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Practice questions for final exam - page 1

Practice Questions for Final


1. JLP Industries has 6.5 million shares of common stock outstanding with a market price of $14 per
share. The company also has outstanding preferred stock with a market value of $10 millon, and
25,000 bonds outstanding, each with a face value of $1,000 and selling at 90% of par value. The cost
of equity is 14%, the cost of preferred is 10%, and the before-tax cost of debt is 7.25%. If JLP’s tax
rate is 34%, what is the WACC?

a) 9.5%
b) 10.0%
c) 10.8%
d) 11.6%
e) 12.0%

2. Eastward Co. has 80,000 shares outstanding at a price of $36 per share. It also has bonds outstanding
with a market value of $1,500,000 (8% coupon rate, face value of the bonds is $1,875,000). Eastwards
cost of equity is 15%, the YTM on the bonds is 10%. If the firm’s tax rate is 38%, what is its
Weighted Average Cost of Capital (WACC)?

a) 12.41%
b) 11.99%
c) 12.50%
d) 9.40%
e) 10.47%

3. A financial manager at Westward Co., an all equity financed firm, is evaluating the following
projects:

Project ß Forecast Return


A 1.8 15%
B 1.3 11.8%
C 0.8 9.1%

The risk free rate is 6% and the expected market return is 10%. Which projects should be accepted?

a) A only
b) B only
c) A and B
d) B and C
e) A and C
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4. Which of the following may be true concerning debt and equity?

a) The cost of debt for Firm A is greater than the cost of equity for Firm A.
b) The cost of debt for Firm A is greater than the cost of equity for Firm B.
c) The cost of debt for Firm A is equal to the cost of equity for Firm A.
d) More than one of the above may be true.
e) None of the statements above could be true.

5. The firm's target (optimal) capital structure is most consistent with which of the following?

a) Maximum earnings per share (EPS).


b) Minimum cost of debt (RD).
c) Minimum risk.
d) Minimum cost of equity (RE).
e) Minimum weighted average cost of capital (WACC).

6. The market value of the debt of Larvets Inc. is $1,500,000 (face value is $1,000,000). Larvets’ tax
rate is 34%, their costs of equity and debt (before-tax) are 15% and 8%, respectively. The current
stock price is $60/share, and there are 50,000 shares of stock outstanding (book value is $23 per
share). Calculate the appropriate equity weight to be used in computing Larvets’ weighted average
cost of capital.

a) 0.50
b) 0.67
c) 0.33
d) 0.75
e) 1.38

7. A company has the following optimal capital structure:

Source Market Value Book Value Cost


Long-term debt $50,000,000 $40,000,000 8.8% (after-tax)
Preferred stock $10,000,000 $9,000,000 12.0%
Common stock $140,000,000 $135,000,000 15.0%

The weighted average cost of capital (WACC) is

a) less than 8.8%


b) 11.9%
c) 12.0%
d) 13.3%
e) more than 13.3%
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8. Financial risk

a) is the same as business risk.


b) increases as the firm issues more equity.
c) causes the firm's cost of debt, RD, to exceed its cost of equity, RE.
d) causes the cost of equity, RE, to increase.
e) is caused by underlying changes in the firm's operations.

9. As the dollar volume of financing needs increases, the costs of the various types of financing will
eventually _____, _____ the firm’s weighted average cost of capital.

a) increase, lowering

b) increase, raising
c) decrease, lowering
d) decrease, raising
e) The costs will never change and the WACC will remain constant.

10.Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target debt/equity
ratio is 0.60, and the tax rate is 35%, what is the firm’s weighted average cost of capital (WACC)?
Select the range in which the correct answer falls.

a) The WACC is less than 11%.


b) The WACC is greater than or equal to 11% but less than 12%.
c) The WACC is greater than or equal to 12% but less than 13%.
d) The WACC is greater than or equal to 13% but less than 14%.
e) The WACC is greater than or equal to 14%.

11.According to the residual theory of dividends, if the firm’s equity need is less than the amount of
retained earnings, the firm would

a) borrow to pay the cash dividend.


b) declare a dividend equal to the remaining balance.
c) pay no cash dividends.
d) not need to consider its dividend policy.
e) issue new common equity to make up the difference.
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12.You are on vacation in Tokyo and you see a vase in a shop window with a price of 23,100¥. Once
inside the shop, the owner offers to sell you the camera for $220. Just prior to entering the shop you
had noticed that the bank next door had a posted exchange rate of 107.80¥/$. How much money (in
$), if any, would you save if you bought the camera for $220 rather than 23,100¥?

