MAS

WEEK 1 TO 5

c. Geometric average

- because it depicts compound annual returns

c. Geometric average

- because it depicts compound annual returns

If an INVESTMENT is expected to be HELD for a LONG PERIOD of time the preferred method of calculating the expected return is

a. Arithmetic average

b. Median

c. Geometric average

d. Subjective estimate

b. Direct relationship

- higher risk = higher returns

Which of the following expresses the RELATIONSHIP between RISK AND RETURN?

a. Inverse relationship

b. Direct relationship

c. Negative relationship

d. No relationship

b. Weighted average

The EXPECTED RETURN OF PORTFOLIO is measured by the

a. Variance

b. Weighted average

c. Standard deviation

d. Beta

C. Investment III

coefficient of variation = standard deviation/expected returns

lower coefficient of variation = lower risk

Russel Inc. is evaluating the four independent investment proposals. The expected returns and standard deviations for each of these proposals are presented below:

INVESTMENT PROPOSAL | EXPECTED RETURN | STANDARD DEVIATION

I | 16% | 10%

II | 14% | 10%

III | 20% | 11%

IV | 22% | 15%

Which one of the investment proposals has the LEAST relative level of RISK?

a. I

b. II

c. III

d. IV

9.86%

expected return x (investment/total investment)

[15% × ($100,000 ÷ 700,000)] + [10% × ($300,000 ÷ 700,000)] + (8% × $200,000 ÷ 700,000)] + [8% × ($100,000 ÷ 700,000)]

2.14 + 4.29 + 2.29 + 1.14

Nalco has the following investment portfolio:

EXPECTED RETURN | INVESTMENT | BETA

A. 15% | P100,000 | 1.2

B. 10% | P300,000 | -0.5

C. 8% | P200,000 | 1.5

D. 8% | P100,000 | -1.0

What is the EXPECTED RETURN of the portfolio?

a. 10.25%

b. 9.86%

c. 12.5%

d. 11.35%

C. Investment C

- the one with the highest beta

Nalco has the following investment portfolio:

EXPECTED RETURN | INVESTMENT | BETA

A. 15% | P100,000 | 1.2

B. 10% | P300,000 | -0.5

C. 8% | P200,000 | 1.5

D. 8% | P100,000 | -1.0

If management decided TO SELL one of the investments, which one should be selected?

a. A

b. B

c. C

d. D

b. Systematic risk is higher than that of the market portfolio

- a beta higher than 1 means systematic risk is higher than market portfolio

The beta of 1.5 implies that

a. Systematic risk is lower than the market portfolio

b. Systematic risk is higher than that of the market portfolio

c. Unsystematic risk is higher than that of the market portfolio

d. Total risk is higher than that of the market portfolio

b. Beta coefficient

- correlation of stock’s price & price of the overall market

It is a measure that describes the RISK OF AN INVESTMENT project RELATIVE TO OTHER INVESTMENTS in general

a. Coefficient of variation

b. Beta coefficient

c. Standard deviation

d. Expected return

d. Mustang because its coefficient of variation is higher

standard deviation/expected returns

- cornhusker = 15%/20% = 0.75

- mustang = 9%/10% = 0.9

- higher coefficient of variation = higher risk

The expected rate of return for the stock of Cornhusker Enterprises is 20%, with a standard deviation of 15%. The expected rate of return for the stock of Mustang Associates Is 10%, with standard deviation of 9%. The RISKIER STOCK is

a. Cornhusker because its return is higher

b. Cornhusker because its standard deviation is higher

c. Mustang because its standard deviation is higher

d. Mustang because its coefficient of variation is higher

a. Undertake the British investment

- increase return from 20% to 21%

- reduce risk from 15% to 3%

The average return on the current investment without the expansion is at 20% with standard deviation of 15%.

