $15,000?

1.18

The quick ratio is 1.0. Current assets are $100,000 and current liabilities are $80,000. What is the amount in the inventory account?

20,000

Capital Budgeting

Making good deicisons: asses an investment for good decision

Purpose of capital budgeting

To invest in projects that maximize shareholder wealth.

Capital Budgeting steps

Identify opportunities → Evaluate opportunities → Implement projects → Post-audit.(Know the general flow — you don’t need “pre-audit.”)

Capital Budgeting: Most errors occur during what stage:

Estimating relevant cash flows (Q1 = C).

Which of the following is the process of deciding which long-term investments or projects a firm will acquire using the long-term funds the firm has available?

investment analysisB) capital budgetingC) capital marketingD) liability managementE) corporate governance

B) Capital Budgeting

The ultimate goal of capital budgeting analysis is to select projects that

maximize shareholder wealth.

The Airbus A380 is the largest civilian aircraft ever built. It can carry 555 passengers on two decks. Initial project investments were $13B. Assume that the initial investment was paid on December 31, 2008. Assume that Airbus will produce 60 aircraft per year for five years. Each aircraft will be sold for $230M and total operating costs are 75% of revenues. Assume that revenues and costs occur at year-end with the first revenues (and costs) occurring on December 31, 2009. Ignore taxes and assume that there are no terminal year cash flows. What is the payback period for the Airbus A380 project? Select the earliest year such that the initial investments are completely paid off.

4 years

The ________ method to analyze cash flows associated with a project does not consider the time value of money

payback period

All of the following are considered to be disadvantages of using the payback method EXCEPT the fact that it

does not provide a good measure of the project's liquidity.

The least desirable capital budgeting technique from a theoretical standpoint is

payback method

Which of the following capital budgeting methods might not consider the salvage value of a machine being considered for purchase?

payback

The ________ is the exact amount of time it takes the firm to recover its initial investment.

payback period

Unsophisticated capital budgeting techniques do NOT

explicitly consider the time value of money

The New Watch Times is considering a new printing press... what is the payback period?

6.67 years

The most widely used capital budgeting technique is

net present value

The primary problem with the NPV technique of capital budgeting is:

Many people without a background in financial theory may not understand it

An advantage of the net present value (NPV) method is that it

provides its users with clear decision creitertion

AN NPV profile:

graphs the NPV at a variety of discount rates

An NPV profile is most helpful in dealing with what type of problem?

problems in estimating a firm's cost of capital

The most preferred capital budgeting technique is

NPV( Net Present Value)

Analysts at Tabby Fur Storage predict that the net present value of a proposed new $10 million warehouse is $1 million. How should these findings be interpreted?

The project should be accepted because it will add value to the firm

The NPV method assumes that cash inflows are reinvested at the

firms cost of capital

If the ________ is greater than or equal to the ________, the project should be accepted.

IRR; cost of capital

According to the internal rate of return method, a firm should accept a project if the:

B) internal rate of return exceeds the cost of capital

If the calculated NPV is negative, then the discount rate used is:

C) greater than the IRR

Which of the following statements is incorrect? Regarding IRR and NPV

The NPV and IRR always provide the same rankings for a set of possible projects

When the net present value is negative, the internal rate of return is ________ the cost of capital

less than

For mutually exclusive projects, the underlying cause of conflicts in ranking for projects by internal rate of return and net present value methods is:

The reinvestment rate assumption regarding cash flows

The opportunity cost associated with the firm’s capital investment in a project is called its

cost of capital.

The overall cost of capital for a retail store

reflects the return investors require on the total assets of the firm.

The discount rate assigned to an individual project should be based on

the risk level of the project itself.

When evaluating a project, a firm’s managers should select projects whose cash flows

produce higher returns than the firm’s average cost of capital.

The weighted average of the firm’s costs of equity, preferred stock, and after-tax debt is the

weighted average cost of capital (WACC).

Assigning separate discount rates to individual projects when determining which projects

should be accepted by the firm

may cause the firm’s overall weighted average cost of capital to vary over time if the projects

The cost of capital assigned to an individual project should be that rate which

Considers both the nature and the characteristics of the actual project.

The return that shareholders require on their investment in the firm is called the

cost of equity.

Use the data provided on Cadbury to answer the question below. The risk-free rate is 4.25%.

The expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face

value of Cadbury’s outstanding bonds is 2.450 billion pounds sterling. The coupon rate on

Cadbury’s bonds is 4.5%. Assume that the bonds pay annual coupons. The yield to maturity on

Cadbury’s bonds is 4.5%. Cadbury’s bonds mature in 7 years. Cadbury has 1.650 billion

common shares outstanding. The market price of Cadbury’s common shares as of Dec 31, 2008

is 6.25 pounds sterling. Cadbury’s Beta is 0.8. What is Cadbury’s cost of debt (after-tax)?

2.70% After-tax cost of debt = (1 - T)

0.045(1 - 0.40) = 0.027 or 2.70%

Pan American Airlines’ shares are currently trading at $69.25 each. The yield on Pan Am’s

debt is 4% and the firm’s beta is 0.7. The T-Bill rate is 4% and the expected return on the market

is 9%. The company’s target capital structure is 25% debt and 75% equity. Pan American Airlines pays a combined federal and state tax rate of 35%. What is Pan Am’s cost of debt (after tax)?

2.6%

The pre-tax cost of debt is the yield to maturity on the company’s bonds, or 4%. After-tax cost of debt = kd  (1 - T)

0.04(1 - 0.35) = 2.6%

the interest paid on corporate bonds is tax deductible.

Gaunt Computer Displays plans to issue bonds to finance research and development for

computer monitors that can be read while sleeping. The firm’s investment bankers report that the

bonds should be sold to yield 10%. What is Gaunt’s cost of debt if its marginal tax rate is 30%?

7.0% 0.10(1 - .30) = 0.07 or 7%

The return that lenders require on their loaned funds to the firm is called the

cost of debt.

Jensen’s Travel Agency has a 7 percent preferred stock outstanding that is currently selling

for $48 a share. The preferred stock has a $100 par value. The market rate of return is 10 percent

and the firm’s tax rate is 34 percent. What is the Jensen’s cost of preferred stock?

14.58 percent $7/$48

Donnelly and Son pay $8 as the annual dividend on their preferred stock. Currently, this

stock is selling for $72 a share. What is Donnelly’s cost of preferred stock?

11.11 %

Teri’s Tires has 7 percent preferred stock outstanding that sells for $68 a share. The preferred

stock has a $100 par value. What is Teri’s cost of preferred stock?

10.29 percent

What is the after-tax cost of preferred stock if its price is $25 per share and it pays a $1 per

share dividend? Assume the firm’s marginal tax rate is 25% and there are no flotation costs.

4%

If investors require a 10% after-tax return from a firm’s preferred stock and its dividend is

$5.00 per share, what is the price per share assuming a marginal tax rate of 25%?

$50.00

Preferred stock constitutes what percentage of the average firm’s capital structure?

5%

The cost of preferred stock

is equal to the dividend yield on the stock. 

Dividend/Price per Share

The Delta Co. owns retail stores that market home building supplies. Largo, Inc. builds

single family homes in residential developments. Delta has a beta of 1.22 and Largo has a beta of 1.34. The risk-free rate of return is 4 percent and the market risk premium is 6.5 percent. What should Delta use as their cost of equity if they decide to purchase some land and create a new

residential community?

12.71 percent

Pan American Airlines’ shares are currently trading at $69.25 each. The yield on Pan Am’s debt is 4% and the firm’s beta is 0.7. The T-Bill rate is 4% and the expected return on the markets is 9%. The company’s target capital structure is 25% debt and 75% equity. Pan American Airlines pays a combined federal and state tax rate of 35%. What is Pan Am’s cost of

equity?

7.5%

Neeson Co. paid dividends in the last three years of $3.00, $3.15, and $3.31, respectively.

The current stock price of Neeson is $30.00. Assuming the next dividend will grow at the same

rate as the last three years, what is Neeson’s cost of equity?

16.62%

If Fluppy Dog Grooming shareholders require a 20% return, what is the dividend growth rate if the dividend yield is 12%?

8%

0.20 = 0.12 + g

g = 0.08 or 8%

Ben’s Ice Cream just paid their annual dividend of $.75 a share. The stock has a market price of $32 and a beta of .90. The return on the U.S. Treasury bill is 4 percent and the market has a 12 percent rate of return. What is the cost of equity?