a) $5.71
b) $6.61
c) $11.00
d) -$6.61
e) -$5.71

13. A __________ option is an option to purchase a specified number of shares of a stock on or before
some future date at a specified price, whereas a ________ option is an option to sell a specified
number of shares of a stock on or before some future date at a specified price. _________ are
purchased if the stock price is expected to fall.

a) put; call; Puts


b) call; put; Puts
c) put; call; Calls
d) call; put; Calls
e) call; call; Calls

14. AC/DC Co. is presented with following possible projects for investment:

Year Project A($) Project B($)

0 -73,000 -85,000
1 15,000 17,000
2 20,000 27,000
3 20,000 27,000
4 18,000 24,000
5 18,000 24,000

Compute the pay-back periods in years for projects A and B.

Project A Project B
a) 4 yrs. 3.58 yrs.
b) 4.01 yrs. 3.5 yrs.
c) 3.95 yrs. 3.4 yrs.
d) 4 yrs. 4 yrs.
e) 5 yrs. 3.5 yrs.
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15. A major disadvantage of the payback period method is that it

a) is useless as a risk indicator.


b) ignores cash flows beyond the payback period.
c) does not directly account for the time value of money.
d) All of the answers above are correct.
e) Only answers (b) and (c) are correct.

16.A corporation has an optimal capital structure of 40 percent debt and 60 percent equity. The 2000
investment opportunity schedule totals $1,500,000. If the 1999 retained earnings are $900,000 and
the firm follows the residual theory of dividends, it would pay ______ in dividends.

a) $0
b) $150,000
c) $450,000
d) $540,000
e) $1,500,000

17.You have been asked by the president of your company to evaluate the proposed acquisition of a new
special-purpose truck. The truck’s basic price is $50,000, and it will cost another $10,000 to modify
it for special use by your firm. The truck falls into the MACRS three-year class life, and it will be
sold after three years for $20,000. Use of the truck will require an increase in net working capital
(spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to
save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm’s marginal tax
rate is 40 percent. The truck’s cost of capital is 10 percent. What is its NPV?

a) -$1,547
b) -$562
c) $0
d) $562
e) $1,034

18. An investor is considering buying 500 shares of ABC Company at $32 per share. Analysts agree
that the firm’s stock price may increase to $45 per share in the next 4 months. As an alternative, the
investor could purchase a 120-day call option on 500 shares at a striking price of $30/share for
$5,000. At what stock price would the investor break even on her option purchase?

a) $35
b) $40
c) $42
d) $45
e) $50

19.Walton's Consumer Products imports jalapeno peppers from Mexico for use in its Rosa's Cantina
Salsa. The company has an agreed price of 16 pesos/pound of jalapeno peppers and it buys peppers
once a month. Walton's expects the dollar to depreciate over the next month and thus forecasts that
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the spot rate 30 days from today will be 7.0126 pesos/$. If the current spot rate is 7.8247 pesos/$
and the 30-day forward rate is 7.5930 pesos/$, what will one pound of jalapenos cost in dollars 30
days from today if Walton's hedges; and if it doesn't hedge?

Hedge No Hedge

a) $2.11/lb. $2.28/lb.
b) $2.04/lb. $2.28/lb.
c) $2.11/lb. $2.04/lb.
d) $2.04/lb. $2.11/lb.
e) $2.28/lb. $2.11/lb.

20.Which of the following statements is most correct?

a) The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR
method assumes reinvestment at the IRR.
b) The NPV method assumes that cash flows will be reinvested at the risk-free rate while the IRR method
assumes reinvestment at the IRR.
c) The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR
method assumes reinvestment at the risk-free rate.
d) The NPV method does not consider the inflation premium.
e) The NPV method does not consider all relevant cash flows, and particularly cash flows beyond the
payback period.

21.Your company is considering purchasing the Kappa Computer Co. for a price of $425,000. The
annual sales of Kappa Computer Co. are expected to remain constant at $580,000 forever. The firm
incurs annual fixed costs of $85,000 and its variable costs are 77% of sales. Kappa Computer has no
debt outstanding and its shareholders require an 8% return. The corporate tax rate is 34%. What is
the internal rate of return (IRR) for this investment?

a) The IRR is less than 6%.


b) The IRR is greater than or equal to 6%, but less than 7%.
c) The IRR is greater than or equal to 7%, but less than 8%.
d) The IRR is greater than or equal to 8%, but less than 9%.
e) The IRR is greater than or equal to 9%.
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22.Jet Industries currently has $5 million in bonds with a 10% coupon and 2 million shares of common
stock outstanding. The company is considering a $10 million expansion program, which can be
financed in either of two ways:

Plan A: Issue new bonds at par ($1,000) with a 12% coupon


Plan B: Issue new common stock at $50 per share

The company has a 40% marginal tax rate. Next year’s expected EBIT is $4 million if the expansion
project is accepted. The level of EBIT that would result in the same EPS for either financing plan is

a) $13,700,000
b) $13,200,000
c) $12,000,000
d) $11,500,000
e) $1,200,000

23. Generally, ____ in leverage result in _____ return and ____ risk.

f) increases, decreased, increased


g) increases, decreased, decreased
h) increases, increased, increased
i) decreases, increased, decreased
j) None of the above are correct.