Investment | Mean return | Standard deviation

US and Britain | 21% | 3%

US and Canada | 24% | 15%

The company wants to select the optimal combination of countries based on risk and return for the domestic and international investments taken together. Because the company is new to the international business environment, it is relatively risk averse. Based on the above data, which one of the following alternatives provides the BEST RISK-ADJUSTED RETURN to the firm?

a. Undertake the British investment

b. Undertake the Canadian investment

c. Do not undertake either investment

d. Unable to determine based on data given

c. Life insurance companies

According to market segmentation theory, LONG-TERM INTEREST RATES are determined primarily by

a. Commercial banks

b. Savings institutions

c. Life insurance companies

d. Individual investors

a. Usually lower than long-term rates

- less risk involved in the short run (fluctuations)

- investors are willing to accept lower rates because of liquidity

SHORT-TERM investment rates are

a. Usually lower than long-term rates

b. Usually higher than long-term rates

c. Lower than long-term rates during periods of high inflation only

d. Not significantly related to long-term rates

c. Interest

The RETURN PAID for the use of borrowed capital is referred to as

a. Cash dividends

b. Stock dividends

c. Interest

d. Principal payment

d. Underlying assets

- underlying assets are not relevant.

- an interest rate swap involves an exchange of cash flows, usually the exchange of fixed cash flows for variable cash flows.

In valuing interest rate swaps, the zero-coupon method uses all of the following variables except:

a. Discount rate

b. Timing of cash flows as specified by the contract

c. Estimated net settlement cash flows

d. Underlying assets

d. Basis risk

- basis risk is the risk of loss from ineffective hedging activities.

Which of the following risks relates to the possibility that a DERIVATIVE might NOT BE EFFECTIVE AT HEDGING a particular asset?

a. Credit risk

b. Legal risk

c. Market risk

d. Basis risk

d. A hedging approach

- matching asset and liability maturities (to ensure funds are generated from assets when related liabilities are due)

When a firm finances each asset with a financial instrument of the SAME APPROXIMATE MATURITY as the LIFE OF THE ASSET, it is applying

a. Weighted capital management

b. Return maximization

c. Financial leverage

d. A hedging approach

d. Exchange rate risk

The risk of loss because of FLUCTUATIONS in the relative value of FOREIGN CURRENCIES is called

a. Expropriation risk

b. Sovereign risk

c. Multinational beta

d. Exchange rate risk

c. 123,056

annual savings x 3.60 = 500,000 - 100,000 (0.57)

annual savings = (500,000 - 57,000) / 3.60

= 443,000 / 3.60

Para Co., is reviewing the following data relating to an energy saving investment proposal:

Cost P 500,000

Residual value at the end of 5 years 100,000

Present value of an annuity of 1 at 12% for 5 years 3.60

Present value of 1 due in 5 years at 12% 0.57

What would be the annual savings needed to make the investment realize a 12% yield?

a. 81,890

b. 111,111

c. 123,056

d. 138,890

d. 5 years

payback period = cost of investment of asset / annual cash inflows

100,000/20,000

Tam Co. is negotiating for the purchase of equipment that would cost P100,000, with the expectation that P20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment’s estimated useful life is ten years, with no residual value, and would be depreciated by the straight-line method. The PAYBACK PERIOD is

a. 4 years

b. 4.4. years

c. 4.5 years

d. 5 years

b. The technique corresponds to the measure that is often used to evaluate performance.

Which of the following is an ADVANTAGE of the ACCOUNTING RATE OF RETURN METHOD of evaluating investment returns?

a. The technique considers depreciation

b. The technique corresponds to the measure that is often used to evaluate performance.

c. The technique considers the time value of money.

d. The technique considers the risk of the investment.

b. P 103,980

net of income taxes x present value

50,000 x 0.870 = 43,500

80,000 x 0.756 = 60,480

43,500 + 60,480

Kern Co. is planning to invest in a two-year project that is expected to yield cash flows from operations, net of income taxes, of P 50,000 in the first year and P 80,000 in the second year. Kern requires an internal rate of return of 15%. The present value of P 1 for one period at 15% is 0.870 and for two periods at 15% is 0.756. The future value of P 1 for one period at 15% is 1.150 and for two periods at 15% is 1.323. The MAXIMUM that Kern SHOULD INVEST immediately is

a. P 81,670

b. P 103,980

c. P 130,000

d. P 163,340

c. P 62,900

Y1: 30,000 x 0.88 = 26,400

Y2: 30,000 x 0.77 = 23,100

Y3: 20,000 x 0.67 = 13,400

Total = 62,900

0.88 = given

0.77 = 1.65 (y2) - 0.88 (y1)

