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Review for Exam 2

savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/quiz_2_-_review.htm

1.

If a firm pays 10% compounded semi-annually, the true rate of interest is greater than 10%.

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2.

Compounding refers to the earning of interest on interest.

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3.

It takes longer than 8 years to retire a $24,000 loan at 8% if the annual payment is $3,000.

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4.

An annuity of $100 for 10 years is currently less valuable if interest rates are 10% instead of 12%.

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5.

If a person buys a stock for $10 and sells it after 10 years for $20, the annual compound return is 10%.

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6.

If interest rates are 9 percent, an annuity of $100 for 10 years is to be preferred to $1,000 after 10 years.

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7.

Realized returns frequently differ from expected returns.

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8.

Systematic risk is reduced through portfolio diversification.

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9.

A beta coefficient is an index of an asset's unsystematic risk.

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10.

The numerical value of a stock's beta tends to be stable over time.

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11.

A portfolio consisting of securities that are highly correlated is well diversified.

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12.

Beta coefficients and standard deviations may be used as indicators of risk.

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13.

The expected return on an investment includes both the expected of income plus expected price
appreciation.

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14.

If a firm sells inventory at cost for cash, its total assets rise.

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15.

If a firm has retained earnings, it has an equal amount of cash.

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16.

Retained earnings represents the earnings accumulated by the firm over its life.

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17.

Accounts receivable are adjusted for doubtful accounts (i.e., accounts that may not be paid).

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18.

Accountants suggest that assets should always be valued at their market value.

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19.

If liabilities are decreased or assets increased, that generates a cash inflow.

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20.

Since depreciation is a non-cash expense, it has no impact on a firm's income taxes.

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21.

The numerical value of the quick ratio can never exceed the numerical value of the current ratio.

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22.

Leverage ratios indicate the extent to which the firm uses debt financing.

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23.

The DuPont system combines liquidity and earnings.

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24.

The owners of a corporation elect the board of directors.

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25.

Cumulative voting concentrates voting power in the hands of a majority of corporate voters.

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26.

A cash dividend reduces the firm's assets.

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27.

A constant payout ratio implies dividends vary with earnings.

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28.

A reverse split (e.g., 1 for 2) increases the number of shares the firm has outstanding.

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29.

Stockholders who seek to defer taxes prefer capital gains to dividends.

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30.

Most publicly held American firms that pay dividends tend to pay a regular quarterly cash dividend.

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31.

Stock dividends increase the wealth of stockholders who receive additional shares.

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32.

Dividend reinvestment plans are a convenient means to encourage individuals to save.

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33.

The value of stock depends in part on future dividends and investors' required return.

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34.

The required return for an investment in a stock increases if the firm's beta declines.

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35.

An increase in the required return on the market will tend to decrease stock prices.

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36.

The value of a common stock depends in part on the expected growth in dividends.

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37.

An increase in risk should cause the value of a common stock to fall.

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38.

One index of systematic risk is a stock's beta coefficient.

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39.

The risk-adjusted model for the valuation of common stock excludes yields on competitive securities.

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40.

A P/E ratio may be used as a multiple to forecast a firm's future earnings.

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Multiple Choice
Identify the choice that best completes the statement or answers the question.

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41.

The present value of a dollar


1.

increases with lower interest rates

2.

increases with higher interest rates

3.

increases with longer periods of time

4.

decreases with longer periods of time

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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42.

The present value of an annuity due


a.

is less than the present value of an ordinary annuity

b.

is greater than the present value of an ordinary due

c.

is less than the cost of the annuity

d.

is greater than the cost of the annuity

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43.

The future value of a dollar


1.

decreases with compounding

2.

increases with compounding

3.

decreases with higher interest rates

4.

increases with higher interest rates

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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44.

If interest rates rise,


a.

the future value of a dollar declines

b.

the present value of a dollar rises

c.

the present value of an annuity falls

d.

the future value of an annuity falls

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45.

A beta coefficient for a risky stock is


a.

less than 1.0

b.

equal to 1.0

c.

greater than 1.0

d.

negative

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46.

An investor may reduce risk by selecting


a.

high beta stocks

b.

stocks with poorly correlated returns

c.

a cross-section of firms in the same industry

d.

stocks traded on organized exchanges

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47.