11.20 percent

Use the data provided on Cadbury to answer the question below. The risk-free rate is 4.25%. The expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face value of Cadbury’s outstanding bonds is 2.450 billion pounds sterling. The coupon rate on Cadbury’s bonds is 4.5%. Assume that the bonds pay annual coupons. The yield to maturity on Cadbury’s bonds is 4.5%. Cadbury’s bonds mature in 7 years. Cadbury has 1.650 billion common shares outstanding. The market price of Cadbury’s common shares as of Dec 31, 2008 is 6.25 pounds sterling. Cadbury’s Beta is 0.8. What is Cadbury’s cost of equity?

8.65%

= .0425 + 0.80(0.0975 - .0425)

= 8.65%

Rosie’s Grill has a beta of 1.2, a stock price of $26 and an expected annual dividend of $1.30 a share which is to be paid next month. The dividend growth rate is 4 percent. The market has a 10 percent rate of return and a risk premium of 6 percent. What is the average expected cost of equity for Rosie’s Grill?

10.10 percent

The return on the market is 11%. A firm’s beta is 1.4, and the risk-free rate is 6%. The stock is currently selling for $18 and the next dividend is expected to be $1.75. The firm’s growth rate is 5%. The pre-tax cost of debt is 10% and the equity risk premium is 5%. Estimate the cost of equity by taking an average of the three methods to determine the cost of equity.

Use CAPM to estimate the cost of equity.

= .06 + 1.4(.11 - .06)

= 13%

Use the constant growth model to estimate the cost of equity. = 14.72%

Step 3 - Compute the bond yield plus premium.

= 0.10 + 0.05 = 0.15 or 15%

Step 4 - Average the three methods together. = 0.142 or 14.2%

Myopia Camera Stores has a cost of equity of 18% and the market return is 12%. What is the firm’s beta if the risk-free rate is 6%?

2.0

Martin Industries just paid an annual dividend of $1.20 a share. The market price of the stock is $26.60 and the growth rate is 4 percent. What is the firm’s cost of equity?

8.69 percent

Which component of a firm’s capital structure is the most difficult to estimate?

equity

The constant dividend growth model

is highly dependent upon the estimated rate of growth.

The constant dividend growth model

ignores the risk that future dividends may vary from their estimated values.The market risk premium

The market risk premium

varies over time as both the risk-free rate of return and the market rate of return vary.

Which method is best to compute a firm’s cost of equity?

CAPM, bond yield, constant growth,

The weighted average cost of capital for a firm is the

overall rate which the firm must earn on its existing assets to maintain the value of its stock.

The proportions of the market value of the firm’s assets financed via debt, common stock, and preferred stock are called the firm’s

capital structure weights.

The Auto Group has 1,200 bonds outstanding that are selling for $980 each. The company also has 7,500 shares of preferred stock at a market price of $40 each. The common stock is priced at $32 a share and there are 32,000 shares outstanding. What is the weight of the preferred

12 percent

Watson’s Automotive has a $400,000 bond issue outstanding that is selling at 102 percent of face value. Watson’s also has 4,500 shares of preferred stock and 21,000 shares of common stock outstanding. The preferred stock has a market price of $44 a share compared to a price of $21 a share for the common stock. What is the weight of the debt as it relates to the firm’s weighted average cost of capital? Round your answer to the nearest percent.

39 percent

Benson’s, Inc. has an overall cost of equity of 10.24 percent and a beta of 1.2. The firm is financed 100 percent with common stock. The risk-free rate of return is 4 percent. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.5?

11.8 percent

Bob’s Tractor and Party Supply has two separate divisions: party supplies, and tractor

supplies and services. The party supply division has a beta of 1.2 and is financed by 25% debt. The tractor supply and service division has a beta of 0.8 and is financed by 60% debt. The cost of debt for each division is 5%. The risk free rate and market rate are 5% and 10% respectively. A project has recently become available for each division with an expected return of 10%. Which division(s) should take on the project?

Tractor Supply and Services

Swanson & Sons has two separate divisions. Each division is in a separate line of business.

Division A is the largest division and represents 65 percent of the firm’s overall sales. Division

A is also the riskier of the two divisions. Division B is the smaller and least risky of the two.

When the company is deciding which of the various divisional projects should be accepted, they

should

assign different discount rates to each project and then select the projects with the highest net

present values.