0.67 = 2.32 (y3) - 1.65 (y2)

Pole Co. is investing in a machine with a three-year life. The machine is expected to reduce annual cash operating costs by P 30,000 in each of the first two years and by P 20,000 in year three. Present values of an annuity of P 1 at 14% are:

Period 1 0.88

Period 2 1.65

Period 3 2.32

Using a 14% cost of capital, what is the PRESENT VALUE OF THE FUTURE SAVINGS?

a. P 59,600

b. P 60,800

c. P 62,900

d. P 69,500

d. P 11,310

PV of cash inflow (7,500 x 1.74) = 13,050

PV of cash outflow for tax (7,500 – 5,000) x 40% x 1.74 = (1,740)

Total = 11,310

For the next two years, a lease estimated to have an operating net cash inflow of P 7,500 per annum, before adjusting for P 5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an ordinary annuity of P 1 per year at 10% for 2 years is 1.74. What is the lease’s AFTER-TAX PRESENT VALUE using a 10% discount factor?

a. P 2,610

b. P 4,350

c. P 9,570

d. P 11,310

a. Proceeds from the sale of the asset to be replaced.

- project’s net present value is a function of current & future cash flows, including proceeds from sale

A PROJECT’S NET PRESENT VALUE, ignoring income tax considerations, is normally affected by the

a. Proceeds from the sale of the asset to be replaced.

b. Carrying amount of the asset to be replaced by the project.

c. Amount of annual depreciation on the asset to be replaced.

d. Amount of annual depreciation on fixed assets used directly on the project.

a. Rate of interest that EQUATES the present value of cash OUTFLOWS and the present value of cash INFLOWS

IRR - measure of the profitability of an investment / investor expects to earn on an investment

The internal rate of return is the

a. Rate of interest that equates the present value of cash outflows and the present value of cash in-flows.

b. Minimum acceptable rate of return for a proposed investment.

c. Risk-adjusted rate of return.

d. Required rate of return.

a. NPV and IRR criteria will always lead to the same accept and reject decision for two independent projects.

An organization is using capital budgeting techniques to compare two independent projects. It could accept one, or both, or neither of the projects. Which of the following statements is true about the use of net present value (NPV) and internal rate of return (IRR) methods for evaluating these two projects?

a. NPV and IRR criteria will always lead to the same accept and reject decision for two independent projects.

b. If the first project’s IRR is higher than the organization’s cost or capital, the first project will be accepted but the second project will not.

c. If the NPV criterion leads to accepting or rejecting the first project, one cannot predict whether the IRR criterion will lead to accepting or rejecting the first project.

d. If the NPV criterion leads to accepting the first project, the IRR criterion will never lead to accepting the first project.

b. A reduction in income taxes.

A depreciation tax shield is

a. An after-tax cash outflow.

b. A reduction in income taxes.

c. The cash provided by recording depreciation.

d. Total risk is higher than that of the market portfolio

a. Decrease both the amount of benefits and costs.

- income taxes decrease both revenues and cost in projecting future cash flows

Andrew Corporation is evaluating a capital investment that would result in P 30,000 higher contribution margin benefit with increased annual personnel costs of P 20,000. In CALCULATING the net present value of BENEFITS AND COSTS, INCOME TAXES WOULD?

a. Decrease both the amount of benefits and costs.

b. Have no effect on either the amount of the benefits and or costs.

c. Decrease the amount of benefits but increase the amount of the costs.

d. Increase the amount of the benefits but decrease the amount of the costs.

b. P 110,000

amount of contribution to profits x estimated probability of contribution %

[($700,000 × 30%) + ($200,000 × 30%) +(-$400,000 × 40%)