24.General Paper Corp. is considering an investment in a new paper mill that costs $230 million. The
mill will generate after-tax operating cash flows of $55 million at the end of each of the next 8 years.
The firm’s WACC equals 7.15% and the after-tax cost of debt is 5.73%. What is the IRR of the
paper mill investment?

a) 7.15%
b) 12.54%
c) 17.19%
d) 5.73%
e) not enough information provided

25.Transatlantic Airlines is considering an investment in an airplane fleet that costs $1.25 billion. The
fleet would generate revenues of $425 million and costs of $230 million each year for the next 10
years. The investment will be straight-line depreciated (no half-year convention) to zero during the
period. Assume the fleet is sold for $420 million after 10 years. Transatlantic uses a weighted
average cost of capital of 12% and the corporate tax rate is 25%. What is the NPV of the investment
in the new airplane fleet (to the closest million $)?

a) -$852 million
b) -$322 million
c) -$288 million
d) -$146 million
e) -$112 million

26.All else constant, the repurchase of stock _____ the earnings per share and _____ the market price of
stock.
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a) increases; increases
b) decreases; decreases
c) increases; decreases
d) decreases; increases
e) increases; does not change

27. Which of the following statements is most correct?

a) Firms whose sales are very sensitive to changes in the business cycle are more likely to rely on debt
financing.
b) Firms with lower fixed costs tend to have greater operating leverage.
c) Firms with a high operating leverage are more likely to rely on debt financing.
d) None of the statements above is correct.
e) Answers (a) and (c) are correct.

28.A Swiss family wants to visit the Japanese gardens in Japan and a travel agent has quoted them a
price of 109,650¥. If the current exchange rates are 126.23¥/$ and 15.81SF/$, what is the cost of the
trip in Swiss Francs (SF)?

a) 13,733.40SF
b) 87,546.61SF
c) 173,356.65SF
d) 693.55SF
e) 1,995.70SF

29. Which of the following statements is incorrect?

a) Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than the cost of
capital.
b) If the multiple IRR problem does not exist, any independent project acceptable by the NPV method
will also be acceptable by the IRR method.
c) If IRR is equal to the cost of capital, then NPV = 0.
d) NPV can be negative if the IRR is positive.
e) The NPV method is not affected by the multiple IRR problem.

30. The internal rate of return (IRR) of a capital investment

a) Changes when the cost of capital changes.


b) Is equal to the annual net cash flows divided by one half of the project's cost when the cash flows are
an annuity.
c) Should exceed the weighted average cost of capital in order for the firm to accept the investment.
d) Is calculated in a manner similar to the yield to maturity on a bond.
e) Answers (c) and (d) are correct.

31. An investment of $1,000 will return $60 annually forever. What is its internal rate of return?

a) Cannot be determined with the information provided.


b) 6.00%
c) 0.60%
d) 16.67%
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e) 60.00%

32. When a project’s NPV exceeds zero,

a) The project will also be acceptable using payback criteria.


b) The IRR should be calculated to insure that the project’s projected rate of return exceeds the cost of
capital.
c) The project should be accepted without any further consideration, assuming we are confident that
the cash flows and the cost of capital have been properly estimated.
d) Only answers (a) and (c) are correct.
e) None of the statements above is correct.

33.An investor is considering buying 500 shares of ABC Company at $32 per share. Analysts agree that
the firm’s stock price may increase to $45 per share in the next four months. As an alternative, the
investor could purchase a 120-day call option for 500 shares at a striking price of $30/share for
$5,000. What profit would the investor realize on their option purchase if the stock price increased to
$42 per share?

a) $0
b) $1,000
c) $4,000
d) $6,000
e) None of the above are correct.

