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200 PRACTICE

QUESTIONS NEW!!!

CORPORATE FINANCE

Chartered Financial Analyst


program
CFA -Level 1-2021
Francesco M. Solari
This book is intended for all CFA Level 1 exam candidates; but
it is also aimed at all Finance Baccalaureate and Finance MBA
students. You should solve, understand, and master these
practice questions to reach the advanced level or the expert
level. You will find the following exercises:

1).- 200 practice questions with answers properly and


easily explained

The difficulty level of this book is similar to the CFA exam


questions and mock exam questions. It contains a wide variety
of exercises, covering 100% of all the topics included in the
CFA 2021 Program Curriculum, level 1.

The author has 25 years of experience in the banking and


investment industry. He has a Master of Business
Administration (MBA) and a Finance-MBA. He is Industrial
Engineer with studies in Actuarial Science and Computer
Science. The author is also trilingual, he speaks English,
French and Spanish.

Francesco M. Solari
INDEX
CORPORATE FINANCE
(Questions)
Corporate Finance (Answers)
CORPORATE FINANCE (Questions)
1. Which action is most likely considered a secondary
source of liquidity?

A. Increasing the efficiency of cash flow management


B. Renegotiating current debt contracts to lower interest
payments
C. Increasing the availability of bank lines of credit

2. Which of the following is most likely considered an


example of matrix pricing when determining the cost of debt?

A. debtrating approach only.


B. Yield-to-maturity approach only.
C. Both the yield-to-maturity and the debt-rating
approaches.

3. Given the following information, the degree of operating


leverage (DOL) is closest to:

A. 2.4.
B. 1.1.
C. 1.7.

4. Other factors held constant, the reduction of a company’s


average accounts payable because of suppliers offering less
trade credit will most likely:

A not affect the operating cycle.


B reduce the operating cycle.
C increase the operating cycle.

5. A firm’s estimated costs of debt, preferred stock, and


common stock are 12%, 17%, and 20%, respectively.
Assuming equal funding from each source and a marginal
tax rate of 40%, the weighted average cost of capital (WAAC)
is closest to:

A 13.9%.
B 14.7%.
C 16.3%.

6. Which of the following statements is the most appropriate


treatment of flotation costs for capital budgeting purposes?
Flotation costs should be:

A expensed in the current period.


B incorporated into the estimated cost of capital.
C deducted as one of the project’s initial-period cash
flows.
7. Given two mutually exclusive projects with normal cash
flows, the point at which their net present value profiles
intersect the horizontal axis is most likely the projects’:

A weighted average cost of capital.


B crossover rate.
C internal rate of return.

8. Based on best practices in corporate governance


procedures, it is most appropriate for a company’s
compensation committee to:

A link compensation with long-term objectives.


B include a retired executive from the firm.
C include a representative from the firm’s external auditor.

9. A company has a fixed $1,100 capital budget and has the


opportunity to invest in the four independent projects listed in
the table:

Project Investment Outlay NPV


1 $600 $100
2 $500 $100
3 $300 $50
4 $200 $50
The combination of projects that provides the best choice
is:

A. 2, 3, and 4.
B. 1, 3, and 4.
C. 1 and 2.

For an NPV = $200.

10. Introduction of a new model causes a decline in sales of


a car manufacturer’s older models. This is most likely an
example of:

A. An externality.
B. A sunk cost.
C. An opportunity cost.

11. The NPV profile of Project A is steeper than that of


Project B. Which of the following is most likely that the
crossover point occurs at an NPV of $5,000?

A. Project B has higher total cash inflows.


B. Project A receives most of its cash flows later in its life.
C. Project A has a higher IRR.

12. A drag on liquidity is most likely to occur when:

A. There is a delay in cash coming into the company.


B. Cash leaves the company too quickly.
C. The company loses creditworthiness.

13. Consider the following statements:

Statement 1: Dual-class share structures can easily be


changed over time.

Statement 2: Activist investors tend to have little impact


on the company’s long-term investors. Which of the
following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are incorrect.

14. A project’s beta is least likely to be exposed to:

A. Business risk.
B. Financial risk.
C. Default risk.

15. ABC Company currently has a debt‐to‐equity ratio of 0.3.


Its target debt‐to‐equity ratio is 0.4. The risk‐free rate is 6%,
and expected equity market return is 12%. ABC is
considering a project that has a beta of 1.2. Given that the
company’s after‐tax cost of debt is 7%, and the applicable
tax rate is 40%, the WACC that should be used in evaluating
this project is closest to:

A. 10.63%.
B. 11.43%.
C. 11.77%.
16. An analyst gathered the following information about a
company:

Credit sales $30,000


Cost of goods $17,000
sold
Accounts $4,000
receivable
Closing inventory $2,750
Accounts payable $2,000
Purchases $12,000
The operating cycle for the company is closest to:

A. 47 days.
B. 169 days.
C. 108 days.

17. Williams Inc. borrows $1.5m for a month through a


banker’s acceptance. The company is offered an all‐inclusive
rate of 9%. Its effective borrowing cost is closest to:

A. 9.00%.
B. 9.23%.
C. 9.07%.

18. Aztec Ltd. is considering investing $650 million in a new


project. The CFO of the company tells the directors that the
present value of the net cash flows that will be generated
from the project will be around $800 million. The company
has 7 million shares outstanding with a market price of $120
each. The price of the company’s shares if it undertakes the
new project will be closest to:

A. $114.29.
B. $135.72.
C. $141.43.

19. Which of the following approaches is least likely to be


used in determining a company’s cost of debt?

A. Yield to maturity approach


B. Pure‐play approach
C. Debt rating approach
20. Which of the following is least likely one of the principles of
capital budgeting?

A. The timing of cash flows is very important.


B. Financing costs must be considered in the calculation of
operating cash flows.
C. Projects are evaluated based on incremental cash flows
over and above their opportunity costs.

21. The point of intersection between the marginal cost of capital


and the investment opportunity schedule is known as the:

A. Crossover rate.
B. Optimal capital budget.
C. WACC

22. All other factors remaining the same, which of the following
statements is most likely regarding yields on short-term
investments?

A. The money market yield will be greater than the bond


equivalent yield.
B. The discount basis yield will be lower than the money
market yield.
C. The discount basis yield will be greater than the bond
equivalent yield.

23. Consider the following statements:

Statement 1: Any amendments to the company’s bylaws typically


occur at Extraordinary General Meetings (EGMs).

Statement 2: Proxy voting is adopted as a practice in order to


protect the rights of creditors. Which of the following is most
likely?

A. Only Statement 1 is correct.


B. Only Statement 2 is correct.
C. Both statements are incorrect.

24. Michael wants to calculate the WACC for a company which has
$6 million worth of debt outstanding with an interest rate of 7%. The
company is expected to issue new debt at an interest rate of 8%.
Assuming a tax rate of 40%, the company’s after‐tax cost of debt to
be used in calculating the WACC is closest to:

A. 4.2%.
B. 7%.
C. 4.8%.

25. A manufacturing firm issues a semi‐annual coupon bond to


finance a new project. The bond has a par value of $1,000, offers a
coupon rate of 9%, and will mature in 15 years. Given that the
bond’s current market value is $1,020.63, and the applicable tax
rate is 35%, the company’s after‐ tax cost of debt is closest to:

A. 4.38%.
B. 8.75%.
C. 5.69%.

26. A 180‐day U.S. T‐bill with a par value of $1,000 is issued at a


discount of 8%. The bond equivalent yield for this security is closest
to:

A. 8%.
B. 8.45%.
C. 8.11%.

27. An analyst gathers the following information about the cost of


raising new debt and equity for a company:

New Debt ($ After‐Tax New Equity Cost of


millions) Cost of Debt ($ millions) Equity (%)
(%)
≤5 5 ≤6 12
>5 6 >6 13
The company’s target capital structure is 70% equity and 30%
debt. If the company raises $12m in financing, its cost of
capital will be closest to:

A. 10.90%.
B. 10.20%.
C. 10.60%.

28. A company has been offered trade credit terms of “1/30 net 50.”
What is the cost of trade credit for the company if it pays on the
40th day?

A. 9.60%
B. 44.32%
C. 13.00%

29. Which of the following is least likely an issue in estimating a


company’s cost of debt?

A. Some debt instruments may contain option‐like features.


B. Some companies may use leases extensively as a source
of finance.
C. Companies in different jurisdictions may face different tax
rates.

30. Which of the following statements is most likely correct with


respect to the break point on the marginal cost of capital schedule?
It represents the point:

A. of optimal capital budget.


B. where the marginal cost of capital is lowest.
C. where a company’s marginal cost of capital changes.
31. A company executive is holding a meeting with members of the
board of directors. One of the members proposes a stock dividend
and cites two advantages.

Advantage 1: Issuing a stock dividend should help improve the


debt-to-equity ratio as contributed capital will
increase by the number of shares issued.

Advantage 2: Stock dividends are generally not taxable to


the shareholder. Which of the cited advantages is most
likely correct?

A. Both advantages.
B. Advantage 1 only.
C. Advantage 2 only.

32. A company uses trade credit with the terms 1/10, net 30 and
paid credit on day 30. The effective borrowing cost of skipping the
discount on day 10 is closest to:

A. 13.00%
B. 19.91%
C. 20.13%.

33. Which of the following factors least likely serves as a motivation


for corporations engaging in share repurchases?

A. To provide company management with discretion in


controlling their dividend policy.
B. To reduce the impact of a decline in EPS resulting from
the exercise of employee stock options.
C. To communicate to the market that company management
believes that a company’s share is overvalued.

34. The primary attraction of uncommitted line of credit is that


A. they do not require any compensation other than interest.
B. bank cannot refuse to honor any request for use of the
line.
C. companies present them as financial reserves in their
financial statements.

35. Social factors considered in ESG consideration include all of


the following except:

A. human rights.
B. pollution prevention.
C. welfare concerns in the workplace.

36. Dwight Enterprises is a manufacturing firm that plans to borrow


$2 million to finance a three-month project. The company would like
to minimize borrowing costs; its financial officer has identified three
alternative borrowing sources.

Alternative 1: Drawing down a line of credit at 4.50% with a 1%


commitment fee on the full amount borrowed.

Alternative 2: A banker’s acceptance at an all-in inclusive rate of


6.40%.

Alternative 3: Commercial paper at 4.0% with a dealer’s


commission of 1/9 percent and a backup line cost of
1/5 percent, both of which are assessed on the $2
million of commercial paper issued.

The financing cost associated with the cheapest Alternative is


closest to:

A. Alternative 1.
B. Alternative 2.
C. Alternative 3.
37. A large corporation accepts a project which generates no
revenue and has a negative net present value. The project most
likely is classified in which of the following categories?

