BUS 106
BUS 106 Final Exam Practice Questions1. A bond's par value can
also be called its:A.coupon payment.B.present value.C.default
value.D.face valueLearning Objective: 06-01 Distinguish among a
bond's coupon rate; current yield; and yield to maturity.Topic:
Bond Characteristics and Prices2. The discount rate that makes the
present value of a bond's payments equal to its price is termed
the:A.rate of return.B.yield to maturity.C.current yield.D.coupon
rate. Learning Objective: 06-01 Distinguish among a bond's coupon
rate; current yield; and yield to maturity.Topic: Calculating
Yields3. How does a bond dealer generate profits when trading
bonds?A.By maintaining bid prices lower than ask pricesB.By
maintaining bid prices higher than ask pricesC.By retaining the
bond's next coupon paymentD.By lowering the bond's coupon rate
Learning Objective: 06-01 Distinguish among a bond's coupon rate;
current yield; and yield to maturity.Topic: Bond Characteristics
and Prices
4. Which of the following identifies the distinction between a
U.S. Treasury bond and a Treasury note?A.Bonds make coupon
payments; notes do not.B.Bills have default risk; bonds do
not.C.Bonds are priced in 32s; notes are not.D.Bonds initially have
more than 10 years until maturity; notes have fewer than 10 years
initially.Learning Objective: 06-01 Distinguish among a bond's
coupon rate; current yield; and yield to maturity.Topic: Bond
Characteristics and Prices5. How much does the $1,000 to be
received upon a bond's maturity in 4 years add to the bond's price
if the appropriate discount rate is
6%?A.$209.91B.$260.00C.$760.00D.$792.09
$1,000/(1.06)4 = $792.09
Learning Objective: 06-02 Find the market price of a bond given
its yield to maturity; find a bond's yield given its price; and
demonstrate why prices and yields move in opposite
directions.Topic: Calculating Yields6. How much should you pay for
a $1,000 bond with 10% coupon, annual payments, and 5 years to
maturity if the interest rate is
12%?A.$927.90B.$981.40C.$1,000.00D.$1,075.82
Learning Objective: 06-02 Find the market price of a bond given
its yield to maturity; find a bond's yield given its price; and
demonstrate why prices and yields move in opposite
directions.Topic: Bond Characteristics and Prices7. The yield curve
depicts the current relationship between:A.bond yields and default
risk.B.bond maturity and bond ratings.C.bond yields and
maturity.D.promised yields and default premiums.
Learning Objective: 06-02 Find the market price of a bond given
its yield to maturity; find a bond's yield given its price; and
demonstrate why prices and yields move in opposite
directions.Topic: The Yield Curve
8. Which of the following best characterizes the difference
between growth stocks and income stocks?A.Growth stocks do not pay
dividends.B.Income stocks offer higher rates of return.C.Income
stocks are seasoned issues.D.Growth stocks have greater
PVGO.Learning Objective: 07-01 Understand the stock trading reports
on the Internet or in the financial pages of the newspaper.Topic:
Stocks and the Stock Market
9. Common stock can be valued using the perpetuity valuation
formula if the:A.discount rate is expected to remain
constant.B.dividends are not expected to grow.C.growth rate in
dividends is not constant.D.investor does not intend to sell the
stock.