34.The internal rate of return of a capital investment

a) Changes when the cost of capital changes.


b) Is equal to the annual net cash flows divided by one half of the project’s cost when the cash flows are
an annuity.
c) Must exceed the cost of capital in order for the firm to accept the investment.
d) Is similar to the yield-to-maturity on a bond.
e) More than one of the above are correct.
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35.Steinbach Construction Co.’s stock is trading at $30 a share. There are also call options on the
company’s stock, some with an exercise price of $25 and some with an exercise price of $35. All
options expire in three months. Which of the following best describes the value of these options?

a) The options with the $25 exercise price will sell for $5.
b) The options with the $25 exercise price will sell for less than the options with the $35 exercise price.
c) The options with the $25 exercise price have a payoff value greater than $5.
d) The options with the $35 exercise price have a payoff value greater than $0.
e) If Steinbach’s stock price rose by $5, the payoff value of the options with the $25 exercise price
would also increase by $5.

36.If the inflation rate in the United States is greater than the inflation rate in Sweden, other things held
constant and assuming that interest rate parity holds, the Swedish currency will

a) Appreciate against the U.S. dollar.


b) Depreciate against the U.S. dollar.
c) Remain unchanged against the U.S. dollar.
d) Appreciate against all other major currencies.
e) Appreciate against the dollar and all other major currencies.

37.The date on which the board of directors passes a resolution authorizing payment of a dividend to the
shareholders is the _______ date.

a) ex-rights
b) ex-dividend
c) record
d) payment
e) declaration

38.Which of the following statements is true?

a) Option contracts are a zero sum game.


b) If an in-the-money option is not exercised at expiration, the owner has zero net cash flow for the
investment.
c) The owner of a put option essentially has unlimited upside profit potential.
d) One disadvantage to buying options on a stock rather than the stock itself is that it requires a larger
initial investment per share.
e) As the price of a stock falls, the value of a put option on the stock also falls.
Practice questions for final exam - page 11

INSTRUCTION: Use the following information for problem 39 and 40:

The DMB Co., which produces a single product, is financed with debt and equity and has the following
data available:

Sales (20,000 units) $800,000


Variable cost per unit $9.00
Operating income (EBIT) $220,000
Earnings after taxes $80,000
Tax rate 35%

39.What is DMB’s degree of financial leverage at the current level of sales?

a) 1.00
b) 1.38
c) 1.57
d) 1.79
e) 2.76

40.What is the expected percentage change in EBIT if sales increase by 2%?

a) 1.41%
b) 2.00%
c) 2.82%
d) 4.23%
e) 5.64%

41.If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the
use of all the firm’s earnings for that year (along with new debt according to the optimal debt/total
assets ratio), the firm should pay

a) no dividends except out of past retained earnings.


b) no dividends to common stockholders.
c) dividends, in effect, out of a new issue of common stock.
d) dividends by borrowing the money (debt).
e) Either (c) or (d) above could be used.
Practice questions for final exam - page 12

42.You are the financial manager for a large and highly profitable manufacturing company. You are
currently evaluating a project proposal involving the construction of a new product line. The
proposed project will have a 5-year life and will require the purchase of new capital equipment with a
total purchase price of $175,000. The equipment will have no salvage value at project’s end. The
new product line is expected to increase annual cash sales by $80,000 and increase annual cash
operating expenses by $10,000 for the life of the project. The new equipment will have a 3-year
MACRS class life (see attached MACRS table for depreciation calculations). Assume the marginal
tax rate is 34 percent. The project’s internal rate of return is

a) less than or equal to 20 percent.


b) greater than 20 percent but less than or equal to 21 percent.
c) greater than 21 percent but less than or equal to 22 percent.
d) greater than 22 percent but less than or equal to 23 percent.
e) greater than 23 percent.

43.Val Venis, Inc. (VV) has assets denominated in Swiss francs (SF) of 800,000 SF and liabilities of
450,000 SF. If the current exchange rate between U.S. dollars and Swiss francs is 2.50 SF = $1.00,
the dollar value of VV’s equity is

a) $140,000
b) $320,000
c) $350,000
d) $600,000
e) $875,000

Use the following information to answer questions 44-45.

Waves, Inc. manufactures waterbeds. The financial manager is considering a project proposal involving
expansion of productive capacity through the purchase of new manufacturing equipment. The purchase
price of the equipment is $750,000. Assume that the equipment will be depreciated for tax purposes over
three years at $250,000 per year. The project is expected to last for 3 years. At the end of this time, it
will be terminated and the equipment is expected to be worthless. The project is expected to increase
cash revenue by $450,000 per year and increase cash operating expenses by $150,000 per year. Use a
34% marginal tax rate for your calculations.