210,000 + 60,000 – 160,000

The Madison Company has decided to introduce a new product. The company estimates that there is a 30% probability that the product will contribute P 700,000 to profits, a 30% probability that it will contribute P 200,000, and 40% probability that the contribution will be a negative P 400,000. The EXPECTED CONTRIBUTION of the new product is

a. P 500,000

b. P 110,000

c. P 166,667

d. P 380,000

d. P 67,200

expected value of sales = sales estimate x probability

[($60,000 × 25%) + ($85,000 × 40%) + ($100,000 × 35%)] = 84,000

COGS: 84,000 x 80%

Philip has developed the following range of sales estimates and associated probabilities for the year:

SALES ESTIMATE | PROBABILITY

P 60,000 | 25%

85,000 | 40%

100,000 | 35%

Philip’s cost of goods sold averages 80% of sales. What is the EXPECTED VALUE of Philip’s 2013 BUDGETED COST OF GOODS SOLD?

a. P 85,000

b. P 84,000

c. P 68,000

d. P 67,200

c. Internal control

- function of the controller’s office

- processes to ensure the reliability of financial reporting

Which of the following is NOT a FUNCTION OF FINANCIAL MANAGEMENT?

a. Financing

b. Risk management

c. Internal control

d. Capital Budgeting

d. Financing permanent inventory build-up with long-term debt is an example of an aggressive working capital policy.

- conservative, not aggressive

All of the following statements in regard to WORKING CAPITAL are CORRECT EXCEPT:

a. Current liabilities are an important source of financing for many small firms.

b. Profitability varies inversely with liquidity.

c. The hedging approach to financing involves matching maturities of debt with specific financing needs.

d. Financing permanent inventory build up with long-term debt is an example of an aggressive working capital policy.

a. Adopting a new inventory system that reduces the inventory conversion period.

Which of the following actions is likely to REDUCE THE LENGTH of a firm’s CASH CONVERSION CYCLE?

a. Adopting a new inventory system that reduces the inventory conversion period.

b. Adopting a new inventory system that increases the inventory conversion period.

c. Increasing the average days sales outstanding on its accounts receivable.

d. Reducing the amount of time the firm takes to pay its suppliers.

d. A compensating balance of P 1,750,000

a. 126,000 (0.50 x 252,000 checks)

Number of checks issued during the year = total of 252,000 checks (700 x 360 days)

b. 125,000

c. 136,080 (453,600,000 x 3%)

Total collections = 453,600,000 (252,000 checks x $1,800 per check)

d. 122,500 (1,750,000 x 7%) - has the lowest cost = optimal

New Products Corp has received proposals from different banks to speed up receipts. New Products receives an average of 700 checks per day averaging P 1,800 each, and its cost of short-term funds is 7% per year. Assuming that all proposals will produce equivalent processing results and using a 360-day year, which one of the following proposals is optimal for New Products?

a. A P 0.50 fee per check.

b. A flat fee of P 125,000 per year.

c. A fee of 0.03% of the amount collected.

d. A compensating balance of P 1,750,000

c. Average daily sales

- include average daily sales, average delivery time, and stock-out costs

To determine the inventory REORDER POINT, calculations normally include the

a. Ordering cost.

b. Carrying cost

c. Average daily sales

d. Economic order quantity

d. No effect.

- change in safety stock does NOT affect EOQ, but does affect reorder point

As a consequence of finding a more dependable supplier, Dee Corp. reduced its safety stock of raw materials by 80%. What is the EFFECT of this SAFETY STOCK REDUCTION on Dee’s ECONOMIC ORDER QUANTITY?

a. 80% decrease.

b. 64% decrease.

c. 20% increase.

d. No effect.

b. 400 units

√(2 x ordering cost x annual demand) / holding cost

√(2 x 32 x 20,000) / 8

Ral Co. sells 20,000 radios evenly throughout the year. The cost of carrying one unit in inventory for one year is P 8, and the purchase order cost per order is P 32. What is the ECONOMIC ORDER QUANTITY?

a. 625

b. 400

c. 283

d. 200

d. 3,200

daily demand x lead time in days + safety stock

(20,000/250) x 30 + 800

The following information pertains to material X that is used by Sage Co:

Annual usage in units 20,000

Working days per year 250

Safety stock in units 800

Normal lead time in working days 30

Units of material X will be required evenly throughout the year. The ORDER POINT is

a. 800

b. 1,600

c. 2,400

d. 3,200

d. Alternative 1 with P 10,000 savings

average inventory (1.5M - 2M) x 8% = 40,000

production cost (6.05M - 6M) = 50,000

50,000 - 40,000

Ethan Inc. has seasonal demand for its products and they are considering between the two sorts of production level to be implemented. The firm’s short term interest cost is 8%, and management has developed the following information to make the decision:

ALTERNATIVE 1 | ALTERNATIVE 2

Average inventory P2,000,000 | P1,500,000

Production cost P6,000,000 | P6,050,000

Which alternative should be ACCEPTED and how much is SAVED?

a. Alternative 1 with P 500,000 savings

b. Alternative 2 with P 50,000 savings

c. Alternative 2 with P 10,000 savings

d. Alternative 1 with P 10,000 savings

c. 10%

production cost = 50,000

average inventory (2M - 1.5M) = 500,000

50,000 / 500,000 = 0.1 or 10%

Ethan Inc. has seasonal demand for its products and they are considering between the two sorts of production level to be implemented. The firm’s short term interest cost is 8%, and management has developed the following information to make the decision:

ALTERNATIVE 1 | ALTERNATIVE 2

Average inventory P2,000,000 | P1,500,000

Production cost P6,000,000 | P6,050,000

At what short-term interest RATE would the two alternatives have the SAME COST?

a. 6%

b. 9%

c. 10%

d. 12%

c. P 3,333,334 decrease.

Old credit policy = 35,000,000 (50M x 70%)

Average A/R = 7,291,667 (35M credit sales/360 days) x 75 days

New policy (sales) = 28,500,000 (50M x 95%) x 60%

New policy (a/r) = 3,958,333 (28.5M credit sales/360 days) x 50 days

Change in A/R balance = average receivable - new policy

7,291,667 - 3,958,333

A company plans to make a new credit policy which they believe will decrease the number of days in collection from 75 to 50 days and reduce the ratio of credit sales to total revenue from 70 to 60%. The company estimates that projected sales would be 5% less if the proposed new credit policy were implemented. The firm’s short-term interest cost is 10%.

The projected sales for the coming year is P 50M.

Calculate the impact of the proposed CHANGE IN CREDIT POLICY in the ACCOUNTS RECEIVABLE. Assume a 360-day year.

a. P 3,819,445 decrease.

b. P 6,500,000 decrease.

c. P 3,333,334 decrease.

d. P 18,749,778 increase

b. P 2,166,667 decrease.

2,500,000 loss in sales - (3,333,334 x 10%)

A company plans to make a new credit policy which they believe will decrease the number of days in collection from 75 to 50 days and reduce the ratio of credit sales to total revenue from 70 to 60%. The company estimates that projected sales would be 5% less if the proposed new credit policy were implemented. The firm’s short-term interest cost is 10%.

The projected sales for the coming year is P 50M.

What EFFECT would the implementation of this NEW CREDIT POLICY have on INCOME BEFORE TAXES?

a. P 2,500,000 decrease.

b. P 2,166,667 decrease.

c. P 83,334 increase.

d. P 33,334 increase

d. 31.81%

(Discount percent/(100% - Discount percent )) × (360 days/(Total pay period - Discount period))

(3% / (100% - 3%)) × (360 days / (45 days - 10 days))

If a retailer’s terms of trade are 3/10, net 45, what is the COST on an annual basis of NOT TAKING THE DISCOUNT? Use 360-day year.

a. 24%

b. 37.11%

c. 36%.

d. 31.81%

d. 8.75%

effective interest rate = interest paid / funds available

interest paid = 100,000 x 7% = 7,000

funds available = 100,000 x 80% = 80,000

7,000 / 80,000 = 8.75%

Hagar Inc.’s bank requires a compensating balance of 20% on a P 100,000 loan. If the stated interest on the loan is 7%, what is the EFFECTIVE COST OF THE LOAN?

a. 5.83%

b. 7%

c. 8.4%

d. 8.75%

b. 25.2%

Interest cost:

Web master = 25,000 x 2%

Softidee = 50,000 x 5%

Annualized interest:

Web master = ((500 / 24,500) x 360 days) / (30 -10 days)

Softidee ((2,500/47.500) x 360 days) / (90-10 days)

Weighted average amount borrowed:

Web master = 24,500 (20 days/360 days)

Softidee = 47,500 (80 days/360 days)

Weighted average interest

((36.73% x 1.361.11) + annual interest x 10,555.56 (ave. amount borrowed)) / (1,361.11 + 10,555,56)

Assuming a 360-day year and that CyberAge continues paying on the last day of the credit period, the company’s weighted-average annual interest rate for trade credit (ignoring the effects of compounding) for these two vendors is

a. 27.0%

b. 25.2%

c. 28.0%

d. 30.2%

d. Yes, if the cost of alternative short-term financing is greater.

- The company is currently paying an annual rate of 25.2% (see previous question) to obtain trade credit and pay at the end of the credit period. This policy should be continued if trade credit is the only source of financing, or if other sources are available only at a higher rate.

Assuming a 360-day year and that CyberAge continues paying on the last day of the credit period, the company’s weighted-average annual interest rate for trade credit (ignoring the effects of compounding) for these two vendors is 25.2%

Should CyberAge USE TRADE CREDIT and CONTINUE PAYING at the end of the credit period?

a. Yes, if the cost of alternative short-term financing is less.

b. Yes, if the firm’s weighted-average cost of capital is equal to its weighted average cost of trade credit.

c. No, if the cost of alternative long-term financing is greater.

d. Yes, if the cost of alternative short-term financing is greater.

a. 6.44%

net interest expense - interest income from the compensating balance

(250,000 X 6%) – (25,000 X 2%)

15,000 - 500 = 14,500

14,500 / (250,000 - 25,000)

A company obtained a short-term bank loan of P 250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of P 50,000 in its checking account. The company’s checking account earns interest at an annual rate of 2%. Ordinarily , the company maintains a balance of P 25,000 in its checking account for transaction purposes. What is the EFFECTIVE INTEREST RATE of the loan?

a. 6.44%

b. 7.11%

c. 5.80%

d. 6.66%

a. Simple interest, no compensating balance.

- the cheapest borrowing terms, assuming the nominal interest rate is the same for all options, would be simple interest without a compensating balance

- simple interest with no compensating balance is the most favorable terms from an effective interest basis

A manufacturing firm wants to obtain a short-term loan and has approached several lending institutions. All of the potential lenders are offering the same nominal interest rate, but the terms of the loans vary. Which of the following combination of LOAN TERMS will be most ATTRACTIVE for the BORROWING FIRM?

a. Simple interest, no compensating balance.

b. Discount interest, no compensating balance.

c. Simple interest, 20% compensating balance required.

d. Discount interest, 20% compensating balance required.

c. Market; increases

- if the market value of interest increases, the bond value will decrease (an inverse effect)

Wilson Corporation issued bonds two years ago. If the ______ interest rate ________, the market value of the bond will decrease.

a. Coupon; increases

b. Coupon; decreases

c. Market; increases

d. Market; decreases

b. 10

DOL = percentage in operating income/percentage change in unit volume

operating income = (300,000 - 200,000) / 200,000 = 50%

unit volume = (105,000 - 100,000 units) / 100,000 units = 5%

50% / 5%

Number of units sold | 100,000 units | 105,000 units

Sales | 3,000,000 | 3,150,000

Expenses | (2,800,000) | (2,850,000)

Operating income (EBIT) | 200,000 | 300,000

Earnings per share (EPS) | 0.20 | 1.20

What is Rothenberg’s DEGREE OF OPERATING LEVERAGE?

a. 1/5

b. 10

c. 5

d. 2/3

a. 10

DFL = percentage change in EPS / percentage change in EBIT

EPS = (1.20 - 0.20) / 0.20 = 500%

EBIT = (300,000 - 200,000) / 200,000 = 50%

500% / 50%

Number of units sold | 100,000 units | 105,000 units

Sales | 3,000,000 | 3,150,000

Expenses | (2,800,000) | (2,850,000)

Operating income (EBIT) | 200,000 | 300,000

Earnings per share (EPS) | 0.20 | 1.20

What is the DEGREE OF FINANCIAL LEVERAGE for Rothenberg, Inc.?

a. 10

b. 5

c. 1/6

d. 1/10

d. The company has no firm obligation to pay dividends to common shareholders.