To measure risk, the capital asset pricing model uses


a.

beta

b.

an asset's standard deviation

c.

the volatility of an asset's cash flows

d.

the term during which the asset is held

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48.

Which of the following will reduce the required return on an investment?


a.

an increase in beta and a reduction in the Treasury bill rate

b.

an increase in the Treasury bill rate and a decrease in beta

c.

a decrease in the Treasury bill rate and a decrease in beta

d.

an increase in the Treasury bill rate and an increase in beta

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49.

Components of the capital asset pricing model include


a.

a stock's market price

b.

the standard deviation of a stock's return

c.

the rate on a risk-free security

d.

the investor's need for income versus capital gains

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50.

A diversified portfolio reduces


a.

unsystematic risk

b.

systematic risk

c.

purchasing power risk

d.

interest rate risk

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51.

The standard deviation measures


a.

the dispersion around an average value

b.

systematic risk

c.

unsystematic risk

d.

the security's high-low prices

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52.

Which of the following is not a source of systematic risk?


a.

inflation

b.

reduction in the value of the British pound

c.

how a firm finances its assets

d.

a decline in the Dow Jones industrial average

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53.

The risk-adjusted required rate of return excludes


a.

the stock's standard deviation

b.

the stock's beta

c.

the risk-free rate

d.

the anticipated return on the market

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54.

Accountants suggest that assets


a.

should be valued at market

b.

should be valued at cost

c.

should be valued at the lower of market or cost

d.

should be valued at the higher of market or cost

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55.

Which of the following is a cash inflow?


a.

an increase in accounts receivable

b.

a decrease in inventory

c.

distributing cash dividends

d.

a decrease in long-term debt

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56.

Which of the following is a cash outflow?


a.

a new issue of bonds

b.

a decrease in accounts receivable

c.

an increase in plant

d.

an increase in accounts payable

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57.

Current assets include


a.

plant

b.

inventory

c.

equipment

d.

additional paid-in capital (capital surplus)

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58.

Equity includes
a.

cash

b.

investments

c.

retained earnings

d.

assets

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59.

Determination of earnings (profits) requires knowing


a.

paid-in capital (capital surplus)

b.

cash

c.

retained earnings

d.

depreciation

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60.

The use of accelerated depreciation


a.

initially increases the firm's profits

b.

initially decreases the firm's taxes

c.

discourages investment in plant and equipment

d.

increases expenses and decreases cash flow

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61.

The current ratio excludes


a.

accrued interest

b.

inventory

c.

cash equivalents

d.

retained earnings

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62.

A high current ratio suggests that the firm


a.

has a small amount of long-term debt

b.

is carrying little inventory

c.

is able to meet its current obligations

d.

is profitable

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63.

Leverage ratios measure


a.

extent to which the firm uses debt financing

b.

the speed with which the firm sells inventory

c.

sales relative to some base such as equity

d.

capacity of the firm to meet current obligations

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64.

The larger the debt ratio


a.

the more equity the firm is using

b.

the riskier the firm becomes

c.

the larger are the firm's total assets

d.

the smaller is the firm's use of financial leverage

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65.

Which of the following is equity?


1.

investments

2.

additional paid-in capital

3.

retained earnings

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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66.

The retention of earnings instead of paying dividends


a.

may result in greater growth and higher prices

b.

is advantageous for all stockholders

c.

is favored by stockholders in lower income tax brackets

d.

leads to lower future dividends

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67.

Dividends are paid on the


a.

declaration date

b.

ex dividend date

c.

date of record

d.

distribution date

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68.

Management may prefer not paying dividends to


a.

reduce corporate income taxes

b.

finance growth and increase the value of their shares

c.

use the money to reduce investments in assets

d.

increase the firm's liabilities

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69.

Dividend reinvestment plans are


a.

a convenient means to accumulate shares

b.

a means to defer federal income taxes on the dividends

c.

available only if the corporation distributes stock dividends

d.

more expensive than buying the stock through brokers

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70.

An increase in investors' required return should cause the value of a common stock to
a.

rise

b.

fall

c.

remain unchanged

d.

remain stable or rise slightly

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Problem

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71.

If you open an individual retirement account (IRA) at a commercial bank and deposit $1,000 in the account
per year, how much will be in the account after 20 years if the funds earn 7% annually?

RESPONSE:
ANSWER:

$1,000(40.995) = $40,995
40.995 is the interest factor for the future value of an annuity at 7% for twenty years.
(PV = 0; N = 20; I = 7; PMT = -1000, and FV = ?. FV = 40995.)

