Questions and Answers

7/16/2019 Questions and Answers

http://slidepdf.com/reader/full/questions-and-answers-5634fafd43644 1/23

Selected practice questions from Chapters 6 – 8, FIN 335, with Dr.

Graham

From Chapter 6 – Bonds and Bond Value

1. The stated interest payment, in dollars, made on a bond each period is called the bond's:A) Coupon.B) Face value.C) Maturity.

D) Yield to maturity.E) Coupon rate.Answer: A

2. The principal amount of a bond that is repaid at the end of the loan term is called the bond's:A) Coupon.B) Face value.C) Maturity.D) Yield to maturity.E) Coupon rate.Answer: B

3. The rate of return required by investors in the market for owning a bond is called the:A) Coupon.B) Face value.C) Maturity.D) Yield to maturity.E) Coupon rate.Answer: D

4. The annual coupon of a bond divided by its face value is called the bond's:A) Coupon.B) Face value.C) Maturity.D) Yield to maturity.E) Coupon rate.Answer: E

5. A bond with a face value of $1,000 that sells for less than $1,000 in the market is called a:A) Par bond.B) Discount bond.C) Premium bond.D) Zero coupon bond.E) Floating rate bond.Answer: B

6. A bond with a face value of $1,000 that sells for more than $1,000 in the market is called a:A) Par bond.B) Discount bond.C) Premium bond.D) Zero coupon bond.E) Floating rate bond.Answer: C



7. The long-term bonds issued by the United States government are called:A) Treasury bonds.B) Municipal bonds.C) Floating rate bonds.D) Junk bonds.E) Zero coupon bonds.Answer: A

8. A bond that makes no coupon payments (and thus is initially priced at a deep discount to par

value) is called a _______ bond.A) TreasuryB) municipalC) floating rateD) junk E) zero couponAnswer: E

9. A bond which, at the election of the holder, can be swapped for a fixed number of shares of common stock at any time prior to the bond's maturity is called a _____________ bond.A) zero couponB) callable

C) putableD) convertibleE) warrantAnswer: D

10. The annual coupon payment of a bond divided by its market price is called the:A) Coupon rate.B) Current yield.C) Yield to maturity.D) Bid-ask spread.E) Capital gains yield.Answer: B

11. The price a dealer is willing to accept for selling a security to an investor is called the:A) Equilibrium price.B) Auction price.C) Bid price.D) Ask price.E) Bid-ask spread.Answer: D

12. A bond with a face value of $1,000 has annual coupon payments of $100 and was issued 10 yearsago. The bond currently sells for $1,000 and has 8 years remaining to maturity. This bond's ______________ must be 10%.

I. yield to maturityII. market premiumIII. coupon rateA) I onlyB) I and II onlyC) III onlyD) I and III onlyE) I, II and IIIAnswer: D



13. If you divide a bond's annual coupon payment by its current yield you get the ___________.A) yield to maturityB) investors' required rate of returnC) annual coupon rateD) cost of capitalE) bond priceAnswer: E

14. Which of the following statements regarding bond pricing is true?A) The lower the discount rate, the more valuable the coupon payments are today.B) Bonds with high coupon payments are generally (all else the same) more sensitive to changes

in interest rates than bonds with lower coupon payments.C) When market interest rates rise, bond prices will also rise, all else the same.D) Bonds with short maturities are generally (all else the same) more sensitive to changes in

interest rates than bonds with longer maturities.E) All else the same, bonds with larger coupon payments will have a lower price today.Answer: A

15. Your broker offers you the opportunity to purchase a bond with coupon payments of $90 per year

and a face value of $1000. If the yield to maturity on similar bonds is 8%, this bond should:A) Sell for the same price as the similar bond regardless of their respective maturities.B) Sell at a premium.C) Sell at a discount.D) Sell for either a premium or a discount but it's impossible to tell which.E) Sell for par value.Answer: B

16. When pricing bonds, if a bond's coupon rate is less than the required rate of return, then:A) The holder of the bond is assured of a profit regardless of when the bond is eventually sold.B) The holder of the bond will realize a capital gain if the bond is held to maturity.C) The bond sells at par because the required rate of return is adjusted to reflect the discrepancy.

D) The bond sells at a premium if it has a long maturity and at a discount if it has a shortmaturity.

E) The bond sells at a discount if it has a long maturity and at a premium if it has a shortmaturity.