Learning Objective: 07-02 Calculate the present value of a stock
given forecasts of future dividends and future stock price.Topic:
Valuing Common Stocks10.What should be the price for a common stock
paying $3.50 annually in dividends if the growth rate is zero and
the discount rate is 8%?A.$22.86B.$28.00C.$42.00D.$43.75
Learning Objective: 07-02 Calculate the present value of a stock
given forecasts of future dividends and future stock price.Topic:
The Dividend Discount Model
11. What constant-growth rate in dividends is expected for a
stock valued at $32.00 if next year's dividend is forecast at $2.00
and the appropriate discount rate is
13%?A.5.00%B.6.25%C.6.75%D.15.38%
Learning Objective: 07-02 Calculate the present value of a stock
given forecasts of future dividends and future stock price.Topic:
The Dividend Discount Model
12. What is the plowback ratio for a firm that has earnings per
share of $12.00 and pays out $4.00 per share as
dividends?A.25.00%B.33.33%C.66.67%D.75.00%
Learning Objective: 07-02 Calculate the present value of a stock
given forecasts of future dividends and future stock price.Topic:
Valuing Common Stocks
13. What should be the price of a stock that offers a $4 annual
dividend with no prospects of growth, and has a required return of
12.5%?A.$8.50B.$25.00C.$32.00D.$50.00
P = $4/.125P = $32
Learning Objective: 07-02 Calculate the present value of a stock
given forecasts of future dividends and future stock price.Topic:
The Dividend Discount Model14. Which of the following values treats
the firm as a going concern?A.Market valueB.Book valueC.Liquidation
valueD.None of these
Learning Objective: 07-03 Use stock valuation formulas to infer
the expected rate of return on a common stock.Topic: Market, Book,
and Liquidation Values
15. .If a stock's P/E ratio is 13.5 at a time when earnings are
$3 per year, what is the stock's current
price?A.$4.50B.$18.00C.$22.22D.$40.50
P/E = 13.5xThen P = 13.5 ( $3Price = $40.50
Learning Objective: 07-04 Interpret price-earnings ratios.Topic:
Valuing Common Stocks
16. Under which of the following forms of market efficiency
would stock prices always reflect fair value?A.Weak-form
efficiency.B.Semistrong-form efficiency.C.Strong-form
efficiency.D.All of these are correct due to capital market
efficiency.
Learning Objective: 07-05 Understand what professionals mean
when they say that there are no free lunches on Wall Street.Topic:
Market Analysis
17. A fundamental analyst:A.relies on the same information as
the technical analyst, but believes in the random walk.B.studies a
firm's financial statements to determine pricing
inefficiencies.C.believes that the market is strong-form
efficient.D.performs an unnecessary function, since markets are
efficient.
Learning Objective: 07-05 Understand what professionals mean
when they say that there are no free lunches on Wall Street.Topic:
Market Analysis
18. Capital structure decisions refer to the:A.dividend yield of
the firm's stock.B.blend of equity and debt used by the
firm.C.capital gains available on the firm's stock.D.maturity date
for the firm's securities.
Learning Objective: 13-03 Calculate the weighted-average cost of
capital.Topic: Understanding Capital Structure19. What is the WACC
for a firm with 50% debt and 50% equity that pays 12% on its debt,
20% on its equity, and has a 40% tax
rate?A.9.6%B.12.0%C.13.6%D.16.0%
WACC = [.5 ( (.12 ( .6)] + (.5 ( .2)= 3.6% + 10% = 13.60%
Learning Objective: 13-03 Calculate the weighted-average cost of
capital.Topic: Weighted-Average Cost of Capital
20. What is the WACC for a firm using 55% equity with a required
return of 15%, 35% debt with a required return of 8%, 10% preferred
stock with a required return of 10%, and a tax rate of
35%?A.10.72%B.11.07%C.11.70%D.12.05%
WACC = [.35 ( (1 - .35).08] + (.1 ( .1) + (.55 ( .15)= 1.82% +
1.0% + 8.25%= 11.07%
Learning Objective: 13-03 Calculate the weighted-average cost of
capital.Topic: Weighted-Average Cost of Capital21. What would you
estimate to be the required rate of return for equity investors if
a stock sells for $40.00 and will pay a $4.40 dividend that is
expected to grow at a constant rate of
5%?A.7.6%B.12.0%C.12.6%D.16.0%
Learning Objective: 13-03 Calculate the weighted-average cost of
capital.Topic: Rates of Return
22. A project will generate $1 million net cash flow annually in
perpetuity. If the project costs $7 million, what is the lowest
WACC shown below that will make the NPV
negative?A.10%B.12%C.14%D.16%
$1 million/.16 = $6.25 million < $7 millionTherefore, NPV
< $0At 14%, the NPV is still positive by $142,857.