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72.

You borrow $100,000 to buy a house; if the annual interest rate is 6% and the term of the loan is 20 years,
what is the annual payment required to retire the mortgage loan?

RESPONSE:
ANSWER:

X = $100,000/11.470 = $8,718.40
8.514 is the interest factor for the present value of an annuity at 6% for twenty years.
(PV = 100000; N = 20; I = 6; PMT = ?, and FV = 0. PMT = -8718.46.)

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73.

A firm has a $1,000,000 debt (e.g., a bond) outstanding that matures after 10 years. The sinking fund
requires the firm to set aside annually an amount so the debt may be retired at maturity. If the firm can earn
10% annually on these funds, how much must it invest annually to meet the sinking fund?

RESPONSE:
ANSWER:

X(15.937) = $1,000,000
X = $1,000,000/15.937 = $62,747
15.937 is the interest factor for the future value of $1 at 10% for 10 years. (PV = 0; N =
10; I = 10; PMT = ?, and FV = 1000000. PMT = -62745.39.)

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74.

An investor expects a stock to double in 7 years. What is the expected annual rate of growth in the price of
the stock?

RESPONSE:
ANSWER:

$1(1 + g) 7 = $2
(1 + g) 7 = $2/$1 = 2
g is approximately 10%.
(PV = -1; N = 7; I = ?; PMT = 0, and FV = 2. I = 10.41.)

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75.

You are offered two jobs. One initially pays $25,000 annually, and your salary will grow annually at 10%.
The other pays $22,000 annually, but your salary will grow at 12%. After 10 years, which job pays the
higher salary?

RESPONSE:
ANSWER:

$25,000(1 + .1) 10 = $25,000(2.594) = $64,850


(PV = -25000; N = 10; I = 10; PMT = 0, and FV = ?. FV = 64843.)
$22,000(1 + .12) 10 = $22,000(3.106) = $68,332
(PV = -22000; N = 12; I = 10; PMT = 0, and FV = ?. FV = 68328.)
The job with the lower initial paying salary generates the higher salary after 10 years.

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76.

You bought a stock for $30 and after 10 years sold it for $50. It paid an annual dividend of $2. Set up an
equation that illustrates how the annual return is determined. Show that this return is not 14%.

RESPONSE:
ANSWER:

Does $30 = $2(PVAIF 14I, 10N) + $50(PV$IF 14I, 10N)?


If 14% is the rate of return, the sides of the equation will be equal.
$2(5.216) + $30(.270) = $23.93, so the return is not 14%. 14% is too high.
(PV = -30; N = 10; I = ?; PMT = 2, and FV = 50. I = 10.71.)

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77.

A person has an individual retirement account and can deposit $2,000 a year. What will be the difference in
the amount in the account if this investor earns 8% instead of 6%?

RESPONSE:
ANSWER:

At 6%: $2,000(36.785) = $73,570


36.785 is the interest factor for the future value of an annuity of $1 at 6% for twenty
years. (PV = 0; N = 20; I = 6; PMT = -2000, and FV = ? FV = 73572.)
At 8%: $2,000(45.762) = $91,524
45.762 is the interest factor for the future value of an annuity of $1 at 8% for twenty
years. (PV = 0; N = 20; I = 8; PMT = -2000, and FV = ? FV = 91524.)
The additional interest is $91,524 - $73,570 = $17,954.

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78.

The Big-Sox currently have 30,000 spectators per game and anticipate annual growth in attendance of
9%. If the Big Stadium holds 65,000 people, how long will it take for the team reach capacity?

RESPONSE:
ANSWER:

30,000(1 + .09) t = 65,000


(1 + .09) t = 65,000/30,000 = 2.167
t is 9 years.
Look up 2.167 in the future value of $1 table at 9% and determine that n is
approximately 9 years. (PV = -30000; N = ?; I = 9; PMT = 0, and FV = 65000. N =
8.97.)

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79.

If a company paid a dividend of $1 in 2006 and the dividend grows annually by 7 percent, what will be the
dividend in 2011?

RESPONSE:
ANSWER:

This is another example of future value:


$100(1 + .07) 5 = X
The interest factor for the future value of a dollar at 7 percent for 5 years is 1.403.
Hence
$100(1.403) = $1.40
(PV = -100; N = 5; I = 7; PMT = 0; FV = ?; FV = 140.26.)