Answer: B

17. All else the same, a(n) __________ will decrease the required return on a bond.A) call provisionB) lower bond ratingC) sinking fundD) increase in inflationE) increase in the size of a bond issuance

Answer: C

18. Which of the following items generally appears in a corporate bond quote from The Wall Street

Journal ?A) Yield to maturityB) Original issue priceC) Current yieldD) Name of the trusteeE) Bond ratingAnswer: C



19. For a discount bond, the current yield is _________ the yield to maturity, and the coupon rate is _____________ the yield to maturity.A) less than; less thanB) less than; greater thanC) greater than; less thanD) greater than; greater than

E) equal to; equal toAnswer: A

20. For a premium bond, the required return is less than the:

I. Current yield.II. Yield to maturity.III. Coupon rate.

A) I onlyB) I and II onlyC) II and III only

D) I and III onlyE) I, II, and III

21. If investors are uncertain that they will be able to sell a corporate bond quickly, the investors willdemand a higher yield in the form of a(n) ____________.A) inflation premiumB) liquidity risk premiumC) interest rate risk premiumD) default risk premiumE) increased real rate of interestAnswer: B

22. Dizzy Corp. bonds bearing a coupon rate of 12%, pay coupons semiannually, have 3 yearsremaining to maturity, and are currently priced at $940 per bond. What is the yield to maturity?A) 12.00%B) 13.99%C) 14.54%D) 15.25%E) 15.57%Answer: CResponse: $940 = 1000 FV, 60 PMT, 6 N, -940 PV, CPT I/Y = 7.27%;YTM = 7.27% x 2 = 14.54%

23. Whitesell Athletic Corporation's bonds have a face value of $1,000 and a 9% coupon paid

semiannually; the bonds mature in 8 years. What current yield would be reported in The Wall Street Journal if the yield to maturity is 7%?A) 4%B) 5%C) 6%D) 7%E) 8%Answer: EResponse:1000 FV, 45 PMT, 16 N, 3.5 I/Y, CPT PV = $1,120.94; Annual coupon is 45 x 2 = 90.Current Yield (CY) = $90 / 1,120.94 = 8.03%



24. D&G Enterprises issues bonds with a $1,000 face value that make coupon payments of $30 every3 months. What is the coupon rate?A) 0.30%

B) 3.00%C) 9.00%D) 12.00%E) 30.00%Answer: DResponse: coupon rate = ($30 x 4) / 1,000 = 12%

25. Suppose you purchase a zero coupon bond with face value $1,000, maturing in 25 years, for $180. What is the implicit interest, in dollars, in the first year of the bond's life?A) $ 2.86B) $ 9.84C) $12.78

D) $19.27E) $30.00Answer: C1000 FV, 25 N, -180 PV, CPT I/Y = YTM = 7.1%; Year 1 interest = $180 x .071 = $12.78

26. Suppose you purchase a zero coupon bond with a face value of $1,000 and a maturity of 25 years,for $180. If the yield to maturity on the bond remains unchanged, what will the price of the bond be 5 years from now?A) $253.64B) $287.52C) $310.91D) $380.58

E) $500.00Answer: A1000 FV, 25 N, -180 PV, CPT I/Y = 7.1%; -180 PV, 5 N, 7.1 I/Y, CPT FV = $253.64

27. What is the yield to maturity on an 18-year, zero coupon bond selling for 30% of par value?A) 4.86%B) 5.86%C) 6.37%D) 6.92%E) 30.00%Answer: D1000 FV, 18 N, -300 PV, CPT I/Y = YTM = 6.92%

28. J&J Enterprises wants to issue sixty 20-year, $1,000 zero-coupon bonds. If each bond is to yield7%, how much will J&J receive (ignoring issuance costs) when the bonds are first sold?A) $11,212B) $12,393C) $15,505D) $18,880E) $20,000Answer: C

Response: price = $1,000 / 1.0720

= $258.42; proceeds = $258.42 x 60 = $15,505



There is the algebra, but what are the entries using your TVOM keys on your TI BA II Plus?And what of the algebra and keystrokes for numbers 29-40 below? Recognizing the algebra isimportant, and extending that recognition to the keystrokes is “key.”

29. J&J Enterprises wants to issue 20-year, $1,000 face value zero-coupon bonds. If each bond is toyield 7%, what is the minimum number of bonds J&J must sell if they wish to raise $5 million

from the sale? (Ignore issuance costs.)A) 17,290B) 19,349C) 20,164D) 23,880E) 26,159Answer: BResponse: price = $1,000 / 1.0720 = $258.42; # of bonds = $5,000,000 / 258.42 = 19,349

30. What is the market value of a bond that will pay a total of fifty semiannual coupons of $80 eachover the remainder of its life? Assume the bond has a $1,000 face value and a 12% yield tomaturity.

A) $ 734.86B) $ 942.26C) $1,135.90D) $1,315.24E) $1,545.62Answer: D50 N, 80 PMT, 1000 FV, 12/2 = I/Y, CPT PV = -1,315

31. J&J Manufacturing just issued a bond with a $1,000 face and a coupon rate of 8%. The bond hasa life of 20 years, annual coupons, and a yield to maturity is 7.5%, what will the bond sell for?A) $ 975B) $1,020

C) $1,051D) $1,087E) $1,162Answer: C1000 FV, 80 PMT, 20 N, 7.5 I/Y, CPT PV = -1,051

32. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what percentof the bond's total price is represented by the present value of the coupons?A) 45.7%B) 56.1%C) 77.6%

D) 93.2%E) 100.0%Answer: CResponse:Using the TVOM keystrokes above, you get the price of around $1,051. The algebra?