Learning Objective: 13-03 Calculate the weighted-average cost of
capital.Topic: Weighted-Average Cost of Capital
23. The stability of a firm's operating income is the focus
of:A.financial leverage.B.weighted-average cost of
capital.C.capital structure.D.business risk.
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Capital
Structure and Corporate Taxes
24. What is the proportion of debt financing for a firm that
expects a 24% return on equity, a 16% return on assets, and a 12%
return on debt? Ignore taxes.A.54.0%B.60.0%C.66.7%D.75.0%
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Capital
Structure and Corporate Taxes
25. According to MM II, as a firm's debt-equity ratio
decreases:A.its financial risk increases.B.its operating risk
increases.C.the required rate of return on equity increases.D.the
required rate of return on equity decreases.
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Understanding
MM26. An implicit cost of adding debt to the capital structure is
that it:A.adds interest expense to the operating
statement.B.increases the required return on equity.C.reduces the
expected return on assets.D.decreases the firm's beta.
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Capital
Structure and Corporate Taxes27. What is the return on equity for a
firm with 15% return on assets, 10% return on debt, and a .75
debt-equity ratio?A.18.75%B.20.00%C.23.75%D.26.25%
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Capital
Structure and Corporate Taxes
28. What is the maximum rate that can be paid on debt and
maintain a 14% WACC with a 19% expected return on equity in a firm
with a 60% debt-to-asset ratio? Ignore
taxes.A.6.50%B.9.90%C.10.67%D.11.14%
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Capital
Structure and Corporate Taxes
29. The WACC is used to value:A.projects with any
risk.B.projects with the same risk as the firm's current
business.C.projects with the same risk as the firm's
debt.D.projects with the same risk as the firm's equity.
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Capital
Structure and Corporate Taxes
30. A corporation's dividend payout ratio is the percentage of
_____ paid out as dividends.A.cashB.earningsC.earnings before
interest and taxesD.retained earnings
Learning Objective: 17-01 Describe how dividends are paid and
how corporations decide how much to pay.Topic: Payout Policy
31. An increase in share price following an increase in
dividends is logical if the:A.firm borrows to obtain cash for the
dividend.B.increased dividend signals higher future
earnings.C.dividend is believed to be temporary.D.clientele effect
is not important.
Learning Objective: 17-01 Describe how dividends are paid and
how corporations decide how much to pay.Topic: Dividend Policy
32. Capital gains may be preferred by investors over dividends
even if their tax rates are equal because:A.taxes on dividends are
withheld from paychecks.B.taxes on capital gains are paid
annually.C.taxes on capital gains can be timed.D.after-tax
dividends are less certain than capital gains.
Learning Objective: 17-05 Show how market imperfections;
especially the different tax treatment of dividends and capital
gains; can affect payout policy.Topic: Payout Policy
33. You now own 84 shares of XYZ stock which is selling for $40
each, 4 of which you just received from the XYZ corporation. XYZ
has declared a:A.stock dividend of 5%.B.cash dividend of $4.C.stock
dividend of 4.76%.D.cash dividend of $160.
(4 shares/80) = 5%
Learning Objective: 17-01 Describe how dividends are paid and
how corporations decide how much to pay.Topic: Dividend Policy34.
The Beta corporation had 1,000 shares outstanding and a market
value of $90,000 prior to the declaration of a $5 per share
dividend. To finance a new project they will issue equity and the
end result will be that the market value of the firm:A.drops by
$1,000.B.drops to $85,000.C.increases by $1,000.D.increases to
$95,000.
Share price prior to declaration:= ($90,000/1,000) = $90Share
price after declaration:= $90 - $5 = $85Market value of firm = $85
((1,000) = $85,000
Learning Objective: 17-01 Describe how dividends are paid and
how corporations decide how much to pay.Topic: Payout Policy
35. When an outside group acquires a firm, primarily through the
use of borrowed funds, the acquisition is known as a:A.management
buyout.B.tender offer.C.leveraged buyout.D.successful proxy
fight.