A. Replacement project.
B. New product or service.
C. Regulatory or environmental project.

38. A company recently opened a limestone quarry at a location


outside its traditional service area. Because limestone is a major
ingredient in concrete, if the quarry is successful the company
plans to build a ready-mix concrete plant at the same location. The
investment in the concrete plant is best described as:

A. an externality.
B. project sequencing.
C. an example of investment synergy.

39. An analyst determines the following cash flows for a capital


project:

Year 0 1 2 3 4 5
Cash flow (€) -100 30 40 40 30 20

The required rate of return for the project is 13


percent. The net present value (NPV) of the project is
closest to:

A. €14.85.
B. €60.00.
C. €214.85.

40. An analyst gathers the following information about the capital


structure and before-tax component costs for a company. The
company’s marginal tax rate is 40 percent.
Capital Book Value Market Value Component
component (000) (000) cost
Debt $100 $80 8%
Preferred stock $20 $20 10%
Common stock $100 $200 12%

The company’s weighted average cost of capital (WACC) is


closest to:

A. 8.55%.
B. 9.95%.
C. 10.80%.

41. A company is considering issuing a 10-year, option-free,


semiannual coupon bond with a 9 percent coupon rate. The bond is
expected to sell at 95 percent of par value. If the company’s
marginal tax rate is 30 percent, then the after-tax cost of debt is
closest to:

A. 6.30%.
B. 6.86%.
C. 9.80%.

42. A company plans to issue nonconvertible, noncallable, fixed-


rate perpetual preferred stock with a $6 annual dividend. The
preferred stock is expected to sell for $40. If the company’s
marginal tax rate is 30 percent, then the cost of preferred stock is
closest to:

A. 6.67%.
B. 10.5%.
C. 15.0%.

43. An analyst gathers the following information about a company


and the market:
Current market price per share of common €32.00
stock
Most recent dividend per share paid on €2.40
common stock
Expected dividend payout rate 40%
Expected return on equity (ROE) 15%
Beta for the common stock 1.5
Expected return on the market portfolio 12%
Risk-free rate of return 4%

Using the dividend discount model approach, the cost


of common equity for the company is closest to:

A. 16.0%.
B. 16.5%.
C. 17.2%.

44. A company is investigating the purchase of a banker’s


acceptance (BA). The $1,000,000 face value BA has 150 days to
maturity and is quoted at 4.05 percent on a discount-basis yield. If
the company’s marginal tax rate is 25 percent, then the money
market yield on the BA is closest to:

A. 3.13%.
B. 4.12%.
C. 4.18%.

45. Regarding corporate governance, which of the following is most


likely a reason for concern when evaluating the compensation
committee? The compensation committee:

A. includes members of executive management.


B. purchases shares on the open market to fund stock option
commitments.
C. discloses information about compensation paid to
executives and board members.
46. Which of the following is least likely classified as a takeover
defense?

A. Greenmail.
B. Cumulative voting.
C. Golden parachutes.

47. The cash flows of projects A and B are given below:

Year Cash flows


Project A Project B
0 -1,500 -1,500
1 400 500
2 300 500
3 600 500
4 800 500

For a 12% internal rate of return, as compared to project


B, the discounted payback period of project A is
approximately:

A. equivalent.
B. 0.93 years higher.
C. 1.25 years higher.

48. Net present value method assumes that cash flows are
reinvested at the:

A. internal rate of return.


B. accounting rate of return.
C. opportunity cost of capital.
49. Which of the following is most likely a correct implication of
stock dividends to the shareholders?

A. Generally stock dividends are taxable.


B. Stock dividends positively affect the market value of
shareholders’ wealth.
C. When stock dividends are paid shareholders’ cost per
share held decreases.

50. An analyst gathered the following information to estimate the


cost of equity for JI Inc. located in Fiji.

Risk free rate 3.2%


Market risk premium 5.5%
Beta 1.3
U.S 10-year T-bond yield 2.84%
Fiji’s 10-year dollar denominated Govt. 10.81%
bond yield

Annualized SD of Fiji’s stock market 44%


Annualized SD of Fiji’s dollar 37%
denominated bond

The sovereign yield spread and JI Inc.’s cost of equity are closest
to:

A. 7.97% and 18.51% respectively.


B. 9.48% and 19.83% respectively.
C. 7.97% and 22.67% respectively.

51. When a company finances share repurchases with cash:

A. assets and shareholders’ equity decrease and leverage


increases.
B. assets and shareholders’ equity decrease and leverage
remains - unchanged.
C. leverage increases, shareholders’ equity decreases and
assets remain unchanged.

52. When a reliable current market price for a firm’s debt is not
available, the cost of debt can be estimated using the:

A. matrix pricing model.


B. coupon rate of the same bonds.
C. interest expense of the firm’s income statement.

53. A manager is computing the cost of trade credit for the terms
1.5/5 net 30. The account is paid on either the 15th day or the net
day. The cost of credit is:

A. 24.69% lower if the credit is paid on the net day.


B. 48.92% lower if the credit is paid on the net day.
C. 24.21% higher if the credit is paid on 15th day

54. An analyst gathered the following financial information from


Daniel Inc.

2013 Expected
2014
Units Sold 1300 1400
Revenue ($) 130,000 140,000
Operating income 38,000 52,000
($)
Interest cost ($) 12,000 12,000
Other financing cost 8,000 8,000
($)
Tax ($) 6300 11,200
Net Income ($) 11,700 20,800

The degree of operating leverage of Daniel Inc. from 2013 to


expected 2014 is closest to:
A. 2.11.
B. 3.68.
C. 4.79.

55. Which of the following is considered to be best practice from


shareowners’ perspective?

A. Acquiring entity is required to deal directly with


management and board.
B. Board and management should be able to use cash or
available credit lines to pay hostile bidders to forgo
takeover.
C. Under change-in-control provisions, executives should not
be granted severance packages to leave the company.

56. As compared to firms with high degree of financial leverage,


firms with high degree of operating leverage:

A. can easily emerge as a going concern by using


bankruptcy laws and protection.
B. are less flexible in making changes and bankruptcy
protection help little to reduce operating costs.
C. do not lead to major dislocations in the rights and
privileges of owners, lenders and management.

57. The following information is available for a firm:

The firm’s unleveraged beta is closest to:

A. 0.75.
B. 1.20.
C. 1.05.

58. The acceptance of which of the following capital budgeting


projects is most likely to expose a company to the highest level of
uncertainty?

A. Replacement of worn out equipment


B. Expansion projects
C. Newly launched product or services

59. The optimal capital budget for a firm is best described as


occurring when the company’s marginal cost of capital is:

A. equal to the investment opportunity schedule.


B. less than the investment opportunity schedule.
C. greater than the investment opportunity schedule.

60. Financial risk is least likely affected by:


A. debentures.
B. dividends.
C. long-term leases.

61. Which of the following is the least appropriate method for an


external analyst to use to estimate a company’s target capital
structure for determining the weighted average cost of capital
(WACC)?

A. Using the company’s current capital structure at book


value weights
B. Using averages of comparable companies’ capital
structure
C. Using statements made by the company’s
management regarding capital structure policy
62. Which is most likely considered a secondary source of liquidity?

A. Centralized cash management system


B. Trade credit
C. Liquidating long-term assets

63. Under the stakeholder theory, corporate governance is most


consistent with a system of:

A. internal controls and procedures by which individual


companies are managed.
B. defined roles for management and the majority
shareowner(s).
C. checks and balances to minimize the conflicting
interests among shareowners.

64. Two mutually exclusive projects have the following cash flows
(€) and internal
rates of return (IRR):

Assuming a discount rate of 8% annually for both projects, the


best decision for
the firm to make is to accept:

A both projects.
B Project B only.
C Project A only.

65. An investment strategy that focuses on climate change is most


likely following which approach to environmental, social, and
governance (ESG) investing?

A. Thematic
B. Best in class
C. Impact

66. An investment policy statement’s risk objective states that over


a 12-month period, with a probability of 95%, the client’s portfolio
must not lose more than 5% of its value. This statement is most
likely a(n):

A. total risk objective.


B. relative risk objective.
C. absolute risk objective.

67. The top level of a risk management system most likely is:

A. risk governance.
B. strategic analysis or integration.
C. defined policies or procedures.

68. An investor’s transactions in a mutual fund and the fund’s


returns over a four-year period are provided in the following table:

Based on this data, the money-weighted return (or internal rate


of return) for the investor is closest to:
A. 2.15%.
B. 7.50%.
C. 3.96%.
69. Which of the following sources of credit would an analyst most
likely associate with a borrower of the lowest credit quality?

A. Committed line of credit.


B. Revolving line of credit.
C. Uncommitted line of credit.
70. Which yield measure is the most appropriate for comparing a
company’s investments in short- term securities?

A. Money market yield.


B. Discount basis yield.
C. Bond equivalent yield.
71. Which of the following is most accurate regarding the
component costs and component weights in a firm’s weighted
average cost of capital (WACC)?

A. The appropriate pre-tax cost of a firm’s new debt is the


average coupon rate on the firm’s existing debt.
B. The weights in the WACC should be based on the book
values of the individual capital components.
C. Taxes reduce the cost of debt for firms in countries in
which interest payments are tax deductible.

72. Financial risk is borne by:

A. common shareholders.
B. Creditors
C. Managers

73. Hans Klein, CFA, is responsible for capital projects at Vertex


Corporation. Klein and his assistant, Karl Schwartz, were
discussing various issues about capital budgeting and Schwartz
made a comment that Klein believed to be incorrect. Which of the
following is most likely the incorrect statement made by Schwartz?

A. “Net present value (NPV) and internal rate of return


(IRR) result in the same rankings of potential capital
projects.”
B. “The weighted average cost of capital (WACC) should
be based on market values for the firm’s outstanding
securities.”
C. “It is not always appropriate to use the firm’s marginal
cost of capital when determining the net present value
of a capital project.”
74. A company director's duty of loyalty is most accurately
described as requiring a director to:

A. perform his or her duties in good faith and with due


diligence.
B. carry out the duties assigned by the managers of the
company.
C. act in the interests of the company and its
shareholders.
75. Assume that a company has equal amounts of debt, common
stock, and preferred stock. An increase in the corporate tax rate of
a firm will cause its weighted average cost of capital (WACC) to:

A. rise
B. fall
C. more information is needed
76. Which of the following is least likely to be useful to an analyst
when estimating the cost of raising capital through the issuance of
non-callable, nonconvertible preferred stock?