price = $80 [(1 - 1/1.07520

) / .075] + 1,000 / 1.07520

= $1,050.97

PV of coupons = $80 [(1 - 1/1.07520

)/ .075] = $815.56; percentage = $815.56 / 1,050.97 = 77.6%

33. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the



bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what is the present value of the bond's face value?A) $ 235.41B) $ 341.15C) $ 815.56D) $1,000.00E) $1,050.97

Answer: A, Response: PV of par = $1,000 / 1.07520

= $235.41(1000 FV, 20 N, 7.5 I/Y, CPT PV = 235.41)

34. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what is thetotal present value of the bond's coupon payments?A) $ 235.41B) $ 341.15C) $ 815.56D) $1,000.00E) $1,050.97Answer: C

Response: PV of coupons = $80 [(1 1/1.07520

)/ .075] = $815.56

35. The market price of a bond is $1,236.94, it has 14 years to maturity, a $1,000 face value, and paysan annual coupon of $100 in semiannual installments. What is the yield to maturity?A) 3.18%B) 4.26%C) 5.37%D) 6.11%E) 7.27%Answer: EResponse:

$1,236.94 = $50 {[1 - 1/(1 + R)28

] / R} + 1,000 / (1 + R)28

; R = 3.637%; YTM = 3.64% x 2 =7.27%

36. What would you pay for a bond that pays an annual coupon of $45, has a face value of $1,000,matures in 11 years, and has a yield to maturity of 10%?A) $642.77B) $775.34C) $800.18D) $910.14E) $976.38Answer: A

Response: price = $45 [(1 - 1/1.111)

/ .1] + 1,000 / 1.111

= $642.77

37. King Noodles' bonds have a 9% coupon rate. Interest is paid quarterly and the bonds have amaturity of 10 years. If the appropriate discount rate is 10% on similar bonds, what is the price of King Noodles' bonds?A) $937.24B) $938.55C) $971.27D) $989.63E) $991.27Answer: A

Response: price = $22.50 [(1 - 1/1.02540

) / .025] + 1,000 / 1.02540

= $937.24



38. Cornerstone Industries has a bond outstanding with an 8% coupon rate and a market price of $874.68. If the bond matures in 6 years and interest is paid semiannually, what is the YTM?A) 4.9%B) 6.9%C) 8.9%D) 10.9%E) 12.9%Answer: D

Response: $874.68 = $40 {[1 - 1/(1 + R)12] / R} + 1,000 / (1 + R)12; R = 5.45%; YTM = 5.45%x 2 = 10.9%

39. The make-believe bonds of Facebook carry a 12% annual coupon, have a $1,000 face value, andmature in 5 years. Bonds of equivalent risk yield 9%. What is the market value of Facebook bonds?A) $1,011.20B) $1,087.25C) $1,095.66D) $1,116.69E) $1,160.25Answer: D

Response: price = $120 [(1 - 1/1.095) / .09] + 1,000 / 1.09

5= $1,116.69

40. If the following bonds are identical except for coupon, what is the price of bond B?

B o n d A B o n d BF a c e v a l u e $ 1 , 0 0 0 $ 1 , 0 0 0S e m i a n n u a l C o u p o n $ 5 0 $ 4 0Y e a r s t o m a t u r i t y 2 5 2 5P r i c e $ 1 , 1 5 0 . 0 0 ?

A) $ 944.58

B) $ 975.31C) $1,037.86D) $1,150.00E) $1,279.47Answer: AResponse:

Bond A: $1,150 = $50 {[1 - 1/(1 + R)50

]/ R} + 1,000 / (1 + R)50

; R = 4.27%;

Bond B: price = $40 [(1 - 1/1.042750

) / .0427] + 1,000 / 1.042750

= $944.58

41. If corporate bond yields are at 8.4% and you are in the 34% federal marginal income tax bracket,at what level of municipal bond yields would you be indifferent between owning corporate bonds

or muni bonds? Ignore the impact of state and local taxes.A) 5.95%B) 5.54%C) 5.03%D) 4.67%E) 4.11%Answer: BResponse: 8.4(1 - .34) = 5.54%

CHAPTER 6 QUESTIONS END HERE.



CHAPTER 7 QUESTIONS BEGIN HERE

1. The stock valuation model that determines the current stock price as the next dividend divided bythe (discount rate less the dividend growth rate) is called the:A) Zero growth model.B) Dividend growth model.C) Capital Asset Pricing Model.

D) Earnings capitalization model.Answer: B

2. A stock's next expected dividend divided by the current stock price is the:A) Current yield.B) Total yield.C) Dividend yield.D) Capital gains yield.E) Earnings yield.Answer: C

3. The rate at which the stock price is expected to appreciate (or depreciate) is the:A) Current yield.B) Total yield.C) Dividend yield.D) Capital gains yield.E) Earnings yield.Answer: D

4. Payments made by a corporation to its shareholders, in the form of either cash, stock, or paymentsin kind, are called:A) Retained earnings.B) Net income.C) Dividends.D) Redistributions.E) Infused equity.Answer: C

5. The market in which new securities are originally sold to investors is the ________ market.A) dealer B) auction

C) over-the-counter (OTC)D) secondaryE) primaryAnswer: E

6. The market in which previously issued securities are traded among investors is the:A) Dealer market.B) Auction market.C) Over-the-counter (OTC) market.D) Secondary market.E) Primary market.