Learning Objective: 21-01 Explain why it may make sense for
companies to merge.Topic: The Mechanics of a Merger
36. The cost of a merger equals the:A.cash paid for the target
firm.B.increase in total earnings less price paid.C.premium paid
over the target's value as a separate entity.D.sum of cash and
stock paid for the target firm.
Learning Objective: 21-01 Explain why it may make sense for
companies to merge.Topic: Evaluating Mergers
37. If Georgia Pacific (lumber products) were to acquire a
national homebuilding firm, the combination would be termed
a:A.horizontal merger.B.vertical merger.C.conglomerate
merger.D.spin-off by the national homebuilding firm.
Learning Objective: 21-01 Explain why it may make sense for
companies to merge.Topic: The Mechanics of a Merger
38. Shares of a corporation can, under certain circumstances, be
priced at different amounts to different investors under the terms
of a:A.proxy agreement.B.public tender offer.C.poison pill.D.shark
repellent.
Learning Objective: 21-01 Explain why it may make sense for
companies to merge.Topic: Corporate Control
39. One of the reasons why proxy fights are rarely successful is
that:A.management is always viewed as performing its job
well.B.management can use corporate resources to defend against the
fight.C.mergers are a cheaper form of changing
management.D.shareholders are unconcerned with corporate
management.
Learning Objective: 21-02 Estimate the gains and costs of
mergers to the acquiring firm.Topic: Corporate Control
40. What does empirical evidence suggest about the distribution
of gains from mergers?A.Shareholders of the acquired firm gain the
most.B.Shareholders of the acquiring firm gain the most.C.Neither
group of shareholders is likely to gain.D.Both groups of
shareholders gain equally.
Learning Objective: 21-05 Explain some of the motivations for
leveraged and management buyouts of the firm.Topic: Evaluating
Mergers
Short Answers:
1. One-year Treasury bonds yield 5% while 2-year bonds yield 6%.
You are quite confident that in 1 year's time 1-year bonds will
yield 8%. Would the higher yield on 2-year bonds cause you to
prefer them?
If you invest in a 2-year bond, you will have $1,000 ( 1.06 2 =
$1,123.60. If you are right in your forecast about 1-year rates,
then an investment in 1-year bonds will produce $1,000 ( 1.05 (
1.08 = $1,134.00 by the end of 2 years. You would do better to
invest in the 1-year bond.
Learning Objective: 06-02 Find the market price of a bond given
its yield to maturity; find a bond's yield given its price; and
demonstrate why prices and yields move in opposite
directions.Topic: Calculating Yields2. What are the differences
between the bond's coupon rate, current yield, and yield to
maturity?
A bond is a long-term debt of a government or corporation. When
you own a bond, you receive a fixed interest payment each year
until the bond matures. This payment is known as the coupon. The
coupon rate is the annual coupon payment expressed as a fraction of
the bond's face value. At maturity the bond's face value is repaid.
In the United States most bonds have a face value of $1,000. The
current yield is the annual coupon payment expressed as a fraction
of the bond's price. The yield to maturity measures the average
rate of return to an investor who purchases the bond and holds it
until maturity, accounting for coupon income as well as the
difference between purchase price and face value.
Learning Objective: 06-01 Distinguish among a bond's coupon
rate; current yield; and yield to maturity.Topic: Calculating
Yields3. A stock offers an expected dividend of $3.50, has a
required return of 14%, and has historically exhibited a growth
rate of 6%. Its current price is $35.00 and shows no tendency to
change. How can you explain this price based on the constant growth
dividend discount model?
The constant-growth dividend discount model would indicate that
this stock should currently sell for $43.75, based on the following
formula:
Although stocks can temporarily be out of equilibrium price, the
fact that this stock price shows no tendency to change suggests
that investors do not expect the past growth rate of 6% to continue
into the future. Since there is no indication that the required
rate of return has changed, it appears that the company many
anticipate fewer positive growth opportunities than in the past.