- the lack of a firm obligation to pay dividends to common shareholders is an advantage of equity financing.

- the rest are all disadvantages

Which of the following is an ADVANTAGE OF EQUITY FINANCING in comparison to debt financing?

a. Issuance costs are greater than for debt.

b. Ownership is given up with respect to the issuance of common stock.

c. Dividends are not tax deductible by the corporation whereas interest is tax deductible.

d. The company has no firm obligation to pay dividends to common shareholders.

b. Firm’s profits are more sensitive to changes in sales volume.

- a firm's profits are more sensitive to changes in sales volume when the firm is more leveraged

A firm with a higher degree of operating leverage when compared to the industry average implies that the

a. Firm has higher variable costs.

b. Firm’s profits are more sensitive to changes in sales volume.

c. Firm is more profitable.

d. Firm is less risky.

b. Alternative 2 by 0.59%

ALTERNATIVE 1 = (6% X (100%-15% TAX RATE) = 5.1%

ALTERNATIVE 2 = (7% X (100%-15% TAX) = 5.95%

WEIGHTED AVERAGE cost of capital :

Alt 1 = (5.1% x 3M / 6M) + 10% x 3M / 6M

Alt 2 = (5.95% x 5M / 6M) + 12% x 1M /6M

7.55% - 6.96%

Russel Corporation is considering the following 2 potential capital structure for a newly acquired business:

OPTION 1

Long-term debt, 6% interest P 3,000,000

Common equity P 3,000,000

Cost of common equity, 10%

Marginal tax rate, 15%

OPTION 2

Long-term debt, 7% interest P 5,000,000

Common equity P 1,000,000

Cost of common equity, 12%

Marginal tax rate, 15%

Which of the alternatives has the LOWEST WEIGHTED-AVERAGE COST OF CAPITAL and how much is the DIFFERENTIAL?

a. Alternative 1 by 1.5%

b. Alternative 2 by 0.59%

c. Alternative 1 by 0.167%

d. The alternatives have equal weighted-average cost of capital

b. Investors are exposed to greater risk with equity capital

- equity holders are subject to more risk than debt holders. Therefore, they require a higher rate of return.

In general, it is MORE EXPENSIVE for a company to FINANCE with EQUITY than with debt because

a. Long-term bonds have a maturity date and must, therefore, be repaid in the future.

b. Investors are exposed to greater risk with equity capital.

c. The interest on debt is a legal obligation.

d. Equity capital is in greater demand than debt capital.

b. 14.1%

(2.11 / 23.12) + 5%

Management of Terral Corp. is attempting to estimate the firm’s cost of equity capital. Assuming that the firm has a constant growth rate of 5%, a forecasted dividend of P 2.11, and a stock price of P 23.12, what is the ESTIMATED COST OF COMMON EQUITY using the dividend-yield-plus-growth approach?

a. 9.1%

b. 14.1%

c. 15.6%

d. 12.3%

b. Decrease

- an increase in the nominal interest rate would mean that investors would expect a higher return on all investments. If the stock earnings and dividend growth is unchanged, the stock price will decrease.

If nominal interest rates increase substantially but expected future earnings and dividend growth for a firm over the long run are not expected to change, the firm’s stock price will

a. Increase

b. Decrease

c. Stay constant

d. Change, but in no determinable direction

a. Company X’s investors expect higher dividend growth than Company Y’s investors.

- if investors expect a higher dividend growth rate, the market value of the common shares will be greater.