Answer: D

7. Common stock valuation requires, among other things, information regarding the:

I. Expected dividend growth rate.II. Current dividend payment.III. Par value of the common stock.

A) I only

B) I and II onlyC) I and III onlyD) II and III onlyE) I, II, and IIIAnswer: B

8. As illustrated using the dividend growth model, the total return on a share of common stock iscomprised of a ___________.A) capital gains yield and a dividend growth rateB) capital gains growth rate and a dividend growth rate

C) dividend payout ratio and a required rate of returnD) dividend yield and the present dividendE) dividend yield and a capital gains yieldAnswer: E

9. Which of the following items would usually appear for a stock quote in The Wall Street Journal ?A) Capital gains rateB) Dividend yieldC) Number of shares outstandingD) Par value of the stock E) Dividend growth rateAnswer: B

10. If dividends on a common stock are expected to grow at a constant rate forever, and if you aretold the most recent dividend paid, the dividend growth rate, and the appropriate discount ratetoday, you can calculate ___________.

I. the price of the stock todayII. the dividend that is expected to be paid ten years from nowIII. the appropriate discount rate ten years from now

A) I onlyB) I and II onlyC) I and III only

D) II and III onlyE) I, II, and IIIAnswer: B

11. Which of the following statements regarding dividend yields is true?A) It measures how much the stock's price will increase in a year.B) It incorporates the par value of the stock into the calculation.C) It is analogous to the current yield for a bond.D) It is always greater than the stock's capital gains yield.E) It measures the total annual return an investor can expect to earn by owning the stock.



Answer: C

12. Which of the following is (are) true?I. The dividend yield on a stock is the annual dividend divided by the par value.II. When the constant dividend growth model holds, g = capital gains yield.III. The total return on a share of stock = dividend yield + capital gains yield.A) I onlyB) II onlyC) I and II only

D) II and III onlyE) I, II, and IIIAnswer: D

13. If some shareholders have greater voting power than others, it must be that:A) The company has both preferred stock and common stock outstanding.B) The company has outstanding debentures.C) The company is located outside the United States in a tax-haven locale.D) The company has multiple classes of common stock.E) The company is in bankruptcy proceedings.Answer: D

14. What would you pay for a share of ABC Corporation stock today if the next dividend will be $3 per share, your required return on equity investments is 15%, and the stock is expected to beworth $90 one year from now?A) $78.26B) $80.87C) $82.56D) $90.00E) $98.12Answer: BResponse: P0 = $3 / 1.15 + 90 / 1.15 = $80.87

15. The dividend on Simple Motors common stock will be $3 in 1 year, $4.25 in 2 years, and $6.00 in

3 years. You can sell the stock for $100 in 3 years. If you require a 12% return on your investment, how much would you be willing to pay for a share of this stock today?A) $75.45B) $77.24C) $81.52D) $85.66E) $91.30Answer: CResponse: P0 = $3.00 / 1.12 + 4.25 / 1.122 + 106 / 1.123 = $81.52

16. A stock that pays a constant dividend of $1.50 forever currently sells for $10.71. What is therequired rate of return?

A) 10%B) 12%C) 13%D) 14%E) 15%Answer: DResponse: $10.71 = $1.50 / R; R = 14%

17. ABC Company's preferred stock is selling for $30 a share. If the required return is 8%, what willthe dividend be two years from now?A) $2.00



B) $2.20C) $2.40D) $2.80E) $3.25Answer: CResponse: $30 = D / .08; D = $2.40

18. What would you pay today for a stock that is expected to make a $2 dividend in one year if theexpected dividend growth rate is 5% and you require a 12% return on your investment?

A) $28.57B) $29.33C) $31.43D) $43.14E) $54.30Answer: AResponse: P0 = $2 / (.12 - .05) = $28.57

19. The stock of MTY Golf World currently sells for $90 per share. The firm has a constant dividend

growth rate of 6% and just paid a dividend of $5.09. If the required rate of return is 12%, whatwill the stock sell for one year from now?A) $ 90.00B) $ 93.52C) $ 95.40D) $ 99.80E) $112.78Answer: CResponse: P1 = P0(1 + g) = $90 (1.06) = $95.40

20. Llano's stock is currently selling for $40.00. The expected dividend one year from now is $2 andthe required return is 13%. What is this firm's dividend growth rate assuming the constant

dividend growth model is appropriate?A) 8%B) 9%C) 10%D) 11%Answer: AResponse: g = .13 - ($2 / 40) = 8%