A. The stated par value of the preferred issue.


B. The firm’s corporate tax rate.
C. The preferred stock’s dividend rate.
77. Sinclair Construction Company’s Board of Directors is
considering repurchasing $30,000,000 worth of common stock.
Sinclair assumes that the stock can be repurchased at the market
price of $50 per share. After much discussion Sinclair decides to
borrow $30 million that it will use to repurchase shares. Sinclair’s
Chief Executive Officer (CEO) has compiled the following
information regarding the repurchase of the firm’s common stock:
Share price at the time of buyback = $50
Shares outstanding before buyback = 30,600,000
EPS before buyback = $3.33
Earnings yield = $3.33 / $50 = 6.7%
After-tax cost of borrowing = 8.0%
Planned buyback = 600,000 shares
Based on the information above, Sinclair’s earnings per share
(EPS) after the repurchase of its common stock will be closest
to:

A. $3.18
B. $3.32
C. $3.23

78. A financial analyst is estimating the effect on the cost of capital


for a company of a decrease in the marginal tax rate. The company
is financed with debt and common equity. A decrease in the firm’s
marginal tax rate would:

A. increase the cost of capital because of a higher after-


tax cost of debt and equity.
B. increase the cost of capital because of a higher after-
tax cost of debt.
C. decrease the cost of capital because of a lower after-
tax cost of debt and equity.
79. Nippon Post Corporation (NPC), a Japanese software
development firm, has a capital structure that is comprised of 60%
common equity and 40% debt. In order to finance several capital
projects, NPC will raise USD1.6 million by issuing common equity
and debt in proportion to its current capital structure. The debt will
be issued at par with a 9% coupon and flotation costs on the equity
issue will be 3.5%. NPC’s common stock is currently selling for
USD21.40 per share, and its last dividend was USD1.80 and is
expected to grow at 7% forever. The company’s tax rate is 40%.
NPC’s WACC based on the cost of new capital is closest to:

A. 9.6%
B. 13.1%
C. 9.6%
80. The expected annual dividend one year from today is $2.50 for
a share of stock priced at $25. What is the cost of equity if the
constant long-term growth in dividends is projected to be 8%?

A. 19%
B. 18%
C. 15%
81. Which of the following statements about independent projects is
least accurate?

A. If the internal rate of return is less than the cost of


capital, reject the project.
B. The internal rate of return and net present value
methods can yield different accept/reject decisions for
independent projects.
C. The net present value indicates how much the value of
the firm will change if the project is accepted.

82. The share price of Solar Automotive Industries is $50 per


share. It has a book value of $500 million and 50 million shares
outstanding. What is the book value per share (BVPS) after a share
repurchase of $10 million?

A. $9.84
B. $10.12
C. $10.00
83. Which of the following projects would most likely have multiple
internal rates of return (IRRs)? The cost of capital for all projects is
10.0%.

Cash Flows South East West


CF0 -15,000 -12,000 -8,000
CF1 10,000 7,000 4,000
CF2 -1,000 2,000 0
CF3 15,000 2,000 6,000

A. Projects East and West.


B. Project South only.
C. Projects South and West.

84. Polington Aircraft Co. just announced a sale of 30 aircraft to


Cuba, a project with a net present value of $10 million. Investors
did not anticipate the sale because government approval to sell to
Cuba had never before been granted. The share price of Polington
should:
A. not necessarily change because new contract
announcements are made all the time.
B. increase by the NPV × (1 – corporate tax rate) divided
by the number of common shares outstanding.
C. increase by the project NPV divided by the number of
common shares outstanding.
85. Which of the following is the most appropriate decision rule for
mutually exclusive projects?

A. Accept both projects if their internal rates of return


exceed the firm’s hurdle rate.
B. Accept the project with the highest net present value,
subject to the condition that its net present value is
greater than zero.
C. If the net present value method and the internal rate of
return method give conflicting signals, select the project
with the highest internal rate of return.

86. Hatch Corporation's target capital structure is 40% debt, 50%


common stock, and 10% preferred stock. Information regarding the
company's cost of capital can be summarized as follows:

The company's bonds have a nominal yield to maturity of 7%.


The company's preferred stock sells for $40 a share and pays
an annual dividend of $4 a share.
The company's common stock sells for $25 a share and is
expected to pay a dividend of
$2 a share at the end of the year (i.e., D1 = $2.00). The dividend
is expected to grow at a constant rate of 7% a year.
The company has no retained earnings.
The company's tax rate is 40%.

What is the company's weighted average cost of capital (WACC)?

A. 10.59%
B. 10.03%
C. 10.18%
87. Tapley Acquisition, Inc., is considering the purchase of Tangent
Company. The acquisition would require an initial investment of
$190,000, but Tapley's after-tax net cash flows would increase by
$30,000 per year and remain at this new level forever. Assume a
cost of capital of 15%. Should Tapley buy Tangent?

A. No, because k > IRR.


B. Yes, because the NPV = $10,000.
C. Yes, because the NPV = $30,000.
88. A firm has $3 million in outstanding 10-year bonds, with a fixed
rate of 8% (assume annual payments). The bonds trade at a price
of $92 per $100 par in the open market. The firm’s marginal tax rate
is 35%. What is the after-tax component cost of debt to be used in
the weighted average cost of capital (WACC) calculations?

A. 9.26%
B. 5.40%
C. 6.02%

89. Which of the following sources of liquidity is the most reliable?

A. Committed line of credit.


B. Uncommitted line of credit.
C. Revolving line of credit.

90. Financial managers utilize stock splits and stock dividends


because they perceive that:

A. investors will double the share price if there is a 20%


stock dividend
B. an optimal trading range exists.
C. brokerage fees paid by shareholders will be reduced.
91. Assume that a 30-day commercial paper security has a holding
period yield of 0.80%. The bond equivalent yield of this security is:

A. 9.73%
B. 9.60%
C. 10.12%
92. Which of the following statements about leverage is most
accurate?

A. If the company has no debt outstanding, then its


degree of total leverage equals its degree of operating
leverage.
B. An increase in fixed costs (holding sales and variable
costs constant) will reduce the company's degree of
operating leverage.
C. A decrease in interest expense will increase the
company's degree of total leverage.
93. Jeffery Marian, an analyst with Arlington Machinery, is
estimating a country risk premium to include in his estimate of the
cost of equity for a project Arlington is starting in India. Marian has
compiled the following information for his analysis:

Indian 10-year government bond yield = 7.20%


10-year U.S. Treasury bond yield = 4.60%
Annualized standard deviation of the Bombay Sensex stock
index = 40%.
Annualized standard deviation of Indian dollar denominated 10-
year government bond = 24%
Annualized standard deviation of the S&P 500 Index = 18%.
The estimated country risk premium for India based on Marian’s
research is closest to:

A. 2.60%
B. 4.30%
C. 5.80%

94. To judge whether management's incentives are aligned with a


firm's stated goals, an analyst should examine the firm's:

A. remuneration programs.
B. cross-shareholdings.
C. share class structure

95. All else equal, a firm's business risk is higher when:

A. the firm has low operating leverage.


B. fixed costs are the highest portion of its expense.
C. variable costs are the highest portion of its expense.
96. The quick ratio is considered a more conservative measure of
liquidity than the current ratio because the quick ratio excludes:

A. inventories, which are not necessarily liquid.


B. short-term marketable securities, which may need to be
sold at a significant loss.
C. accounts receivable, which may not be collectible in the
short term.
97. When using net present value (NPV) profiles:

A. one should accept all independent projects with


positive NPVs.
B. the NPV profile's intersection with the vertical y-axis
identifies the project's internal rate of return.
C. one should accept all mutually exclusive projects with
positive NPVs
98. An example of a secondary source of liquidity is:

A. cash flow management.


B. trade credit and bank lines of credit.
C. negotiating debt contracts.
99. Axle Corporation earned £3.00 per share and paid a dividend of
£2.40 on its common stock last year. Its common stock is trading at
£40 per share. Axle is expected to have a return on equity of 15%,
an effective tax rate of 34%, and to maintain its historic payout ratio
going forward. In estimating Axle’s after-tax cost of capital, an
analyst’s estimate of Axle’s cost of common equity would be closest
to:
A. 9.20%
B. 8.80%
C. 9.0%
100. A banker’s acceptance that is priced at $99,145 and
matures in 72 days at $100,000 has a(n):

A. money market yield greater than its discount yield.


B. discount yield greater than its bond equivalent yield.
C. bond equivalent yield greater than its effective annual
yield.

101. Ravencroft Supplies is estimating its weighted average


cost of capital (WACC). Ravencroft’s optimal capital structure
includes 10% preferred stock, 30% debt, and 60% equity. They can
sell additional bonds at a rate of 8%. The cost of issuing new
preferred stock is 12%. The firm can issue new shares of common
stock at a cost of 14.5%. The firm’s marginal tax rate is 35%.
Ravencroft’s WACC is closest to:

A. 13.30%
B. 11.50%
C. 12.30%

102. Steven’s Bakery produces snack cakes and bread.


Listed below are the operating costs for the snack cakes division
and the bread division.

Snack Bread
cakes
Price per package $2.00 $2.50
Variable cost per $1.00 $1.30
package
Fixed operating $25,000 $30,000
costs
Fixed financing $10,000 $10,000
costs
Compared to the snack cakes division, the operating breakeven
quantity for the bread division is:

A. less
B. the same
C. greater
103. A firm has average days of receivables outstanding of
22 compared to an industry average of 29 days. An analyst would
most likely conclude that the firm:

A. has better credit controls than its peer companies.


B. may have credit policies that are too strict.
C. has a lower cash conversion cycle than its peer
companies.

104. Which of the following steps is least likely to be an


administrative step in the capital budgeting process?

A. Arranging financing for capital projects.


B. Conducting a post-audit to identify errors in the
forecasting process.
C. Forecasting cash flows and analyzing project
profitability
105. Enamel Manufacturing (EM) is considering investing in a
new vehicle. EM finances new projects using retained earnings and
bank loans. This new vehicle is expected to have the same level of
risk as the typical investment made by EM. Which one of the
following should the firm use in making its decision?

A. Cost of retained earnings.


B. After-tax cost of debt
C. Marginal cost of capital.

106. The NPV profile is a graphical representation of the


change in net present value relative to a change in the:

A. prime rate.
B. internal rate of return.
C. Discount rate

107. Which of the following statements about the role of the


marginal cost of capital in determining the net present value of a
project is most accurate? The marginal cost of capital should be
used to discount the cash flows:

A. of all projects the firm is considering.


B. for potential projects that have a level of risk near that
of the firm’s average project.
C. if the firm’s capital structure is expected to change
during the project’s life.

108. The interests of community groups affected by a


company's operations are most likely to be considered in corporate
governance under:
A. shareholder theory.
B. stakeholder theory.
C. special interest theory.
109. Utilitarian Co. is looking to expand its appliances
division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal
tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc.
is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of
3, a marginal tax rate of 40%, and its debt is currently yielding
6.8%. The risk-free rate is currently 5% and the expected return on
the market portfolio is 9%. Using this data, calculate Utilitarian’s
weighted average cost of capital for this potential expansion.

A. 4.20%
B. 7.10%
C. 5.70%
110. Which of the following statements about NPV and IRR is
NOT correct?

A. The NPV will be positive if the IRR is less than the cost
of capital.
B. The IRR can be positive even if the NPV is negative.
C. When the IRR is equal to the cost of capital, the NPV
equals zero.
111. If two projects are mutually exclusive, a company:

A. must accept both projects or reject both projects.


B. can accept one of the projects, both projects, or neither
project.
C. can accept either project, but not both projects.