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80.

If an individual can save $1,500 annually, how much will have been accumulated after 4 years if the funds
earn 7 percent?

RESPONSE:
ANSWER:

This problem is also an example of the future value of an annuity:


$1,500(FVIF 7I, 4N) = $1,500(4.440) = $6,660
(PV = 0; N = 4; I = 7; PMT = -1500; FV = ?; FV = 6659.91.)

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81.

If an annuity costs $200,000 and yields 7 percent annually for 5 years, how much cash can an individual
withdraw each year such that the principal is consumed at the end of the time period?

RESPONSE:
ANSWER:

This illustrates the present value of an annuity of $1.00. The interest factor at 7
percent for 5 years is 4.10.
(FVAIF)(X) = $200,000
4.1X = $200,000
X = $200,000/4.1 = $48,780
The person may withdraw over $48,778 annually for five years. (PV = -200000; N = 5;
FV = 0; I = 7; PMT = ? PMT = 48778.14.)

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82.

How much additional interest will you earn on $1,000 at 10 percent for 10 years if interest is compounded
semi-annually instead of annually?

RESPONSE:
ANSWER:

This problem illustrates the impact of more frequent compounding.


Annual compounding:
$1,000(1 + .1) 10 = $1,000(2.594) = $2,594
(PV = -1000; N = 10; I = 10; PMT = 0; FV = ?; FV = 2593.74.)
Semi-annual compounding:
$1,000(1 + .1/2) 10x2 = 1,000(1.05) 20 =
$1,000(2.653) = $2,653
(PV = -1000; N = 20; I = 5; PMT = 0; FV = ?; FV = 2653.30.)
The difference in interest earned is $59.

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83.

What is the expected return on a stock if the firm will earn 24% during a period of economic boom, 14%
during normal economic periods, and 2% during a period of recession if the probabilities of these economic
environments are 20%, 65%, and 15%, respectively?

RESPONSE:
ANSWER:

The expected return is a weighted average of the individual possible returns, each
weighted by the probability of their occurring:
Expected return

= (0.2)(0.24) + (0.65)(0.14) + (0.15)(0.02)


= 14.2%.

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84.

What is the required return using the capital asset pricing model if a stock's beta is 1.2 and the individual,
who expects the market to rise by 11.2%, can earn 4.4% invested in a risk-free Treasury bill?

RESPONSE:
ANSWER:

The required return is


Rr = R f + (R m - Rf) beta = 4.4% + (11.2 - 4.4)1.2 = 12.56%.

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85.

You bought a stock with a beta of 1.4 and earned a return of 8.3%. Did you outperform the market if, during
the same period, the market rose by 7.4% and you could have earned 5.4% by investing in a Treasury bill?

RESPONSE:
ANSWER:

The material in this problem was not explicitly covered in the chapter. You may use the
problem to set up the question, "What return should you have earned during a
particular investment horizon?" The answer uses the capital asset model to evaluate
performance. Thus, the return that should have been realized is
Rf + (R m - Rf) beta = 5.4% + (8.3 - 5.4)1.4 = 9.46%.
The actual return (8.3% return) is less than the return that would be expected given
the beta and the market performance. The stock under-performed the market on a
risk-adjusted basis.

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86.

Given the following information, construct the statement of cash flow. What happened to the firm's liquidity
position during the year?
Net income

$16.7

Decrease in accounts receivable

6.1

Increase in accounts payable

13.6

Sale of bonds

55.1

Dividends

14.8

Retirement of bonds

10.8

Increase in inventory

15.2

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Depreciation expense

56.0

Cost of goods sold

72.1

Reduction in income taxes payable

5.0

Sale of stock

0.4

Purchase of plant and equipment

91.0

Beginning cash

1.1

Repurchase of stock

5.6

RESPONSE:
ANSWER:
Statement of Cash Flows for the Period Ending
December 31, 20XX

Operating activities
Net income

$16.7

Depreciation

56.0

Decrease in accounts receivable

6.1

Increase in inventory

(15.2)

Increase in accounts payable

13.6

Decrease in income taxes payable

(5.0)

Net cash provided by operating activities

$72.2

Investment activities
Increase in plant
Net cash used in investing activities

(91.0)
($91.0)