Assume that two companies, Company X and Company Y, are alike in all respects, except the market value of the outstanding common shares of the Company X is greater than the market value of Company Y shares. This may indicate

a. Company X’s investors expect higher dividend growth than Company Y’s investors.

b. Company X’s investors expect lower dividend growth than Company Y’s investors.

c. Company X’s investors have longer expected holding periods than Company Y’s investors.

d. Company X’s investors have shorter expected holding periods than Company Y’s investors.

c. 14.3%

(dividend / price of shares) + growth

(5 / 60) + 6%

Assume a firm is expected to pay a dividend of P5 per share this year. The firm along with the dividend is expected to grow at a rate of 6%. If the current market price of the stock is P60 per share, what is the ESTIMATED COST OF EQUITY?

a. 8.3%

b. 6.0%

c. 14.3%

d. 12.0%

c. 5.1%

cost of debt before tax = 7% + 1.5% = 8.5%

cost of debt after tax = 8.5% x (1 - 40% tax rate) = 5.1%

- A long term debt was originally issued at par P 1,000 per bond and is currently trading at P1,250 per bond.

- Martin Corporation can now issue debt at 150 basis points (bps = 1/100%) over Treasury bonds.

- The current risk-free rate is 7%.

- Martin’s common stock is currently selling at P 32 per share.

- The expected market return is currently 15%.

- The beta value for Martin is 1.25.

- The effective corporate income tax rate is 40%.

The NET COST OF DEBT is

a. 5.5%

b. 7.0%

c. 5.1%

d. 8.5%

d. 17%

risk free rate + (market rate - risk free rate) x beta

7% + (15% - 7%) x 1.25

- A long term debt was originally issued at par P 1,000 per bond and is currently trading at P1,250 per bond.

- Martin Corporation can now issue debt at 150 basis points (bps = 1/100%) over Treasury bonds.

- The current risk-free rate is 7%.

- Martin’s common stock is currently selling at P 32 per share.

- The expected market return is currently 15%.

- The beta value for Martin is 1.25.

- The effective corporate income tax rate is 40%.

Using the Capital Asset Pricing Model (CAPM), the CURRENT COST OF COMMON EQUITY is

a. 8.75%

b. 10%

c. 15%

d. 17%

a. 10.50%

funds received from debt = (101% - 2%) x 15M = 14,850,000

funds from equity = 35,000,000, the amount of RE

total funding = 14,850,000 + 35,000,000 = 49,850,000

(14,850,000 / 49,850,000) x 7% + (35,000,000/49,850,000) x 12%

DQZ Telecom is considering a project for the coming year that will cost P 50M. DQZ plans to use the following combination of debt and equity to finance the investment.

- Issue P 15M of 20-year bond at a price of 101, with coupon rate of 8%, and flotation cost of 2% of par.

- Use P 35M of funds generated from earnings. The equity market is expected to earn 12%. Treasury bonds are currently yielding 5%. The beta coefficient is estimated to be 0.60. DQZ is subject to an effective corporate income tax rate of 40%.

Assume that the after-tax costs of debt is 7% and the cost of equity is 12%. Determine the WEIGHTED-AVERAGE COST OF CAPITAL.

a. 10.50%

b. 8.50%

c. 9.50%

d. 6.30%

a. 9.20%

5% + (12% - 5%) x 0.60

DQZ Telecom is considering a project for the coming year that will cost P 50M. DQZ plans to use the following combination of debt and equity to finance the investment.

- Issue P 15M of 20-year bond at a price of 101, with coupon rate of 8%, and flotation cost of 2% of par.

- Use P 35M of funds generated from earnings. The equity market is expected to earn 12%. Treasury bonds are currently yielding 5%. The beta coefficient is estimated to be 0.60. DQZ is subject to an effective corporate income tax rate of 40%.

The Capital Asset Pricing Model (CAPM) computes the expected return on a security by adding the risk-free rate of return to the incremental yield of the expected market return that is adjusted by the company’s beta. Compute for the EXPECTED RATE OF RETURN.

a. 9.20%

b. 12.20%

c. 7.20%

d. 12%

c. 9.36%

2/5 x (9% x (100%-40%) + (3/5 x 12%)

Hi-Tech Inc. has determined that it can minimize its weighted-average cost of capital (WACC) by using a debt/equity ratio of 2/3. If the firm’s cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the FIRM’S WACC?

a. 6.48%

b. 7.92%

c. 9.36%

d. 10.80%