44. The payback period for this expansion project is

a) less than 1 year


b) between 1 year and 2 years
c) between 2 years and 3 years
d) more than 3 years
e) cannot be determined

45. The Internal Rate of Return (IRR) for this expansion project is

a) between 5% and 6%
Practice questions for final exam - page 13

b) between 6% and 7%
c) between 7% and 8%
d) between 8% and 9%
e) between 9% and 10%

46. Which of the following statements is most correct?

a) If a project with normal (i.e., conventional) cash flows has an IRR which exceeds the weighted
average cost of capital, then the project must have a positive NPV.
b) If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a higher NPV.
c) NPV must be positive (i.e., greater than zero) if the IRR is positive.
d) More than one of the above are correct.
e) None of the above are correct.

47.The HHH Corp. is financed with long-term debt and 250,000 shares of common stock. The capital
structure is 37.5% debt and 62.5% equity, which is considered to be optimal. The price per share of
HHH common stock is $32. For the coming year, the financial manager has estimated that earnings
after taxes (EAT) will be $750,000 and that the optimal capital budget will be $1,100,000. What is
the expected dividend per share for the coming year if the company uses a residual dividend policy?

a) $0.25
b) $0.50
c) $0.60
d) $0.63
e) $0.75

48.The president of Dex-Tor Laboratories Inc. has asked you to evaluate the proposed acquisition of a
new computer. The computer’s price is $40,000, and it falls into the MACRS 3-year class. Purchase
of the computer would require an increase in net working capital of $2,000. The computer would
increase the firm’s before-tax revenues by $20,000 per year but would also increase before-tax
operating costs by $5,000 per year. The computer is expected to be used for 3 years and then be sold
for $25,000. The firm’s marginal tax rate is 40 percent, and the firm’s weighted average cost of
capital (WACC) is 14 percent. What is the project’s NPV? (round your final answer to the nearest
dollar)

a) $2,622
b) $2,803
c) $2,917
d) $5,712
e) $6,438
49.A and B are identical companies except A has a DOL (Degrees of operating leverage) of 1.5 and a
DFL (Degrees of financial leverage) of 2.0, while B has a DOL of 1.0 and a DFL of 3.0. Both
companies will have a 4% increase in sales in the coming year. Based on this information, which of
the following statements is true?

a) A’s EAT will increase by approximately 6% and B’s EAT will increase approximately 4%.
Practice questions for final exam - page 14

b) A’s EAT will increase by approximately 8% and B’s EAT will increase approximately 12%.
c) For a given change in sales, the change in EBIT will be greater for B than for A.
d) For a given change in EBIT, the change in EAT will be greater for B than for A.
e) None of the above.

50.A year ago, MC Hammer Company had inventory in Britain valued at 240,000 pounds. The
exchange rate for dollars to pounds was 1 pound = 2 U.S. dollars. This year the exchange rate is 1
pound = 1.82 U.S. dollars. The inventory in Britain is still valued at 240,000 pounds. What is the
gain or loss in inventory value in U.S. dollars as a result of the change in exchange rates?

a) $240,000 loss
b) $43,200 loss
c) $0
d) $43,200 gain
e) $47,473 gain

51.Suppose exchange rates between U.S. dollars and Swiss francs is SF 1.41 = $1.00 and the exchange
rate between the U.S. dollar and the German mark is $1.00 = 1.64 DM. What is the cross-rate of
Swiss francs to German marks?

a) 2.27
b) 1.41
c) 1.64
d) 0.43
e) 0.86

52.Which of the following events is likely to decrease the value of call options on the common stock of
GCC Company?

a) An increase in GCC’s stock price.


b) An increase in the exercise price of the option.
c) An increase in the amount of time until the option expires.
d) GCC’s stock price becomes more risky (higher variance).
e) More than one of the above are correct.

53. Which of the following statements is false?

I. The Net Present Value (NPV) will be positive if the Internal Rate of Return (IRR) is less than
the weighed average cost of capital.
II. If the multiple IRR problem does not exist, any independent project acceptable by the NPV
method will also be acceptable by the IRR method.
III. The IRR can be positive even if the NPV is negative.

a) I only
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b) II only
c) III only
d) I and II
e) I and III

54.The Ace Company is considering investing in a piece of property which costs $105,000. The property
will return a constant cash flow forever. If the firm’s cost of capital is 9 percent and the corporate tax
rate is 40 percent, what is the minimum after-tax cash flow that would make the investment
acceptable to Ace?

a) $15,942
b) $10,831
c) $9,450
d) $2,375
e) $5,000

55.As fixed operating costs increase and all other factors are held constant, the degree of operating
leverage will

a) increase.
b) decrease.
c) remain unchanged.
d) change in an undetermined direction.
e) None of the above.