112. Which of the following statements about business risk


and financial risk is least accurate?

A. Business risk is the riskiness of the company's assets if


it uses no debt.
B. The greater a company's business risk, the higher its
optimal debt ratio.
C. Factors that affect business risk are demand, sales
price, and input price variability.
113. Ignoring tax consequences, given a choice between a
cash dividend and a share repurchase of the same amount, a
rational investor would:

A. prefer a cash dividend to a share repurchase.


B. prefer a share repurchase to a cash dividend.
C. be indifferent between a cash dividend and a share
repurchase.
114. The effect of a company announcement that they have
begun a project with a current cost of $10 million that will generate
future cash flows with a present value of $20 million is most likely
to:

A. only affect value of the firm’s common shares if the


project was unexpected.
B. increase the value of the firm’s common shares by $20
million.
C. increase value of the firm’s common shares by $10
million.

115. Which justification for repurchasing stock is the least


valid?

A. Repurchases offer shareholders more choices than


cash dividends.
B. A cash dividend increase, in response to short-term
excess cash flows, may confuse investors.
C. Shareholders prefer capital gains to cash dividends.

116. A firm records the following cash flows on the same day:
$250 million from debt proceeds; $100 million funds transferred to a
subsidiary; $125 million in interest payments; and $30 million in tax
payments. The net daily cash position:

A. improved.
B. remained the same.
C. worsened.
117. Which of the following types of capital budgeting projects
are most likely to generate little to no revenue?

A. Replacement projects to maintain the business.


B. Regulatory projects.
C. New product or market development.

118. In order to more accurately estimate the cost of equity for


a company situated in a developing market, an analyst should:

A. add a country risk premium to the market risk premium


when using the capital asset pricing model (CAPM).
B. use the yield on the sovereign debt of the developing
country instead of the risk free rate when using the
capital asset pricing model (CAPM).
C. add a country risk premium to the risk-free rate when
using the capital asset pricing model (CAPM).
119. Mason Webb makes the following statements to his
boss, Laine DeWalt about the principles of capital budgeting.

Statement 1: Opportunity costs are not true cash outflows and


should not be considered in a capital budgeting analysis.

Statement 2: Cash flows should be analyzed on an after-tax


basis. Should DeWalt agree or disagree with Webb’s
statements?

Statement 1 Statement 2
A. Agree Agree
B. Disagree Disagree
C. Disagree Agree
120. In a recent staff meeting, David Hurley, stated that
analysts should understand that financial ratios mean little by
themselves. He advised his colleagues to evaluate financial ratios
carefully. During the discussion he made the following statements:

Statement 1: A company can be compared with others in its


industry by relating its financial ratios to industry norms. However,
care must be taken because many ratios are industry-specific, but
not all ratios are important to all industries.

Statement 2: Comparing a company to the overall economy is


useless because overall business conditions are constantly
changing. Specifically, it is not the case that financial ratios tend to
improve when the economy is strong and weaken during
recessionary times.

Are statements 1 and 2 as made by Hurley regarding financial ratio


analysis
CORRECT?

Statement 1 Statement 2
A. Incorrect Correct
B. Correct Correct
C. Correct Incorrect

121. Smith Company's board of directors assigns


responsibilities to three committees. The committee that is most
likely to be responsible for establishing the chief executive officer's
compensation package is Smith's:

A. investment and risk committee.


B. nominations and remuneration committee.
C. audit and governance committee.
122. Which of the following is NOT a limitation to financial
ratio analysis?

A. The need to use judgment.


B. A firm that operates in only one industry.
C. Differences in international accounting practices.

123. For a project with cash outflows during its life, the least
preferred capital budgeting tool would be:

A. net present value.


B. internal rate of return.
C. profitability index.

124. Agora Systems Inc. has the following capital structure


and cost of new capital:

Book Value Market Value Cost of


Issuing
Debt $50 million $58 million 5.3%
Preferred stock $25 million $28 million 7.2%
Common stock $200 million $525 million 8.0%
Total capital $275 million $611 million

What is Agora’s weighted-average cost of capital if its marginal tax


rate is 40%?

A. 6.23%
B. 7.50%
C. 8.02%
125. Compared to the prior period, a firm has greater days of
receivables. The effect on the firm’s cash conversion cycle and
operating cycle are most likely a(n):

Cash conversion Operating cycle


A. Increase Increase
B. Increase Decrease
C. Decrease Increase

126. Which of the following best describes a firm with low


operating leverage? A large change in:

A. earnings before interest and taxes result in a small


change in net income.
B. sales result in a small change in net income.
C. the number of units a firm produces and sells result in a
similar change in the firm’s earnings before interest and
taxes.

127. The stakeholder theory of corporate governance is


primarily focused on:

A. the interests of various stakeholders rather than the


interests of shareholders.
B. resolving the competing interests of those who manage
companies and other groups affected by a company's
actions.
C. increasing the value, a company.
128. Stock splits:

A. are less common than stock dividends.


B. increase firm value.
C. do not in and of themselves affect firm value.

129. Which of the following statements concerning the


principles underlying the capital budgeting process is most
accurate?

A. Cash flows should be based on opportunity costs.


B. Financing costs should be reflected in a project's
incremental cash flows.
C. The net income for a project is essential for making a
correct capital budgeting decision.

130. Which of the following statements about the payback


period method is Least accurate? The payback period:

A. provides a rough measure of a project's liquidity.


B. considers all cash flows throughout the entire life of a
project.
C. is the number of years it takes to recover the original
cost of the investment.

131. Which of the following statements about NPV and IRR is


Least accurate?

A. The IRR is the discount rate that equates the present


value of the cash inflows with the present value of
outflows.
B. For mutually exclusive projects, if the NPV method and
the IRR method give conflicting rankings, the analyst
should use the IRRs to select the project.
C. The NPV method assumes that cash flows will be
reinvested at the cost of capital, while IRR rankings
implicitly assume that cash flows are reinvested at the
IRR.

132. Which of the following statements is Least accurate?


The discounted payback period:

A. frequently ignores terminal values.


B. is generally shorter than the regular payback.
C. is the time it takes for the present value of the project's
cash inflows to equal the initial cost of the investment.

133. Which of the following statements about NPV and IRR is


Least accurate?

A. The IRR can be positive even if the NPV is negative.


B. When the IRR is equal to the cost of capital, the NPV
will be zero.
C. The NPV will be positive if the IRR is less than the cost
of capital.

Use the following data to answer Questions 134 through 138


A company is considering the purchase of a copier that costs
$5,000. Assume a required rate of return of 10% and the following
cash flow schedule: •
134. What is the project's payback period?

A. 1.5 years.
B. 2.0 years.
C. 2.5 years.

135. The project's discounted payback period is closest to:

A. 1.4 years.
B. 2.0 years.
C. 2.4 years.

136. What is the project's NPV?

A. -$309.
B. +$883.
C. +$1 ,523.

137. The project's IRR is closest to:

A. 1 0%.
B. 1 5%.
C. 20%.

138. What is the project's profitability index (PI)?

A. 0.72.
B. 1.1 8.
C. 1.72.
139. An analyst has gathered the following information about
a project:
• Cost $10,000
• Annual cash inflow $4,000
• Life 4 years
• Cost of capital 12%
Which of the following statements about the project is least
accurate?

A. The discounted payback period is 3.5 years.


B. The IRR of the project is 21.9%; accept the project.
C. The NPV of the project is +$2, 1 49; accept the project.

Use the following data for Questions 140 and 141


An analyst has gathered the following data about two projects, each
with a 12% required rate of return.

140. If the projects are independent, the company should:

A. accept Project A and reject Project


B. B. reject Project A and accept Project B.
C. accept both projects.

141. If the projects are mutually exclusive, the company


should:
A. reject both projects.
B. accept Project A and reject Project B.
C. reject Project A and accept Project B.
142. The NPV profiles of two projects will intersect:

A. at their internal rates of return.


B. if they have different discount rates.
C. at the discount rate that makes their net present values
equal.

143. The post-audit is used to:

A. improve cash flow forecasts and stimulate management


to improve operations and bring results into line with
forecasts.
B. improve cash flow forecasts and eliminate potentially
profitable but risky projects.
C. stimulate management to improve operations, bring
results into line with forecasts, and eliminate potentially
profitable but risky projects.

144. Based on surveys of comparable firms, which of the


following firms would be most likely to use NPV as its preferred
method for evaluating capital projects?

A. A small public industrial company located in France.


B. A private company located in the United States.
C. A large public company located in the United States.

145. Fullen Machinery is investing $400 million in new


industrial equipment. The present value of the future after-tax cash
flows resulting from the equipment is $700 million. Fullen currently
has 200 million shares of common stock outstanding, with a current
market price of $36 per share. Assuming that this project is new
information and is independent of other expectations about the
company, what is the theoretical effect of the new equipment on
Fullen's stock price? The stock price will:

A. decrease to $33.50.
B. increase to $37.50.
C. increase to $39.50.

146. A company has $5 million in debt outstanding with a


coupon rate of 12%. Currently, the yield to maturity (YTM) on these
bonds is 14%. If the firm's tax rate is 40%, what is the company's
after-tax cost of debt?

A. 5.6%.
B. 8.4%.
C. 14.0%.

147. The cost of preferred stock is equal to:

A. the preferred stock dividend divided by its par value.


B. [(1 - tax rate) times the preferred stock dividend] divided by
price.
C. the preferred stock dividend divided by its market price.

148. A company's $100, 8% preferred is currently selling for


$85. What is the company's cost of preferred equity?

A. 8.0%.
B. 9.4%.
C. 10.8%.
149. The expected dividend is $2.50 for a share of stock
priced at $25. What is the cost of equity if the long-term growth in
dividends is projected to be 8%?

A. 15%.
B. 16%.
C. 18%.

150. An analyst gathered the following data about a


company:

Capital structure Required rate of return


30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the
company earn on its investments?

A. 13.0%.
B. 14.2%.
C. 18.0%.

151. A company is planning a $50 million expansion. The


expansion is to be financed by selling $20 million in new debt and
$30 million in new common stock. The before-tax required return
on debt is 9o/o and 14% for equity. If the company is in the 40% tax
bracket, the company's marginal cost of capital is closest to:
A. 7.2%.
B. 10.6%.
C. 12.0%.

Use the following data to answer Questions 152 through 155


• The company has a target capital structure of 40% debt and 60%
equity.
• Bonds with face value of $ 1,000 pay a 10% coupon
(semiannual), mature in 20 years, and sell for $849.54 with a yield
to maturity of 12%.
• The company stock beta is 1.2.
• Risk-free rate is 10%, and market risk premium is 5%.
• The company is a constant-growth firm that just paid a dividend of
$2, sells for $27 per share, and has a growth rate of 8%.
• The company's marginal tax rate is 40%.