Financing activities

35/40

Proceeds from sale of long-term debt

55.1

Payments on long-term debt

(10.8)

Dividends

(14.8)

Repurchase of stock

(5.6)

Sale of stock

0.4

Net cash provided by financing activities

$24.3

Cash at beginning of the year

$1.1

Cash at the end of the year

$6.6

The firm's cash position has increased, but that does not mean the firm is more liquid
since inventory and accounts payable increased while accounts receivable declined.
You should also note that the firm increased its investment in plant by using the cash
generated through depreciation and the issuing of new long-term debt. The earnings
and sale of stock did not cover dividends and stock repurchases. This indicates that
the firm is more financially leveraged.
POINTS:

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REF:

87.

What is the debt/net worth ratio and the debt to total assets ratio for a firm with total debt of $600,000 and
equity of $400,000?

RESPONSE:
ANSWER:

Debt/Net worth: $600,000/$400,000 = 1.5


Debt ratio (Debt/Total assets):
$600,000/($600,000 + $400,000) = 0.6 = 60%

POINTS:

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REF:

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88.

Construct a new balance sheet showing the impact of a 5 percent stock dividend. What will be the new
price of the stock?

RESPONSE:
ANSWER:

The new balance sheet after the 5 percent stock dividend:


Assets

Liabilities and Equity

Cash

$ 10,000,000

Accounts payable

$ 20,000,000

Accounts

250,000,000

Long-term debt

400,000,000

Common stock ($10 par;

10,500,000

receivable
Inventory

120,000,000

1,050,000 shares
outstanding)

Plant and

325,000,000

Add. paid-in capital

equipment

Retained earnings
$705,000,000

92,400,000
182,100,000
$705,000,000

The firm issues (.05)(1,000,000) = 50,000 shares with a $10 par value. The common
stock entry is increased by $500,000 to $10,500,000.
The market value of the stock is $58 50,000 = $2,900,000.
Retained earnings are reduced by $2,900,000 to $182,100,000.
Since retained earnings are reduced by $2,900,000 and common stock is increased
only by $500,000, $2,400,000 is unaccounted for. In order to balance the balance
sheet, additional paid-in capital is increased by $2,400,000.
The new price of the stock is $58 /1.05 = $55.24. This price adjustment is necessary to
adjust for the dilution of the old stock that results from the stock dividend.
Be certain to point out that in both the stock split and the stock dividend (1) assets are
not changed, (2) liabilities are not changed, and (3) total equity is not changed. All that
occurs is (1) a reduction in the price of the stock resulting from the increase in the
number of shares, and (2) some changes in the individual entries in the equity section
of the balance sheet.
POINTS:

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REF:

89.

A company whose stock is selling for $45 has the following balance sheet:
Assets

$32,000

Liabilities

$10,000

Common stock

6,000

37/40

($6 par; 1,000


shares issued)
Additional paid-in

2,000

capital
Retained earnings

14,000

a.

Construct a new balance sheet showing a 3 for 1 stock split. What is the new price for the stock?

b.

What would be the balance sheet if the firm paid a 10 percent stock dividend (instead of the stock
split)?

RESPONSE:

38/40

ANSWER:
a.

Three for one split:


Assets

$32,000

Liabilities

$10,000

Common stock

6,000

($2 par; 3,000


shares issued)
Additional paid-in

2,000

capital
Retained earnings

14,000

The firm now has 3,000 shares outstanding with a $2 par value. The price of
the stock adjusts to $45/3 = $15.

b.

10 percent stock dividend:


Assets

$32,000

Liabilities

$10,000

Common stock

6,600

($6 par; 1,100


shares issued)
Additional paid-in

5,900

capital
Retained earnings

9,500

The 10 percent stock dividend results in the firm issuing 100 new shares.
$4,500 ($45 100) is subtracted from retained earnings and added to the
other equity accounts. $600 (100 $6 par) is added to stock outstanding. The
residual ($3,900) additional paid-in capital.

POINTS:

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REF:

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90.

What is the value of a preferred stock that pays an annual dividend of $3 a share and competitive yields
are 5%, 10%, and 15%?

RESPONSE:
ANSWER:

Value of the perpetual preferred stock:


At 5%: P p = $3/.05 = $60
At 10%: P p = $3/.10 = $30
At 15%: P p = $3/.15 = $20

POINTS:

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REF:

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