56.The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000,
is expected to last for 10 years and produce after-tax cash flows (the effects of depreciation have
already been accounted for in these cash flows) of $44,503 per year. If the firm’s cost of capital is 14
percent and its tax rate is 40 percent, what is the project’s IRR?

a) –5%
b) 8%
c) 12%
d) 14%
e) 18%

57.Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by
$5,000 annually for the next 5 years. Mars will use the MACRS accelerated method to depreciate the
machine (which has a 5-year class life) to zero dollars. Mars expects to sell the machine at the end of
its 5-year operating life for $10,000. The firm expects to be able to reduce net working capital by
$15,000 when the machine is installed, but required working capital will return to the original level
when the machine is sold after 5 years. Mar’s marginal tax rate is 40 percent, and it uses a 12 percent
weighted average cost of capital to evaluate projects of this nature. If the machine costs $60,000,
what is the project’s net present value (NPV)? MACRS depreciation schedule is attached with
formula sheet. (Round your final answer to the nearest dollar.)

a) -$15,394
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b) -$14,284
c) -$58,512
d) -$21,493
e) -$46,901

58.Anyone who purchases a share of stock before the ________ will receive the declared dividend, but
anyone who purchases the stock on or after this date will not receive it.

a) declaration date
b) date of record
c) ex-dividend date
d) payment date
e) none of the above

59.Sunware Corporation, a U.S. based importer, makes a purchase of crystal glassware from a firm in
Germany for 39,960 marks or $24,000, at the spot rate of 1.665 marks per dollar. The terms of the
purchase are net 90 days, and the U.S. firm wants to cover this trade payable with a forward market
hedge to eliminate its exchange rate risk. Suppose the firm completes a forward hedge at the 90-day
forward rate of 1.682 marks. If the spot rate in 90 days is actually 1.638 marks, how much will the
U.S. firm have saved in U.S. dollars by hedging its exchange rate exposure? (round final answer to
nearest dollar)

a) -$396
b) -$243
c) $0
d) $243
e) $638

60.A firm has EBIT of $375,000, interest expense of $75,000, preferred dividends of $6,000 and a tax
rate of 40 percent. The firm’s degree of financial leverage at a base EBIT level of $375,000 is

a) 0.97
b) 1.29
c) 1.27
d) 1.09
e) None of the above.

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

a) Internal rate of return


b) Net present value
c) Payback period
d) All of the above would always consider the salvage value of the machine.
e) (a) and (c)

Use the following information for Questions 62-63.


Practice questions for final exam - page 17

Listed Options Quotations (CBOE)


SBM Call Call Put Put
Close Strike Exp Volume Last Volume Last
26 20 MAR 100 7.40 75 0.70
20 APR 100 9.25 75 1.25
25 MAR 200 4.00 100 2.05
25 APR 200 5.75 100 2.75
30 MAR 150 1.70 125 4.90
30 APR 150 3.25 125 5.25

62. Which of the following statements is false?

a) The April 20 call is in-the-money.


b) The April 25 call is in-the-money.
c) The April 25 put is in-the-money.
d) The April 30 put is in-the-money.
e) None of the above statements are false.

63. A speculator sells the April 30 call @$3.25. The breakeven (i.e, profit = zero) share price at
expiration is closest to:

a) $ 23.50
b) $ 26.75
c) $ 33.25
d) $ 36.50
e) $ 40.50

64.The NPV of a project

a) measures the dollar change in shareholder wealth if a project is accepted.


b) measures the percentage increase in shareholder wealth if a project is accepted.
c) equals the net investment cash outflow when the discount rate is 0%.
d) is positive if IRR = WACC.
e) increases as the the firm’s WACC increases.

65.An investment project has an initial cost, and then generates inflows of $50 a year for the next five
years. The project has a payback period of 3.6 years. What is the project’s internal rate of return
(IRR)?

a) 11.18%
b) 12.05%
c) 13.47%
d) 14.66%
e) 15.89%

66.Which of the following statements is true?

a) For both calls and puts, an increase in the exercise price will cause an increase in the option price.
b) For both calls and puts, an increase in the time to maturity will cause an increase in the option price.
c) For call, but not for puts, an increase in the time to maturity will cause an increase in the option price.
Practice questions for final exam - page 18

d) For puts, but not for calls, an increase in the time to maturity will cause an increase in the option
price.
e) More than one of the above is true.