21. The current price of XYZ stock is $80.00. Dividends are expected to grow at 5% indefinitely andthe most recent dividend was $2.75. What is the required rate of return on XYZ stock?A) 7.3%B) 8.7%

C) 9.5%D) 10.6%E) 11.2%Answer: BResponse: R = ($2.89 / 80) + .05 = 8.7%

22. ABC Corporation's common stock dividend yield is 3.61%, it just paid a dividend of $2.75, and isexpected to pay a dividend of $2.89 one year from now. Dividends are expected to grow at aconstant rate indefinitely. What is the required rate of return on ABC stock?A) 7.3%



B) 8.7%C) 9.5%D) 10.6%E) 11.2%Answer: BResponse: ($2.89 - 2.75) / 2.75 = .051; R = .036 + .051 = 8.7%

23. If Big Amp, Inc. stock closed at $36 and the current quarterly dividend is $0.75 per share, whatdividend yield would be reported for the stock in The Wall Street Journal ?

A) 2.0%B) 3.6%C) 5.7%D) 6.6%E) 8.3%Answer: EResponse: DY = ($0.75 x 4) / 36 = 8.3%

24. Suppose NoGro, Inc. has just issued a dividend of $3.25 per share. Subsequent dividends willremain at $3.25 indefinitely. Returns on the stock of firms like NoGro are currently running 10%.What is the value of one share of stock?A) $22.50B) $27.25C) $32.50D) $37.25E) $39.75Answer: CResponse: P

0

= $3.25 / .10 = $32.50

25. Suppose Pale Hose, Inc. has just paid a dividend of $1.80 per share. Sales and profits for PaleHose are expected to grow at a rate of 8% per year. Its dividend is expected to grow by the sameamount. If the required return is 14%, what is the value of a share of Pale Hose?A) $18.00B) $25.20C) $27.80D) $30.60E) $32.40Answer: EResponse: P

0= [$1.80(1.08)] / (.14 - .08) = $32.40

26. Suppose that you have just purchased a share of stock for $40. The most recent dividend was $2and dividends are expected to grow at a rate of 7% indefinitely. What must your required return be on the stock?A) 5.45%B) 7.00%C) 10.25%D) 12.35%E) 13.65%Answer: D



Response: R = [$2(1.07)] / 40 + - .07 = 12.35%\

27. The preferred stock of the Limbaugh Institute pays a constant annual dividend of $4 and sells for $50. You believe the stock will sell for $32 in one year. You must, therefore, believe that therequired return on the stock will be _____ percentage points ________ in one year.A) 8; higher B) 8; lower C) 1.5; higher D) 2.5; lower

E) 4.5; higher Answer: EResponse: current: $50 = $4 / R; R = 8%; future: $32 = $4 / R; R = 12.5

28. A firm's stock has a required return of 12%. The stock's dividend yield is 5%. What is thedividend the firm is expected to pay in one year if the current stock price is $50?A) $2.00B) $2.50C) $3.00D) $3.50E) $4.00Answer: B

Response: D1 = $50 (.05) = $2.50

29. A firm's stock has a required return of 12%. The stock's dividend yield is 5%. What dividend didthe firm just pay if the current stock price is $50?A) $2.18B) $2.34C) $2.50D) $2.87E) $3.60Answer: B

Use the following to answer questions 30-36:

5 2 W e e k s Y l d V o lH i L o S t o c k S y m D i v % P E 1 0 0 s H i L o C l o s e C h g .

4 8 . 7 2 2 0 . 1 0 D u k e E n e r g y D U K 1 . 0 0 3 . 3 1 8 2 0 9 2 5 3 1 . 5 5 2 9 . 4 0 3 0 . 2 0 – . 5 6

30. Duke stock must have closed at ___________ per share on the previous trading day.A) $29.64B) $30.76

C) $30.99D) $31.55E) $32.11Answer: BResponse: 30.76 - 0.56 = 30.20

31. For the current year, the expected dividend per share is:A) $0.25B) $1.00C) $2.00



D) $3.30E) $4.00Answer: B

32. Assume the expected growth rate in dividends is 10%. Then the constant growth model suggeststhat the required return on Duke stock is:A) 7.4%B) 8.9%C) 11.0%

D) 13.6%E) 15.8%Answer: DResponse: R = [($1.00 x 1.10) / 30.20] + .10 = 13.6%

33. Based on the quote, a good estimate of EPS over the last four quarters is:A) $0.80B) $1.21C) $1.68D) $1.91E) $2.54Answer: C

Response: EPS = $30.20 / 18 = $1.68

34. On this trading day, the number of Duke shares which changed hands was:A) 209B) 2,092C) 20,925D) 209,250

E) 2,092,500Answer: E

35. Assume that Duke paid a $0.92 annual dividend in the previous period. What is the dividendgrowth rate based on this quote?A) 4.8%B) 6.0%C) 7.2%D) 8.7%E) 9.9%Answer: D : Response: g = ($1.00 / 0.92) - 1 = 8.7%

36. You believe that the required return on Duke stock is 16% and that the expected dividend growthrate is 12%, which is expected to remain constant for the foreseeable future. Is the stock currentlyovervalued, undervalued, or fairly priced?A) OvervaluedB) UndervaluedC) Fairly pricedD) Cannot tell without more informationAnswer: AResponse: P

0= [$1.00 (1.12) ] / (.16 - .12) = $28.00; overvalued at $30.20 in the market



CHAPTER 7 QUESTIONS END HERE

CHAPTER 8 QUESTIONS BEGIN HERE

1. The difference between the market value of an investment and its cost is the:A) Net present value.B) Internal rate of return.C) Payback period.