152. The company's after-tax cost of debt is:

A. 7.2%.
B. 8.0%.
C. 9.1 %.

153. The company's cost of equity using the capital asset


pricing model (CAPM) approach is:

A. 16.0%.
B. 16.6%.
C. 16.9%.

154. The company's cost of equity using the dividend


discount model is:
A. 15.4%.
B. 16.0%.
C. 16.6%.

155. The company's weighted average cost of capital (using


the cost of equity from CAPM) is closest to:

A. 12.5%.
B. 13.0%.
C. 13.5%.

156. What happens to a company's weighted average cost of


capital (WACC) if the firm's corporate tax rate increases and if the
Federal Reserve causes an increase in the risk-free rate,
respectively? (Consider the events independently and assume a
beta of less than one.)

Tax rate increase Increase in risk-free rate


A. Decrease WACC Increase WACC
B. Decrease WACC Decrease WACC
C. Increase WACC Increase WACC

157. Given the following information on a company's capital


structure, what is the company's weighted average cost of capital?
The marginal tax rate is 40%.

158. Derek Ramsey is an analyst with Bullseye Corporation,


a major U.S.-based discount retailer. Bullseye is considering
opening new stores in Brazil and wants to estimate its cost of
equity capital for this investment. Ramsey has found that:
• The yield on a Brazilian government 10-year U.S. dollar-
denominated bond is 7.2%.
• A 10-year U.S. Treasury bond has a yield of 4.9%.
• The annualized standard deviation of the Sao Paulo Bovespa
stock index in the most recent year is 24%.
• The annualized standard deviation of Brazil's U.S. dollar-
denominated 1 0-year government bond over the last year was
18%.
• The appropriate beta to use for the project is 1 .3.
• The market risk premium is 6o/o. • The risk-free interest rate is
4.5%.
Which of the following choices is closest to the appropriate country
risk premium for Brazil and the cost of equity that Ramsey should
use in his analysis?

Country risk premium for Brazil Cost of equity for project


A. 2.5% 15.60%
B. 2.5% 16.30%
C. 3.1% 16.30%

159. Manigault Industries currently has assets on its balance


sheet of $200 million that are financed with 70o/o equity and 30o/o
debt. The executive management team at Manigault is considering
a major expansion that would require raising additional capital.
Rosannna Stallworth, the CPO of Manigault, has put together the
following schedule for the costs of debt and equity:

In a presentation to Manigault's Board of Directors, Stallworth


makes the following statements:
Statement 1: If we maintain our target capital structure of 70%
equity and 30% debt, the break point at which our cost of equity will
increase to 8.0% is $ 1 85 million in new capital.
Statement 2: If we want to finance total assets of $450 million, our
marginal cost of capital will increase to 7.56%. Are Stallworth's
Statements 1 and 2 most Likely correct or incorrect?
Statement 1 Statement 2
A. Correct Correct
B. Incorrect Correct
C. Incorrect Incorrect

160. Black Pearl Yachts is considering a project that requires


a $1 80,000 cash outlay and is expected to produce cash flows of
$50,000 per year for the next five years. Black Pearl's tax rate is
25%, and the before-tax cost of debt is 8%. The current share price
for Black Pearl's stock is $56 and the expected dividend next year
is $2.80 per share. Black Pearl's expected growth rate is 5%.
Assume that Black Pearl finances the project with 60% equity and
40% debt, and the flotation cost for equity is 4.0%. The appropriate
discount rate is the weighted average cost of capital (WACC).
Which of the following choices is closest to the dollar amount of the
flotation costs and the NPV for the project, assuming that flotation
costs are accounted for properly?
Dollar amount of flotation costs NPV of project
A. $4,320 $ 17,548
B. $4,320 $ 13,228
C. $7,200 $ 17,548

161. Jay Company has a debt-to-equity ratio of 2.0. Jay is


evaluating the cost of equity for a project in the same line of
business as Cass Company and will use the pure-play method with
Cass as the comparable firm. Cass has a beta of 1 .2 and a debt-
to-equity ratio of 1.6. The project beta most Likely:

A. will be less than Jay Company's beta.


B. will be greater than Jay Company's beta.
C. could be greater than or less than Jay Company's beta.

162. Business risk is the combination of:

A. operating risk and financial risk.


B. sales risk and financial risk.
C. operating risk and sales risk.

163. Which of the following is a key determinant of operating


leverage?

A. Level and cost of debt.


B. The competitive nature of the business.
C. The trade-off between fixed and variable costs.

164. Which of the following statements about capital structure


and leverage is most accurate?

A. Financial leverage is directly related to operating leverage.


B. Increasing the corporate tax rate will not affect capital structure
decisions.
C. A firm with low operating leverage has a small proportion of its
total costs in fixed costs.

165. Jayco, Inc., sells blue ink for $4 a bottle. The ink's
variable cost per bottle is $2. Ink has fixed operating costs of
$4,000 and fixed financing costs of $6,000. What is Jayco's
breakeven quantity of sales, in units?
A. 2,000.
B. 3,000.
C. 5,000.

166. Jayco, Inc., sells blue ink for $4 a bottle. The ink's
variable cost per bottle is $2. Ink has fixed operating costs of
$4,000 and fixed financing costs of $6,000. What is Jayco's
operating breakeven quantity of sales, in units?

A. 2,000.
B. 3,000.
C. 5,000.

167. If Jayco's sales increase by 10%, Jayco's EBIT


increases by 15%. If]ayco's EBIT increases by 10%, Jayco's EPS
increases by 12%. Jayco's degree of operating leverage (DOL) and
degree of total leverage (DTL) are closest to:

A. 1.2 DOL and 1.5 DTL.


B. 1.2 DOL and 2.7 DTL.
C. 1.5 DOL and 1.8 DTL.

Use the following data to answer Questions 168 and 169


Jayco, Inc., sells 10,000 units at a price of $5 per unit. Jayco's fixed
costs are $8,000, interest expense is $2,000, variable costs are $3
per unit, and EBIT is $12,000.

168. Jayco's degree of operating leverage (DOL) and degree


of financial leverage (DFL) are closest to:

A. 2.50 DOL and 1 .00 DFL.


B. 1.67 DOL and 2.00 DFL.
C. 1.67 DOL and 1.20 DFL.

169. Jayco's degree of total leverage (DTL) is closest to:

A. 2.00.
B. 1.75.
C. 1.50.

170. Vischer Concrete has $1.2 million in assets that are


currently financed with 100% equity. Vischer's EBIT is $300,000,
and its tax rate is 30%. IfVischer changes its capital structure
(recapitalizes) to include 40% debt, what is Vischer's ROE before
and after the change? Assume that the interest rate on debt is 5%.

ROE at 100% equity ROE at 60% equity


A. 17.5% 26.8%
B. 25.0% 26.8%
C. 25.0% 37.5%

171. Which of the following is most likely to increase


shareholders' wealth?

A. A stock dividend.
B. A stock split.
C. A special dividend.

172. Which of the following is most accurate? The purchaser


of a stock will not receive the dividend if the stock was purchased
on or after the:
A. declaration date.
B. ex-dividend date.
C. holder-of-record date.

173. A share repurchase that begins with a company


communicating to shareholders a specific number of shares and a
range of acceptable prices is most likely to be a(n):

A. open market repurchase.


B. fixed price tender offer.
C. Dutch auction.
174. If a company's after-tax borrowing rate is greater than
the company's earning yield when the company repurchases stock
with borrowed money, going forward, the earnings per share is
most likely to:

A. Increase.
B. decrease.
C. remain unchanged.

175. After a share repurchase, book value per share is most


likely to increase if, pre-purchase, BVPS was:

A. greater than the market price per share.


B. less than the market price per share.
C. negative.

176. A company is considering either an open market share


repurchase or a cash dividend of an equal amount. Compared to
the open market share repurchase, the cash dividend is most likely
to:

A. increase a shareholder's wealth by a greater amount.


B. increase a shareholder's wealth by a lesser amount.
C. have a relative impact that depends on the tax treatment of the
two alternatives.

177. Studdard Controls recently declared a quarterly dividend


of $ 1.25 payable on Thursday, April 25, to holders of record on
Friday, April 12. What is the last day an investor could purchase
Studdard stock and still receive the quarterly dividend?
A. April 9.
B. April 10.
C. April 12.

178. Arizona Seafood, Inc., plans $45 million in new


borrowing to repurchase 3,600,000 shares at their market price of $
12.50. The yield on the new debt will be 12%. The company has 36
million shares outstanding and EPS of $0.60 before the
repurchase. The company's tax rate is 40%. The company's EPS
after the share repurchase will be closest to:
A. $0.50.
B. $0.57.
C. $0.67.

179. Northern Financial Co. has a BVPS of $5. The company


has announced a $15 million share buyback. The share price is
$60 and the company has 40 million shares outstanding. After the
share repurchase, the company's BVPS will be closest to:
A. $4.65.
B. $4.90.
C. $5.03.
180. Firm A and Firm B have the same quick ratio, but Firm A
has a greater current ratio than Firm B. Compared to Firm B, it is
most Likely that Firm A has:
A. greater inventory.
B. greater payables.
C. a higher receivables turnover ratio.

181. An increase in Rowley Corp's cash conversion cycle and


a decrease in Rowley's operating cycle could result from:

Cash conversion cycle (+) Operating cycle (-)


A. Decreased receivables turnover Increased payables turnover
B. Decreased receivables turnover Decrease in days of
inventory
C. Increased inventory turnover Increased payables turnover

182. An example of a primary source of liquidity is:


A. liquidating assets.
B. negotiating debt contracts.
C. short-term investment portfolios.

183. Which of the following statements most accurately


describes a key aspect of managing a firm's net daily cash
position?
A. Analyze cash inflows and outflows to forecast future needs for
cash.
B. Maximize the firm's cash inflows and minimize its cash outflows.
C. Minimize uninvested cash balances because they earn a return
of zero.

184. Boyle, Inc., just purchased a banker's acceptance for


$25,400. It will mature in 80 days for $26,500. The discount-basis
yield and the bond equivalent yield for this security are closest to:

Discount-basis Bond equivalent


A. 18.7% 18.7%
B. 18.7% 19.8%
C. 4.2% 19.8%

185. Blodnick Corp. has found that its weighted average


collection period has increased from 50 days last year to 55 days
this year, and its average days of receivables this year is 48
compared to 52 last year. It is most Likely that:

A. Blodnick has relaxed its credit standards this year.


B. Blodnick's credit customers are paying more slowly this year.
C. credit sales are a greater part of Blodnick's business this year.