Therefore, the dividend yield has likely increased to its current
10% level, and the overall market seems to expect a growth rate of
4% rather than the historical 6%. At a growth rate of 4%, the stock
would be correctly priced at $35.00.
Learning Objective: 07-02 Calculate the present value of a stock
given forecasts of future dividends and future stock price.Topic:
The Dividend Discount Model
4. If a stock's P/E ratio is 13.5 at a time when earnings are $3
per year, what is the stock's current price?P/E = 13.5xThen P =
13.5 ( $3Price = $40.50
Learning Objective: 07-04 Interpret price-earnings ratios.Topic:
Valuing Common Stocks
5. How do firms compute weighted-average costs of capital?
WACC = rdebt ( (1 - Tc) ( D/V + requity ( E/VThe WACC is the
expected rate of return on the portfolio of debt and equity
securities issued by the firm. The required rate of return on each
security is weighted by its proportion of the firm's total market
value (not book value). Since interest payments reduce the firm's
income tax bill, the required rate of return on debt is measured
after tax, as rdebt ( (1 - Tc).This WACC formula is usually written
assuming the firm's capital structure includes just two classes of
securities, debt and equity. If there is another class, say
preferred stock, the formula expands to include it. In other words,
we would estimate rpreferred, the rate of return demanded by
preferred stockholders, determine P/V, the fraction of market value
accounted for by preferred, and add rpreferred ( P/V to the
equation. Of course the weights in the WACC formula always add up
to 1.0. In this case D/V + P/V + E/V = 1.0.
Learning Objective: 13-03 Calculate the weighted-average cost of
capital.Topic: Weighted-Average Cost of Capital
6. What is a firm's weighted-average cost of capital if the
stock has a beta of 1.45, Treasury bills yield 5%, and the market
portfolio offers an expected return of 14%? In addition to equity,
the firm finances 30% of its assets with debt that has a yield to
maturity of 9%. The firm is in the 35% marginal tax bracket.
re= 5% + 1.45 (14% - 5%)= 5% + 13.05= 18.05%
rd= 9% (1 - .35)= 5.85%
WACC = (.3 ( 5.85%) + (.7 ( 18.05%)= 1.755% + 12.635%=
14.39%
Learning Objective: 13-03 Calculate the weighted-average cost of
capital.Topic: Weighted-Average Cost of Capital
7. What is the goal of the capital structure decision? What is
the financial manager trying to do?
The goal is to maximize the overall market value of all the
securities issued by the firm. Think of the financial manager as
taking all the firm's real assets and selling them to investors as
a package of securities. Some financial managers choose the
simplest package possible: all-equity financing. Others end up
issuing dozens of types of debt and equity securities. The
financial manager must try to find the particular combination that
maximizes the market value of the firm. If firm value increases,
common stockholders will benefit.
Learning Objective: 16-01 Show why capital structure does not
affect firm value in perfect capital markets.Topic: Capital
Structure and Corporate Taxes
8. Calculate the WACC for a firm with a debt-equity ratio of
1.5. The debt pays 10% interest and the equity is expected to
return 16%. Assume a 35% tax rate and risk-free debt.
Learning Objective: 16-02 Show why the tax system encourages
debt finance and calculate the value of interest tax shields.Topic:
Capital Structure and Corporate Taxes
9. Discuss how agency problems can develop between shareholders
and bondholders when the firm is experiencing financial
distress.
Managers/owners may not have the proper incentives to
accept/reject projects when the firm is under severe financial
distress. Normally, managers will accept projects when the NPV is
positive after being discounted with the appropriate rate for the
project's risk. However, in the case of financial distress and when
a lender will still advance funds, it may appear to be in the best
interest of managers/owners to invest those funds in long-shot
projects that will offer high rates of return under perfect
conditions. Of course, when probability is factored in, the
project's NPV is likely to be negative. The key is that the rewards
of the project will be retained by the owners while the costs of
failure will be borne entirely by the lender.