D) Profitability index.E) Discounted payback period.Answer: A

2. The net present value (NPV) rule can be best stated as:A) An investment should be accepted if, and only if, the NPV is exactly equal to zero.B) An investment should be rejected if the NPV is positive and accepted if it is negative.C) An investment should be accepted if the NPV is positive and rejected if its is negative.D) An investment with greater cash inflows than cash outflows, regardless of when the cash

flows occur, will always have a positive NPV and therefore should always be accepted.Answer: C

3. The length of time required for an investment to generate cash flows sufficient to recover itsinitial cost is the:A) Net present value.B) Internal rate of return.C) Payback period.D) Profitability index.E) Discounted payback period.Answer: C

4. The payback rule can be best stated as:A) An investment is acceptable if its calculated payback period is less than some prespecified

number of years.

B) An investment should be accepted if the payback is positive and rejected if it is negative.C) An investment should be rejected if the payback is positive and accepted if it is negative.D) An investment is acceptable if its calculated payback period is greater than some prespecified

number of years.Answer: A

5. The discount rate that makes the net present value of an investment exactly equal to zero is the:A) Payback period.B) Internal rate of return.C) Average accounting return.D) Profitability index.E) Discounted payback period.

Answer: B

6. The internal rate of return (IRR) rule can be best stated as:A) An investment is acceptable if its IRR is exactly equal to its net present value (NPV).B) An investment is acceptable if its IRR is exactly equal to zero.C) An investment is acceptable if its IRR is less than the required return, else it should be

rejected.D) An investment is acceptable if its IRR exceeds the required return, else it should be rejected.Answer: D



7. A situation in which taking one investment prevents the taking of another is called:A) Net present value profiling.B) Operational ambiguity.C) Mutually exclusive investment decisions.D) Issues of scale.E) Multiple rates of return.Answer: C

8. The present value of an investment's future cash flows divided by its intial cost is the:

A) Net present value.B) Internal rate of return.C) Average accounting return.D) Profitability index.E) Payback period.Answer: D

9. The profitability index (PI) rule can be best stated as:A) An investment is acceptable if its PI is greater than one.B) An investment is acceptable if its PI is less than one.C) An investment is acceptable if its PI is greater than the internal rate of return (IRR).D) An investment is acceptable if its PI is less than the net present value

10. Which of the following statements is true?A) NPV should never be used if the project under consideration has nonconventional cash flows.B) NPV is similar to a cost/benefit ratio.C) If the financial manager relies on NPV in making capital budgeting decisions, she acts in the

shareholders' best interests.D) NPV can normally be directly observed in the marketplace.E) IRR is generally preferred to NPV in making correct capital budgeting acceptance decisions.Answer: C

11. Net present value _____________.

A) is equal to the initial investment in a projectB) is equal to the present value of the project benefitsC) is equal to zero when the discount rate used is equal to the IRR D) is simplified by the fact that future cash flows are easy to estimateE) requires the firm set an arbitrary cutoff point for determining whether an investment is

acceptableAnswer: C

12. The _______ decision rule is considered the "best" in principle.A) internal rate of returnB) payback periodC) average accounting return

D) net present valueE) profitability indexAnswer: D

13. Which of the following decision rules is best for evaluating projects for which cash flows beyonda specified point in time, and the time value of money, can both be ignored?A) Payback B) Net present valueC) Average accounting returnD) Profitability indexE) Internal rate of return



Answer: A

14. An investment generates $1.10 in present value benefits for each dollar of invested costs. Thisconclusion was most likely reached by calculating the project's:A) Net present valueB) Profitability indexC) Internal rate of returnD) Payback periodE) Average accounting return

Answer: B

15. The use of which of the following would lead to correct decisions when comparing mutuallyexclusive investments?

I. Profitability indexII. Net present valueIII. Average accounting return

A) I onlyB) II onlyC) III only

D) I and II onlyE) I and III onlyAnswer: B

16. You own some manufacturing equipment that must be replaced. Two different suppliers present a purchase and installation plan for your consideration. This is an example of a business decisioninvolving _____________ projects.A) mutually exclusiveB) independentC) working capitalD) positive NPVE) crossover Answer: A

17. If a project with conventional cash flows has an IRR less than the required return, then:A) The profitability index is less than one.B) The IRR must be zero.C) The AAR is greater than the required return.D) The payback period is less than the maximum acceptable period.E) The NPV is positive.Answer: A