186. Chapmin Corp. is a large domestic services firm with a


good credit rating. The source of short-term financing it would most
Likely use is:

A. factoring of receivables.
B. issuing commercial paper.
C. issuing bankers' acceptances.

187. Which of the following board characteristics would least


likely be an indication of high-quality corporate governance?
A. Board members have staggered terms.
B. The board can hire independent consultants.
C. The board has a separate committee to set executive pay.
188. Which of the following board members would most likely
be considered well chosen based on the principles of good
corporate governance?

A. A board member of Company B who is also the CEO of


Company B.
B. A board member of Company B who is a partner in an
accounting firm that competes with the firm's auditor.
C. A board member of Company A who is president of Company B,
when the CFO of Company A sits on Company B's board.

189. Which of the following is least likely to enable a


corporate board to exercise its duty by acting in the long-term
interest of shareholders?
A. The board meets regularly outside the presence of
management.
B. A majority of the board members are independent of firm
management. C. The board has representatives from key suppliers
and important customers.

190. Which of the following would most likely be considered a


negative factor in assessing the suitability of a board member? The
board member:
A. has served for ten years.
B. has served on other boards.
C. is a former CEO of another firm.

191. Which of the following would least likely be an indication


of poor corporate governance?
A. A board member leases office space to the company in a
building he owns. B. There are board members who do not have
previous experience in the industry in which the firm operates.
C. A board member has a consulting contract with the firm to
provide strategic vision for the technology research and
development effort.

192. Which of the following would most likely be considered a


poor corporate practice in terms of promoting shareholder
interests?
A. The firm can use "share blocking."
B. The firm uses a third party to tabulate shareholder votes.
C. Voting for board members does not allow cumulative voting by
shareholders of all votes allotted to their shares.

193. Two analysts are discussing shareholder defenses


against hostile takeovers. Alice states, "It is positive for
shareholders that the board has shown a willingness to buy back
shares from holders who may be in a position to effect a hostile
takeover of the firm at less than its long-term value to
shareholders." Bradley states, "Firms that are likely takeover
targets should offer valuable exit packages in the event of a hostile
takeover because they are necessary to recruit highly talented top
executives, such as the CEO." From the perspective of good
corporate governance, are these statements correct?
A. Both statements are correct.
B. Neither statement is correct.
C. Only one of the statements is correct.

194. An analyst calculates the following leverage ratios for


Burkhardt Company and Dutchin Company

If both companies' sales increase by 5%, what are the most likely
effects on the companies' earnings before interest and taxes (EBIT)
and earnings per share (EPS)?
A. Both companies' EBIT will increase by the same percentage.
B. Dutchin's EPS will increase by a larger percentage than
Burkhardt's EPS. C. Burkhardt's EBIT will increase by a larger
percentage than Dutchin's EBIT.

195. Which of the following would most likely lead to an


increase in a typical firm's capital investment for the current period?
A. A need to increase inventory.
B. An increase in the firm's expected marginal tax rate.
C. A decrease in the market value of the firm's debt.

196. Which of the following changes in a firm's working


capital management is most likely to result in a shorter operating
cycle?
A. Reducing stock-outs by carrying greater quantities of inventory.
B. Stretching its payables by paying on the last permitted date.
C. Changing its credit terms for customers from 2/10, net 60 to
2/10, net 30.

197. A company's operations analyst is evaluating a plant


expansion project that is likely to be financed in part by issuing new
common equity. Flotation costs are expected to be 4o/o of the
amount of new equity capital raised. The most appropriate way for
the analyst to treat the flotation costs is to:
A. ignore them, because flotation costs for common equity are
likely to be nonmaterial.
B. estimate the cost of equity capital based on a share price 4%
less than the current price.
C. determine the flotation cost attributable to this project and treat it
as part of the project's initial cash outflow.

198. A board of directors is most likely to act in the long-term


interest of shareholders if:
A. all board members are elected annually.
B. most board members are selected from outside the company's
industry. C. there are board members who represent the company's
key supplier and largest customer

199. The manufacturer of Pow Detergent has developed New


Improved Pow with Dirteaters and is considering adding it to its
product line. New Improved Pow would sell at a premium price
compared to Pow. In order to manufacture New Improved Pow, the
firm will need to build a new facility and purchase new equipment.
Which of the following is least likely included when calculating the
appropriate cash flows for analysis of whether to add New
Improved Pow to its product line?
A. Expected depreciation on the new facility and equipment for tax
purposes. B. Costs of a marketing survey performed last month to
decide whether to introduce New Improved Pow.
C. Reduced sales of Pow that result from the introduction of New
Improved Pow.

200. Acme Corp. has reported the following financial ratios


for the past two years:

Based only on these results, an analyst would most correctly


conclude that the results in year 20X1 compared to those in year
20X0 indicate that Acme's ROE has:
A. declined, in part due to lower profitability.
B. increased because the company has used more debt financing.
C. increased because of the improvement in asset utilization.
201. The use of secondary sources of liquidity would most
likely be considered:
A. a normal part of daily business for a company.
B. a signal that a company's financial position is deteriorating.
C. a lower-cost source of short-term financing compared to primary
sources of liquidity.

202. A firm's debt-to-equity ratio is most likely to increase as


a result of a(n):
A. extra dividend.
B. stock dividend.
C. purchase of a machine for cash.

203. A firm is evaluating two mutually exclusive projects of


the same risk class, Project X and Project Y. Both have the same
initial cash outlay and both have positive NPVs. Which of the
following is a sufficient reason to choose Project X over Project Y?
A. Project Y has a lower profitability index than Project X.
B. Project X has both a shorter payback period and a shorter
discounted payback period compared to Project Y.
C. Project Y has a lower internal rate of return than Project X.
Corporate Finance (answers)
1. Which action is most likely considered a secondary source of
liquidity?

A. Increasing the efficiency of cash flow management


B. Renegotiating current debt contracts to lower interest payments
C. Increasing the availability of bank lines of credit

Answer: B

B is correct. Renegotiating debt contracts is a secondary source of


liquidity because it may affect the company’s operating and/or
financial positions. A is incorrect. Increasing cash flow management
efficiency is a primary source of liquidity. C is incorrect. Increasing
bank lines of credit is a primary source of liquidity.

2. Which of the following is most likely considered an example of


matrix pricing when determining the cost of debt?

A Debt-rating approach only.


B Yield-to-maturity approach only.
C Both the yield-to-maturity and the debt-rating approaches.

Answer: A

A is correct. The debt-rating approach is an example of matrix pricing.


B is incorrect because the yieldto-maturity approach is not an
example of matrix pricing. C is incorrect because the yield-to--
maturity approach is not an example of matrix pricing.

3. Given the following information, the degree of operating


leverage (DOL) is closest to:
A. 2.4.
B. 1.1.
C. 1.7.
Answer: A

DOL= (9.8-7.2)/(9.8-7.2-1.5)=2.36

4. Other factors held constant, the reduction of a company’s


average accounts payable because of suppliers offering less trade
credit will most likely:

A not affect the operating cycle.


B reduce the operating cycle.
C increase the operating cycle.

Answer: A

A is correct. Payables are not part of the operating cycle calculation,


which includes receivables and inventory. B is incorrect. As per
above, payables are not part of the operating cycle calculation. C is
incorrect. As per above, payables are not part of the operating cycle
calculation.

5. A firm’s estimated costs of debt, preferred stock, and common


stock are 12%, 17%, and 20%, respectively. Assuming equal funding
from each source and a marginal tax rate of 40%, the weighted
average cost of capital (WAAC) is closest to:

A 13.9%.
B 14.7%.
C 16.3%.

Answer: B

B is correct. WACC = wdrd(1 – t) + wprp + were = [0.12 × (1 –


0.40) + 0.17 + 0.20]/3 = 14.73%.

6. Which of the following statements is the most appropriate


treatment of flotation costs for capital budgeting purposes? Flotation
costs should be:

A expensed in the current period.


B incorporated into the estimated cost of capital.
C deducted as one of the project’s initial-period cash flows.

Answer:
C

C is correct. Flotation costs are an additional cost of the project


and should be incorporated as an adjustment to the initial-period
cash flows in the valuation computation. A is incorrect. Expensing
is an accounting treatment of the costs, not a capital budgeting
treatment. B is incorrect. Including the flotation cost in the
estimated cost of capital is theoretically incorrect. By doing so we
are adjusting the present value of the future cash flows by a fixed
percentage, i.e., the adjusted cost of capital.

7. Given two mutually exclusive projects with normal cash flows,


the point at which their net present value profiles intersect the
horizontal axis is most likely the projects’:

A weighted average cost of capital.


B crossover rate.
C internal rate of return.

Answer: C

C is correct. For a project with normal cash flows, the NPV profile
intersects the horizontal axis at the point where the discount rate
equals the IRR. The crossover rate is the discount rate at which the
NPVs of the projects are equal. Although it is possible that the
crossover rate is equal to each project’s IRR, it is not a likely event.
It is also possible that the IRR is equal to the WACC, but that
scenario is not the most likely one. B is incorrect. The crossover
rate is the discount rate at which the NPVs of the projects are equal.
While it is possible that the crossover rate is equal to each project’s
IRR, it is not a likely event. A is incorrect. The project’s net present
value (NPV) occurs when the NPV profile intersects the vertical axis
or when the discount rate = 0.

8. Based on best practices in corporate governance procedures,


it is most appropriate for a company’s compensation committee to:

A link compensation with longterm objectives.


B include a retired executive from the firm.
C include a representative from the firm’s external auditor.

Answer: A

A is correct. Under appropriate corporate governance procedures,


the compensation committee should link compensation with long--
term objectives. B is incorrect because the committee should be
composed of independent members only. Good corporate
governance procedures would require that executive (internal)
directors not rule on matters underlying conflicts of interest or on
matters requiring an unbiased judgment (such as audit,
remuneration, or related-party transaction matters). Retired
executives and external auditors are not independent and should
not be a part of the compensation committee. C is incorrect
because the committee should be composed of independent board
members only. Good corporate governance procedures would
require that executive (internal) directors not rule on matters
underlying conflicts of interest or on matters requiring an unbiased
judgment (such as audit, remuneration, or related-party transaction
matters). Retired executives and external auditors are not
independent and should not be a part of the compensation
committee.

9. A company has a fixed $1,100 capital budget and has the


opportunity to invest in the four independent projects listed in the
table:

The combination
of projects that provides the best choice is:
A. 2, 3, and 4.
B. 1, 3, and 4.
C. 1 and 2.

Answer:
A

A is correct. The company should choose the combination of


projects that maximizes net present value (NPV) subject to the
budget constraint of $1,100.

Invest.
Projects Required NPV Decision
1 1+ 2 600 + 500 100 + 100 =200
=1,100
600 + 300
1 1+3+4 +200=1,100 100+50+50=200
500 + 300 NPV = $200 with the
22 2+3+4 +200=1,000 100+50+50=200 least investment

10. Introduction of a new model causes a decline in sales of a car


manufacturer’s older models. This is most likely an example of:

A. An externality.
B. A sunk cost.
C. An opportunity cost.

Answer: A

Cannibalization of sales is an example of a negative externality.