67.Cornell Brothers anticipates that its net income at the end of the year will be $3.6 million (before any
recapitalization). The company currently has 900,000 shares of common stock outstanding and has
no debt. The company’s stock trades at $40 a share. The company is considering a recapitalization
where it will issue $10 million worth of debt with a coupon rate of 10 percent, and use the proceeds
to repurchase common stock. Assume the stock price remains unchanged by the transaction, and the
company’s tax rate is 34 percent. What will be the company’s earnings per share (EPS) if it proceeds
with the recapitalization?

a) $2.23
b) $2.45
c) $3.26
d) $4.52
e) $5.54

68.In the spot market, 1 U.S. dollar equals 1.60 German marks. 6-month German securities have an
annualized return of 6 percent (and therefore have a 6-month periodic return equal to 3 percent). 6-
month U.S. securities have an annualized return of 6.5 percent and a periodic return of 3.25 percent.
If interest rate parity holds, what is the dollar-mark exchange rate in the 180-day forward market?

a) 1 dollar = 0.6235 marks


b) 1 dollar = 0.6265 marks
c) 1 dollar = 1.0000 marks
d) 1 dollar = 1.5961 marks
e) 1 dollar = 1.6039 marks
Practice questions for final exam - page 19

69.Mr. T (I pity the fool who doesn’t know Mr. T) owns 20,000 shares of ABC Corporation stock. The
company is planning to issue a stock dividend. Before the dividend, Mr. T owned 10% of the
outstanding stock, which had a market value of $200,000, or $10 per share. Upon receiving the 10%
stock dividend the value of his shares is

a) $220,000
b) $210,000
c) $200,000
d) $250,000
e) None of the above

70.The CPI was 100 at the end of 1990, 105 at the end of 1991, and 120 at the end of 1992. If the
average return on Treasury Bills was 6% in 1991 and 7% in 1992, what was the real rate of return on
Treasury Bills in 1992?

a) -11.67%
b) -10.83%
c) -7.28%
d) -6.38%
e) not enough information

71.The theory suggesting that for any given issuer, long-term interest rates tend to be higher than short-
term rates is called the

a) expectations hypothesis.
b) liquidity preference theory.
c) market segmentation theory.
d) inverted axiom theory.
e) None of the above is correct.

72.Assume that the pure expectations theory holds. Which of the following statements about Treasury
bill rates is most correct? (Two-year rates apply to bonds which will mature in two years, three-year
rates apply to bonds which will mature in 3 years, and so on).

a) If two-year rates exceed one-year rates, then the market expects interest rates to rise.
b) If two-year rates are 7 percent, and three-year rates are 7 percent, then five-year rates must also be 7
percent.
c) If one-year rates are 6 percent and two-year rates are 7 percent, then the market expects one-year rates
to be 6.5 percent in one year.
d) Answers (a) and (c) are correct.
e) Answers (b) and (c) are correct.
Practice questions for final exam - page 20

73.If the yield curve on U.S. Treasuries is downward sloping, what is the yield to maturity on a 10-year
U.S. Treasury coupon bond, relative to that on a 1-year U.S. T-bond?

a) The yield on the 10-year bond is less than the yield on a 1-year bond.
b) The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of
maturity premiums.
c) It is impossible to tell without knowing the coupon rates of the bonds.
d) The yields to maturity on the two bonds are equal.
e) It is impossible to tell without knowing the relative risks of the two bonds.

74.The key participants in financial transactions are individuals, businesses, and governments.
Individuals are net _________ of funds, and businesses are net _________ of funds.

a) demanders; suppliers.
b) users: providers.
c) suppliers; demanders.
d) purchasers: sellers.
e) None of the answers above is correct.

75.Which of the following statements is most correct?

a) The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily
to the fact that the probability of default is higher on long-term bonds than on short-terms bonds.
b) The liquidity preference theory of the term structure of interest rates states that borrowers generally
prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and
that as a result, the yield curve is normally upward sloping.
c) If the maturity risk premium were zero and the rate of inflation were expected to decrease in the
future, then the yield curve for U.S. Treasury securities would, other things held constant, have an
upward slope.
d) More than one of the above statements is correct.
e) None of the above statements are correct.

76.H.H. Helmsley invested in DX Enterprises one year ago. He earned an 8.70% rate of return on this
investment over the past year. However, when he invested in DX Enterprises, the Consumer Price
Index (CPI) was at 125. Today, the CPI is at 139. Assuming that changes in the CPI accurately
reflect inflation in the economy, what is H.H. Helmsley’s real rate of return?

a) 8.70%
b) 2.50%
c) -1.37%
d) 4.50%
e) -2.50%

77.Which of the following is likely to increase the level of interest rates in the economy? Assume that
households are the primary supplier of capital in the economy and that businesses (corporations) are
the primary demander.
Practice questions for final exam - page 21

a) Households start saving a larger percentage of their income. Assume that households are willing to
loan their savings to corporations.
b) Corporations step up their plans for expansion and increase their demand for capital.
c) The level of inflation is expected to decline.
d) All of the statements above are correct.
e) None of the statements above are correct.