18. Calculate the NPV of the following project using a discount rate of 10%:Yr 0 = –$800; Yr 1 = –$80; Yr 2 = $100; Yr 3 = $300; Yr 4 = $500; Yr 5 = $500A) $ 8.04B) $ 87.28C) $208.04



D) $459.17E) $887.28Answer: B

Response: NPV = -$800 - 80 / 1.1 + 100 / 1.12

+ 300 / 1.13

+ 500 / 1.14

+ 500 / 1.15

= $87.28

19. You are considering a project that costs $600 and has expected cash flows of $224, $250.88 and$280.99 over the next three years. If the appropriate discount rate for the project's cash flows is12%, what is the net present value of this project?A) The NPV is negative

B) $ 0.00C) $ 9.34D) $49.34E) $84.75Answer: B

20. A project costs $300 and has cash flows of $75 for the first three years and $50 in each of the project's last three years. What is the payback period of the project?A) The project never pays back B) 3.75 yearsC) 4.50 yearsD) 5.25 years

E) 5.50 yearsAnswer: CResponse: recover $275 in 4 years, need $25 / 50 = 4.50 years

21. Suppose a project costs $2,500 and produces cash flows of $400 over each of the following 8years. What is the IRR of the project?A) There is not enough information; a discount rate is requiredB) 3.27%C) 5.84%D) 9.61%E) 12.06%Answer: C

Response: $2,500 = $400 {[1 - 1/(1 + IRR)8

] / IRR}; IRR = 5.84%

22. A project has an initial investment of $25,000, with $6,500 annual inflows for each of thesubsequent 5 years. If the required return is 12%, what is the NPV?A) –$6,500.00B) –$2,447.02C) –$1,568.95D) $ 215.46E) $1,763.81Answer: C

Response: NPV = -$25,000 + 6,500 [(1 - 1/1.125) / .12] = -$1,568.95

23. What is the NPV of the following set of cash flows if the required return is 15%?

Y e a r 0 1 2 3 4C a s h F l o w – $ 1 0 , 0 0 0 – $ 1 , 0 0 0 $ 1 0 , 0 0 0 $ 1 0 , 0 0 0 – $ 5 , 0 0 0

A) The NPV is negativeB) $ 408.27C) $ 950.44D) $1,247.90



E) $4,656.12Answer: B

Response: NPV = -$25,000 + 6,500 [(1 - 1/1.125) / .12] = -$1,568.95

24. Would you accept a project which is expected to pay $2,500 a year for 6 years if the initialinvestment is $10,000 and your required return is 8%?A) Yes; the NPV is $1,557B) Yes; the NPV is $928C) Yes; the NPV is $63

D) No; the NPV is –$346E) No; the NPV is –$1,221Answer: A

Response: NPV = + 2,500[(1 - 1/1.086

) / .08] = $1,557.20

25. What is the payback period of a $15,000 investment with the following cash flows?

e a r 1 4C a s h F l o w $ 3 , 0 0 0 $ 4 , 0 0 0 $ 5 , 0 0 0 $ 6 , 0 0 0 $ 7 , 0 0 0

A) 2.75 years

B) 3.50 yearsC) 3.75 yearsD) 4.50 yearsE) 4.75 yearsAnswer: BResponse: recover $12,000 in 3 years, need $3,000 / 6,000 = 3.50 years

26. You are considering an investment which has the following cash flows. If you require a 5 year payback period, should you take the investment?

Y e a r 0 1 2 3 4 5 6C a s h F l o w – $ 3 0 , 0 0 0 $ 1 0 , 0 0 0 $ 5 , 0 0 0 $ 5 , 0 0 0 $ 7 , 5 0 0 $ 1 0 , 0 0 0 $ 2 0 , 0 0 0

A) Yes, the payback is 3.000 years.B) Yes, the payback is 3.75 years.

C) Yes, the payback is 4.25 years.D) No, the payback is 5.25 years.E) No, the payback is 5.75 years.Answer: CResponse: recover $27,500 in 4 years, need $2,500 / 10,000 = 4.25 years

27. Your required return is 15%. Should you accept a project with the following cash flows?Y e a r 0 1 2 3C a s h F l o w – $ 2 5 $ 1 0 $ 1 0 $ 2 5

A) No, because the IRR is 5%.