11. The NPV profile of Project A is steeper than that of Project B.


Which of the following is most likely that the crossover point occurs
at an NPV of $5,000?

A. Project B has higher total cash inflows.


B. Project A receives most of its cash flows later in its life.
C. Project A has a higher IRR.

Answer: B

12. A drag on liquidity is most likely to occur when:

A. There is a delay in cash coming into the company.


B. Cash leaves the company too quickly.
C. The company loses creditworthiness.

Answer: A
A drag on liquidity is most likely to occur when there is a delay in
cash coming into the company.

13. Consider the following statements:

Statement 1: Dual-class share structures can easily be changed


over time.

Statement 2: Activist investors tend to have little impact on the


company’s long-term investors. Which of the following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are incorrect.

Answer: C

Dual-share systems are virtually impossible to dismantle once they


are in place.

It is very important for long-term investors to consider how activist


investors affect the company, as they can materially change a
company’s strategic direction.

14. A project’s beta is least likely to be exposed to:

A. Business risk.
B. Financial risk.
C. Default risk.

Answer: C

Default risk is a consideration when investing in a bond. It has


nothing to do with the risk associated with investing in a particular
project.
15. ABC Company currently has a debt‐to‐equity ratio of 0.3. Its
target debt‐to‐equity ratio is 0.4. The risk‐free rate is 6%, and
expected equity market return is 12%. ABC is considering a project
that has a beta of 1.2. Given that the company’s after‐tax cost of
debt is 7%, and the applicable tax rate is 40%, the WACC that
should be used in evaluating this project is closest to:

A. 10.63%.
B. 11.43%.
C. 11.77%.

Answer: B

Cost of equity = 0.06 + 1.2 (0.12 − 0.06) = 13.2%


Using component weights in the target capital structure: WACC =
[0.132 × (1 / 1.4)] + [0.07 × (0.4 / 1.4)] = 11.43%

16. An analyst gathered the following information about a


company:

Credit sales $30,000


Cost of goods sold $17,000
Accounts $4,000
receivable
Closing inventory $2,750
Accounts payable $2,000
Purchases $12,000
The operating cycle for the company is closest to:

A. 47 days.
B. 169 days.
C. 108 days.

Answer: C

Number of days of inventory = 2,750 / (17,000 / 365) = 59.04 days


Number of days of receivables = 4,000 / (30,000 / 365) = 48.67
days Operating cycle = 59.04 + 48.67 = 107.7 days

17. Williams Inc. borrows $1.5m for a month through a banker’s


acceptance. The company is offered an all‐inclusive rate of 9%. Its
effective borrowing cost is closest to:

A. 9.00%.
B. 9.23%.
C. 9.07%.

Answer: C

18. Aztec Ltd. is considering investing $650 million in a new


project. The CFO of the company tells the directors that the present
value of the net cash flows that will be generated from the project will
be around $800 million. The company has 7 million shares
outstanding with a market price of $120 each. The price of the
company’s shares if it undertakes the new project will be closest to:

A. $114.29.
B. $135.72.
C. $141.43.

Answer: C

Net present value of the project = 800 – 650 = $150 million


Current market value of the company = 7 × 120 = $840
million
Market value of the company if it undertakes the project = 840
+ 150 = $990 million New share price = 990 / 7 = $141.43
19. Which of the following approaches is least likely to be used in
determining a company’s cost of debt?

A. Yield to maturity approach


B. Pure‐play approach
C. Debt rating approach

Answer: B
The pure‐play method is used to estimate the beta of a project,
which is then used to determine the cost of equity.

20. Which of the following is least likely one of the principles of


capital budgeting?

A. The timing of cash flows is very important.


B. Financing costs must be considered in the calculation of
operating cash flows.
C. Projects are evaluated based on incremental cash flows over
and above their opportunity costs.

Answer: B

Financing costs should not be considered in the calculation of


operating cash flows. Financing costs are considered in the
discount rate (required rate of return).

21. The point of intersection between the marginal cost of capital


and the investment opportunity schedule is known as the:

A. Crossover rate.
B. Optimal capital budget.
C. WACC

Answer: B
The optimal capital budget occurs at the point where the MCC
schedule intersects the investment opportunity schedule.

22. All other factors remaining the same, which of the following
statements is most likely regarding yields on short-term
investments?

A. The money market yield will be greater than the bond equivalent
yield.
B. The discount basis yield will be lower than the money market
yield.
C. The discount basis yield will be greater than the bond equivalent
yield.

Answer: B

• The discount basis yield will be lower than the money


market yield, as it is based on the face value, not the price.
Because the face value of a discounted instrument is greater
than its price, the discount basis yield will be lower.
• The bond equivalent yield is greater than the money market
yield because it is annualized over a 365‐day year, whereas
the money market yield uses a 360‐day year.
• The discount basis yield can be greater than or less than the
bond equivalent yield.

23. Consider the following statements:

Statement 1: Any amendments to the company’s bylaws typically


occur at Extraordinary General Meetings (EGMs).

Statement 2: Proxy voting is adopted as a practice in order to


protect the rights of creditors. Which of the following is most
likely?

A. Only Statement 1 is correct.


B. Only Statement 2 is correct.
C. Both statements are incorrect.

Answer: A

An amendment to corporate bylaws would normally take place


during an EGM, which covers significant changes to a company,
such as bylaw amendments.

Proxy voting is put in place to protect shareholders. Debtholders


use collateral and covenants to protect their interests.

24. Michael wants to calculate the WACC for a company which has
$6 million worth of debt outstanding with an interest rate of 7%. The
company is expected to issue new debt at an interest rate of 8%.
Assuming a tax rate of 40%, the company’s after‐tax cost of debt to
be used in calculating the WACC is closest to:

A. 4.2%.
B. 7%.
C. 4.8%.

Answer: C

After‐tax cost of debt = 0.08 × (1 − 0.4) = 4.8%

25. A manufacturing firm issues a semi‐annual coupon bond to


finance a new project. The bond has a par value of $1,000, offers a
coupon rate of 9%, and will mature in 15 years. Given that the
bond’s current market value is $1,020.63, and the applicable tax rate
is 35%, the company’s after‐ tax cost of debt is closest to:

A. 4.38%.
B. 8.75%.
C. 5.69%.

Answer: C
N = 30; PV = –$1,020.63; FV = $1,000; PMT = $45; CPT I/Y; I/Y =
4.375

The yield to maturity on a BEY basis equals 4.375 × 2 = 8.75%. This is


the before‐tax cost of debt (rd). After‐tax cost of debt = rd (1 – t) = 8.75
(1 – 0.35) = 5.688%

26. A 180‐day U.S. T‐bill with a par value of $1,000 is issued at a


discount of 8%. The bond equivalent yield for this security is closest
to:

A. 8%.
B. 8.45%.
C. 8.11%.

Answer: B

Purchase price = 1,000 − [0.08 × (180 / 360) × 1,000] = $960

Bond equivalent yield = [(1,000 − 960) / 960] × 365 / 180 = 8.45%

27. An analyst gathers the following information about the cost of


raising new debt and equity for a company:

New Debt ($ After‐Tax Cost New Equity Cost of


millions) of Debt (%) ($ millions) Equity (%)
≤5 5 ≤6 12
>5 6 >6 13
The company’s target capital structure is 70% equity and 30%
debt. If the company raises $12m in financing, its cost of capital
will be closest to:

A. 10.90%.
B. 10.20%.
C. 10.60%.

Answer: C

Break point for debt = 5 / 0.3 = $16.67m

Because the company will only be raising $12m (less than the break
point for debt), its after‐tax cost of debt equals 5%.

Break point for equity = 6 / 0.7 = $8.57m


Because the company will be raising $12m (more than the break
point for equity) its cost of equity equals 13%.

WACC = [0.13 × 0.7] + [0.05 × 0.3] = 10.6%.

28. A company has been offered trade credit terms of “1/30 net
50.” What is the cost of trade credit for the company if it pays on the
40th day?

A. 9.60%
B. 44.32%
C. 13.00%

Answer: B

Cost of trade credit = {1 + [0.01 / (1 − 0.01)]} 365/10 − 1 = 44.32%

29. Which of the following is least likely an issue in estimating a


company’s cost of debt?

A. Some debt instruments may contain option‐like features.


B. Some companies may use leases extensively as a source of
finance.
C. Companies in different jurisdictions may face different tax rates.

Answer: C
Different tax rates across companies do not create problems in
estimating the cost of debt. Once the before‐tax cost of debt has
been determined, it is adjusted for the company’s tax rate to
determine the after‐tax cost of debt.

30. Which of the following statements is most likely correct with


respect to the break point on the marginal cost of capital schedule? It
represents the point:

A. of optimal capital budget.


B. where the marginal cost of capital is lowest.
C. where a company’s marginal cost of capital changes.

Answer: C

The break point on the marginal cost of capital schedule


represents the point where the cost of one of the company’s
sources of capital changes and capital structure may experience
deviations from the target capital structure.

31. A company executive is holding a meeting with members of the


board of directors. One of the members proposes a stock dividend
and cites two advantages.

Advantage 1: Issuing a stock dividend should help improve the


debt-to-equity ratio as contributed capital will increase
by the number of shares issued.

Advantage 2: Stock dividends are generally not taxable to the


shareholder. Which of the cited advantages is most likely
correct?

A. Both advantages.
B. Advantage 1 only.
C. Advantage 2 only.
Answer: C

Advantage 1 is incorrect; advantage 2 is correct. Issuing a stock


dividend has no impact on a company’s debt-to-equity ratio.
This is because although retained earnings are reduced by the
value of the stock dividends paid, contributed capital increases
by the same amount resulting in a zero net impact on total
shareholder’s equity.

The payment of stock dividend does not impose any tax liability
on the shareholders of a company; this is because shareholders
are compensated in the form of shares as opposed to cash.

32. A company uses trade credit with the terms 1/10, net 30 and
paid credit on day 30. The effective borrowing cost of skipping the
discount on day 10 is closest to:

A. 13.00%
B. 19.91%
C. 20.13%.

Answer: C

33. Which of the following factors least likely serves as a


motivation for corporations engaging in share repurchases?

A. To provide company management with discretion in


controlling their dividend policy.
B. To reduce the impact of a decline in EPS resulting from the
exercise of employee stock options.
C. To communicate to the market that company management
believes that a company’s share is overvalued.

Answer: C
One of the motivations for a company to engage in share
repurchases is to communicate to the market that its
management believes that its share is undervalued or simply to
support share price.

Share repurchases can also be undertaken to mitigate the


impact of a decline in EPS resulting from the exercise of
employee stock options. Exercising employee stock options will
increase the number of shares outstanding and decline earnings
per share. On the other hand, share repurchases will decrease
the number of shares outstanding thereby decreasing the net
decline resulting from exercising options.