78.U.S. Treasury securities with 2 years to maturity currently yield 7% per year. U.S. Treasury securities
with 4 years to maturity currently yield 5.5% per year. Assume that the pure expectations theory
holds. What does the market believe the annual rate will be on two-year U.S. Treasury securities two
years from now?

a) 4.0%
b) 5.5%
c) 7.0%
d) 8.0%
e) 10.0%

79.The real risk-free rate of interest is 3 percent. Inflation is expected to be 4 percent this coming year,
jump to 5 percent next year (Year 2), and run at 6 percent the year after (Year 3). According to the
expectations theory, what should be the interest rate on 3-year (i.e., they have three years to maturity)
risk-free securities today?

a) 18%
b) 12%
c) 6%
d) 8%
e) 10%

80.If the expectations theory of the term structure of interest rates is correct, and we observe a downward
sloping yield curve, which of the following is a true statement?

a) Investors expect short-term rates to be constant over time.


b) Investors expect short-term rates to increase in the future.
c) Investors expect short-term rates to decrease in the future.
d) It is impossible to say unless we know whether investors require a positive or negative maturity risk
premium.
e) The maturity risk premium must be positive.
Practice questions for final exam - page 22

81.The greatest band of all-time is

a) Guns N’ Roses
b) The Monkees
c) Earth, Wind & Fire
d) Black Eyed Peas
e) The Backstreet Boys

Best of luck on the real exam!!


Practice questions for final exam - page 23

Formula Sheet

Total capital = MV of debt + MV of equity + MV of preferred

ATCF from asset sales= Market Value - [Market Value - Book Value] X T

THE INITIAL CASH OUTLAY


(-) Installed cost of the asset
(± ) Net working capital change
(-) Incremental cash expenses (1-T)
(+)After-tax cash flow from old asset
= INITIAL CASH OUTLAY
THE ANNUAL OPERATING CASH FLOWS
Incremental Sales × (1 - T)
(± )Incremental Costs × (1 - T)
+ Depreciation for new asset × T
- Depreciation for old asset × T
= Annual Operating Cash Flow

THE TERMINAL CASH FLOWS


± NWC invested at start of project
+ After-tax cash flow from selling new asset
= TERMINAL CASH FLOW

Total risk = firm-specific risk + market risk = diversifiable risk + non-diversifiable risk
N
b portfolio =∑b i wi
i=1

1 −1 /(1 + YTM / m)t   1 


Bond Value = $COUPON PMT   + FACE VALUE  t 
 YTM / m  (1 + YTM / m) 

after-tax cost of debt = YTM X (1 - tax rate) = RD X (1 - T)

PVt = PMTt+1 / (r - g),

RE = (D1 / P0 )+ g RE = RRF + (RM - RRF) β

RE = {D1 / [P0 (1 - F)]} + g RE = {D1 / Nn} + g


RP = DP / VP RP = DP / NP
Practice questions for final exam - page 24

RP = DP / [VP (1 - F)] WACC = wD RD (1 - T) + wp RP + wE RE

Income Statement
Sales
-Expenses
-Depreciation
EBIT
-Interest Expense
EBT
-Taxes
EAT

Cross rate example = (Dollars/Pound) X (Francs/Dollar) = Francs/Pound

FV = PV X (1 + r/m)t
PV = FV / (1 + r/m)t

1 −1 /(1 +r / m) t 
PV of annuity = $ PMT  
 r/m 
(1 +r / m)t −1
FV of Annuity =$ PMT  
 r/m 

PV F
V
PMT = P
M T =
1−1 /( 1 +r / m) t  , (1 + 1
r / m) t −
   
 r/m   r /m 

PMT t +1
PV of perpetuity t =
r/m
PMT t+
PV of a growing perpetuity =PV t = 1

r− g
Practice questions for final exam - page 25

MACRS table

Percentage by recovery year


Recovery year 3 years 5 years 7 years 10 years
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 4

percentage change in EBIT (sales - variable costs)


DOL = or
percentage change in sales (sales - variable costs - fixed costs)

percentage change in EPS EBIT


DFL = or [EBIT - I - (PD/(1 - T))]
percentage change in EBIT

percentage change in EPS


DTL = = DOL x DFL
percentage change in sales

(EBIT - I) (1 - T)
Earnings per share (EPS) =
# of shares outstandin g

$ of common dividend
Dividend payout ratio =
$ of earnings available to common shareholde rs