Similarly, when financial distress has decreased the value of
debt below its book value, managers/owners may be reluctant to
accept projects even when they offer a positive NPV. In this case
the reasoning is that the rewards of the project will be "seized"
by the bondholders in the way of increasing the market value of the
debt. Thus, little if any benefit may accrue to equityholders, and
they are not properly motivated to accept the project.
Learning Objective: 16-03 Show how costs of financial distress
can lead to an optimal capital structure.Topic: Costs of Financial
Distress
10. Why would payout decisions be used by management to signal
the prospects of the firm?
A firm that chooses a high-dividend policy without the cash flow
to back it up will find that it ultimately has to either cut back
on investments or turn to capital markets for additional debt or
equity financing. Because this is costly, managers do not increase
dividends unless they are confident that the firm is generating
enough cash to pay them. This is the principal reason that we say
that there is an information content of dividendsthat is, dividend
changes are liable to be interpreted as signals of a change in the
firm's prospects.Investors also seem to welcome the announcement
that a company plans to repurchase its stock. If they are worried
that the company has more cash than it can profitably employ, they
may be pleased to see the cash given back to the shareholders.
Learning Objective: 17-01 Describe how dividends are paid and
how corporations decide how much to pay.Topic: Payout Policy
11. Discuss the concept of dividend "smoothing."
Managers are quite concerned with the message that may be
"signaled" with each change in the level of dividends. Thus, if
management held the notion of adhering to a fixed dividend payout,
they would find themselves declaring a dividend of a different
amount each quarter, as the firm goes through the normal gyrations
of business cycles and various growth phases. The managers are
especially sensitive to dividend reductions, as it signals that the
future prospects of the firm are less attractive. Therefore,
management is more likely to "smooth" the dividend, and hopefully
show a stable pattern of continual growth. In periods of high
earnings, then, management may raise the dividend only a portion of
the way, so as to not be required to later reduce the regular
dividend.
Learning Objective: 17-01 Describe how dividends are paid and
how corporations decide how much to pay.Topic: Dividend Policy
12. How should the gains and costs of mergers to the acquiring
firm be measured?
A merger generates an economic gain if the two firms are worth
more together than apart. The gain is the difference between the
value of the merged firm and the value of the two firms run
independently. The cost is the premium that the buyer pays for the
selling firm over its value as a separate entity. When payment is
in the form of shares, the value of this payment naturally depends
on what those shares are worth after the merger is complete. The
merger should proceed if the gain exceeds the cost.
Learning Objective: 21-02 Estimate the gains and costs of
mergers to the acquiring firm.Topic: Evaluating Mergers
13. Why is it stated that the safest way of evaluating the
potential gains from a merger is to focus on the changes in cash
flow that will transpire as a result of the merger?
The alternative to this approach is to determine the present
value of the target and subtract from that the price paid for
acquisition. In most cases it should be assumed that the market has
already done this accurately, and thus the only item remaining to
value is the change in value that occurs as a result of acquiring
the target. In other words, what will change as a result of the
acquisition? This forces the acquiring firm to realize that mergers
are not valuable unless they create economic benefits that were
previously not in existence.
Learning Objective: 21-02 Estimate the gains and costs of
mergers to the acquiring firm.Topic: Evaluating Mergers
14. How are the gains from mergers distributed between the
shareholders of the acquired and acquiring firms?
We observed that when the target firm is acquired, its
shareholders typically win: target firms' shareholders earn
abnormally large returns. The bidding firm's shareholders roughly
break even. This suggests that the typical merger generates
positive net benefits, but competition among bidders and active
defense by the management of the target firm pushes most of the
gains toward the selling shareholders.
Learning Objective: 21-06 Summarize the evidence on whether
mergers increase efficiency and on how the gains from mergers are
distributed between shareholders of the acquired and acquiring
firms.Topic: The Mechanics of a Merger