B) No, because the IRR is 10%.C) Yes, because the IRR is 20%.D) Yes, because the IRR is 30%.E) Yes, because the IRR is 40%.Answer: D

Response: $25 = $10 / (1 + IRR) + 10 / (1 + IRR)2

+ 25 / (1 + IRR)3;

IRR = 30%

28. You are going to choose between two investments. Both cost $50,000, but investment A pays$25,000 a year for 3 years while investment B pays $20,000 a year for 4 years. If your required

return is 12%, which should you choose?A) A because it pays back sooner.B) A because its IRR exceeds 12%.C) A because it has a higher IRR.D) B because its IRR exceeds 12%.E) B because it has a higher NPV.Answer: EResponse:

A: NPV = + 25,000 [(1 - 1/1.123

) / .12] = $10,046

B: NPV = + 20,000 [(1 - 1/1.124

) / .12] = $10,747

29. Using the profitability index, which of the following projects would you choose if you havelimited funds?

Project Initial Investment NPV1 $50,000 $10,0002 75,000 25,0003 60,000 15,0004 40,000 17,0005 90,000 40,000

A) Project 1B) Project 2C) Project 3D) Project 4E) Project 5Answer: EResponse:Project 1: PI = $60,000 / 50,000 = 1.200; Project 2: PI = $100,000 / 75,000 = 1.333Project 3: PI = $75,000 / 60,000 = 1.250; Project 4: PI = $57,000 / 40,000 = 1.425Project 5: PI = $130,000 / 90,000 = 1.444

30. You have a choice between 2 mutually exclusive investments. If you require a 15% return, whichinvestment should you choose?

A BY e a r C a s h F l o w C a s h F l o w

0 – $ 1 0 0 , 0 0 0 – $ 1 2 5 , 0 0 01 2 0 , 0 0 0 7 5 , 0 0 02 4 0 , 0 0 0 4 5 , 0 0 03 8 0 , 0 0 0 4 0 , 0 0 0

A) Project A, because it has a smaller initial investment.B) Project B, because it has a higher NPV.C) Either one, because they have the same profitability indexes.



D) Project A, because it has the higher internal rate of return.E) Project B, because it pays back faster.Answer: BResponse:

A: NPV = + 20,000 / 1.15 + 40,000 / 1.152

+ 80,000 / 1.153

= $238

B: NPV = + 75,000 / 1.15 + 45,000 / 1.152

+ 40,000 / 1.153

= $545

31. For a project with an initial investment of $8,000 and cash inflows of $2,000 each year for 6

years, calculate NPV given a required return of 13%.A) –$846B) –$263C) $ 0D) $149E) $552Answer: C

Response: NPV = -$8,000 + 2,000 [(1 - 1/1.136

) / .13] = $0 (actual -$4.90)

32. What is the IRR of an investment that costs $18,500 and pays $5,250 a year for 5 years?A) 13%B) 15%C) 19%D) 25%E) 28%Answer: A

Response: $18,500 = $5,250 {[1 - 1/(1 + IRR)5] / IRR}; IRR = 12.92%

33. What is the profitability index of the following investment if the required return = 10%?

Y e a r 0 1 2 3C a s h F l o w – $ 1 5 0 $ 5 0 $ 7 5 $ 7 5

A) 0.94B) 1.09C) 1.18D) 1.27E) 1.45Answer: B

Response: PV = $50 / 1.1 + 75 / 1.12 + 75 / 1.13

= $163.79; PI = $163.79 / 150 = 1.09

34. What is the payback period for the following investment?

Y e a r 0 1 2 3 4C a s h F l o w – $ 2 5 , 0 0 0 $ 1 0 , 0 0 0 $ 8 , 0 0 0 $ 4 , 0 0 0 $ 2 , 0 0 0

A) 4 yearsB) 3 yearsC) 2 yearsD) 1 year E) The investment doesn't payback Answer: E



Response: recover $10,000 + 8,000 + 4,000 + 2,000 = $24,000; never pays back

Use the following to answer questions 35-38:

Bill plans to open a do-it-yourself dog bathing center in a storefront. The bathing equipment will cost$50,000. Bill expects the after-tax cash inflows to be $15,000 annually for 8 years, after which he plans toscrap the equipment and retire to the beaches of Jamaica.

35. What is the project's payback period?

A) 2.67 yearsB) 3.33 yearsC) 3.67 yearsD) 4.33 yearsE) 5.67 yearsAnswer: BResponse: payback = $50,000 / 15,000 = 3.33 years

36. Assume the required return is 10%. What is the project's NPV?A) $ 887B) $13,322C) $22,759

D) $30,024E) $45,001Answer: D

Response: NPV = + 15,000 [(1 - 1/1.108

) / .10] = $30,023.89

37. Assume the required return is 20%. What is the project's IRR? Should it be accepted?A) 15%; yesB) 15%; noC) 25%; yesD) 25%; noE) 20%; indifferentAnswer: C

Response: $50,000 = $15,000 {[1 - 1/(1 + IRR)8

] / IRR}; IRR = 24.95% > 20%; accept

38. Assume the required return is 20%. What is the project's PI? Should it be accepted?A) 0.85; yesB) 0.85; noC) 1.00; indifferentD) 1.15; yesE) 1.15; noAnswer: DResponse:

PV of inflows = $15,000 [(1 - 1/1.2

8

) / .2] = $57,557; PI = $57,557 / 50,000 = 1.15; accept

END OF CHAPTER 8 QUESTIONS

Questions and Answers

Documents

dzero coupon bond

efloating rate bond

apar bond

bdiscount bond

cpremium bond

bond value1

bond pricing

bond prices