Unlike cash dividends, management need not commit to a


policy of share repurchases. Therefore, with a share repurchase
program, company management has greater flexibility with
respect to the timing and amount of cash distributions to
shareholders.

34. The primary attraction of uncommitted line of credit is that

A. they do not require any compensation other than interest.


B. bank cannot refuse to honor any request for use of the line.
C. companies present them as financial reserves in their financial
statements.

Answer: A

The primary attraction of uncommitted line of credit is that they do


not require any compensation other than interest. However, bank
reserves the right to refuse to honor any request for use of the
line. Such credit lines cannot be shown as financial reserves to
the company’s financial statements.

35. Social factors considered in ESG consideration include all of


the following except:

A. human rights.
B. pollution prevention.
C. welfare concerns in the workplace.
Answer: B

Social factors considered in ESG integration generally include


human rights and welfare concerns in the workplace.
Environmental factors include natural resource management,
pollution prevention, water conservation, energy efficiency,
reduced emissions, adherence to environmental safety and
regulatory standards etc.

36. Dwight Enterprises is a manufacturing firm that plans to borrow


$2 million to finance a three-month project. The company would like
to minimize borrowing costs; its financial officer has identified three
alternative borrowing sources.

Alternative 1: Drawing down a line of credit at 4.50% with a 1%


commitment fee on the full amount borrowed.

Alternative 2: A banker’s acceptance at an all-in inclusive rate of


6.40%.

Alternative 3: Commercial paper at 4.0% with a dealer’s


commission of 1/9 percent and a backup line cost of
1/5 percent, both of which are assessed on the $2
million of commercial paper issued.

The financing cost associated with the cheapest Alternative is


closest to:

A. Alternative 1.
B. Alternative 2.
C. Alternative 3.

Answer: C
37. A large corporation accepts a project which generates no
revenue and has a negative net present value. The project most
likely is classified in which of the following categories?

A. Replacement project.
B. New product or service.
C. Regulatory or environmental project.

Answer: C

Regulatory, safety, and environmental projects are often


mandated by governmental agencies. They may generate
no revenue and might not be undertaken by a company
maximizing its own private interests. For example, a
corporation may be required to install equipment to meet a
regulatory standard, and the cost of satisfying the standard
is born by the corporation. In this case, the corporation
selects the lowest cost alternative that meets the
requirement, i.e., the alternative with the least negative net
present value.

38. A company recently opened a limestone quarry at a location


outside its traditional service area. Because limestone is a major
ingredient in concrete, if the quarry is successful the company
plans to build a ready-mix concrete plant at the same location. The
investment in the concrete plant is best described as:

A. an externality.
B. project sequencing.
C. an example of investment synergy.

Answer: B

Project sequencing occurs when the investment in one


project creates the option to invest in future projects.

39. An analyst determines the following cash flows for a capital


project:

Year 0 1 2 3 4 5
Cash flow -100 30 40 40 30 20
(€)

The required rate of return for the project is 13


percent. The net present value (NPV) of the project is
closest to:

A. €14.85.
B. €60.00.
C. €214.85.

Answer: A

Using a calculator with a 13 percent discount rate, the NPV is


€14.85 (= –100, = 30, = 40, = 40, = 30, = 20, I = 13%, solve for
NPV).

40. An analyst gathers the following information about the capital


structure and before-tax component costs for a company. The
company’s marginal tax rate is 40 percent.
Book Market
Capital Component
Value Value
component cost
(000) (000)
Debt $100 $80 8%
Preferred
$20 $20 10%
stock
Common
$100 $200 12%
stock

The company’s weighted average cost of capital (WACC) is


closest to:

A. 8.55%.
B. 9.95%.
C. 10.80%.

Answer: B

Because the target capital weights are not given, market value
weights are used to compute the WACC. The market value
weights for debt, preferred stock and equity are 0.2667, 0.0667,
and 0.6667 respectively.

WACC = = 0.2667 × 8% × (1 – 0.4) + 0.0667 × 10% + 0.6667 ×


12% = 9.95%

41. A company is considering issuing a 10-year, option-free,


semiannual coupon bond with a 9 percent coupon rate. The bond
is expected to sell at 95 percent of par value. If the company’s
marginal tax rate is 30 percent, then the after-tax cost of debt is
closest to:

A. 6.30%.
B. 6.86%.
C. 9.80%.
Answer: B

Using a financial calculator: N = 20, PMT = 45, PV = –950, FV =


1000; solve for I/Y = 4.90%. The annual yield is twice the
semiannual yield = 4.90% × 2 = 9.80%. The after-tax cost of debt
= annual yield × (1 – t) = 9.80% × (1 – 0.30) = 6.86%

42. A company plans to issue nonconvertible, noncallable, fixed-


rate perpetual preferred stock with a $6 annual dividend. The
preferred stock is expected to sell for $40. If the company’s
marginal tax rate is 30 percent, then the cost of preferred stock is
closest to:

A. 6.67%.
B. 10.5%.
C. 15.0%.

Answer: C

The cost of a perpetuity is the annual cash flow divided by the


selling price. In this case, the cost of preferred = 6.00 / 40 =
15.0%. Because the preferred stock dividend is not tax deductible
to the issuing company, there is no after-tax adjustment.

43. An analyst gathers the following information about a company


and the market:

Current market price per share of common €32.00


stock
Most recent dividend per share paid on €2.40
common stock
Expected dividend payout rate 40%
Expected return on equity (ROE) 15%
Beta for the common stock 1.5
Expected return on the market portfolio 12%
Risk-free rate of return 4%
Using the dividend discount model approach, the cost of
common equity for the company is closest to:

A. 16.0%.
B. 16.5%.
C. 17.2%.

Answer: C

According to the dividend discount model approach, the cost of


common equity is equal to the dividend yield plus the growth rate.
In this case, the growth rate is the earnings retention rate times
the expected ROE or (1 – dividend payout rate) × expected ROE
= 1 – 0.4) × 15% = 9%. The expected dividend = 2.40 × (1 +
0.09)= 2.616. The expected dividend yield = 2.616 / 32 = 8.175%.
The cost of common equity = 8.175% + 9.0% ≈ 17.2%.

44. A company is investigating the purchase of a banker’s


acceptance (BA). The $1,000,000 face value BA has 150 days to
maturity and is quoted at 4.05 percent on a discount-basis yield. If
the company’s marginal tax rate is 25 percent, then the money
market yield on the BA is closest to:

A. 3.13%.
B. 4.12%.
C. 4.18%.

Answer: B
Money market yield = discount-basis yield × (face value /
purchase price) Purchase price = face value – [face value ×
discount-basis yield × (days to maturity / 360)]= $1,000,000 –
[$1,000,000 × 0.0405 × (150 / 360)] = $983,125 then Money
market yield = 4.05% × ($1,000,000 / $983,125) = 4.12%

45. Regarding corporate governance, which of the following is most


likely a reason for concern when evaluating the compensation
committee? The compensation committee:

A. includes members of executive management.


B. purchases shares on the open market to fund stock option
commitments.
C. discloses information about compensation paid to
executives and board members.

Answer: A

The compensation committee should be independent from


executive management.

46. Which of the following is least likely classified as a takeover


defense?

A. Greenmail.
B. Cumulative voting.
C. Golden parachutes.

Answer: B

47. The cash flows of projects A and B are given below:

Year Cash flows


Project A Project B
0 -1,500 -1,500
1 400 500
2 300 500
3 600 500
4 800 500

For a 12% internal rate of return, as compared to project


B, the discounted payback period of project A is
approximately:

A. equivalent.
B. 0.93 years higher.
C. 1.25 years higher.

Answer: A

The discounted payback period for project A and B are almost


equal. The calculations are given below:

For Project A

Year 0 1 2 3 4
Cash flow (CF) -1500 400 300 600 800
Cumulative CF -1500 -1100 -800 -200 600
Discounted CF -1500 357.14 239.15 427.07 508.41
Cumulative -1500 -1142.8 -903.71 -476.64 31.77
discounted CF 6

Discounted Payback Period = 3 + 476.64/508.41 = 3 + 0.9347 =


3.94 For Project B

Year 0 1 2 3 4
Cash flow (CF) -1500 500 500 500 500
Cumulative CF -1500 -1000 -500 0 500
Discounted CF -1500 446.43 398.60 355.89 317.76
Cumulative -1500 -1053.5 -654.97 -299.08 18.68
discounted CF 7

Discounted Payback Period = 3 + 299.08/317.76 = 3 + 0.94 = 3.94

48. Net present value method assumes that cash flows are
reinvested at the:

A. internal rate of return.


B. accounting rate of return.
C. opportunity cost of capital.

Answer: C

Net present value method assumes that cash flows of a project


are reinvested at ‘r’, that is the opportunity cost of capital, which
is a more realistic discount rate.

49. Which of the following is most likely a correct implication of


stock dividends to the shareholders?

A. Generally stock dividends are taxable.


B. Stock dividends positively affect the market value of
shareholders’ wealth.
C. When stock dividends are paid shareholders’ cost per share
held decreases.

Answer: C

Option C is correct. Stock dividends do not affect the


shareholders’ total cost basis however the cost per share held
decreases when stock dividends are paid. Generally stock
dividends are not taxable and do not affect the market value of
shareholders’ wealth.
50. An analyst gathered the following information to estimate the
cost of equity for JI Inc. located in Fiji.
Risk free rate 3.2%
Market risk premium 5.5%
Beta 1.3
U.S 10-year T-bond yield 2.84%
Fiji’s 10-year dollar denominated 10.81%
Govt.
bond yield
Annualized SD of Fiji’s stock 44%
market
Annualized SD of Fiji’s dollar 37%
denominated bond

The sovereign yield spread and JI Inc.’s cost of equity are


closest to:

A. 7.97% and 18.51% respectively.


B. 9.48% and 19.83% respectively.
C. 7.97% and 22.67% respectively.

Answer: C

Sovereign yield spread:


= Fiji’s Govt. Bond yield - U.S T-Bond yield
= 10.81% - 2.84%
= 7.97%
51. When a company finances share repurchases with cash:

A. assets and shareholders’ equity decrease and leverage


increases.
B. assets and shareholders’ equity decrease and leverage remains
- unchanged.
C. leverage increases, shareholders’ equity decreases and assets
remain unchanged.

Answer: A

When a company finances share repurchases with cash its


assets and shareholders’ equity decrease and leverage
increases.

52. When a reliable current market price for a firm’s debt is not
available, the cost of debt can be estimated using the:

A. matrix pricing model.


B. coupon rate of the same bonds.
C. interest expense of the firm’s income statement.

Answer: A

When a reliable current market price for a company’s debt is


not available, the cost of debt can be estimated using the
current rates based on the bond rating we expect when we
issue new bonds. This approach is referred to as matrix pricing.

53. A manager is computing the cost of trade credit for the terms
1.5/5 net 30. The account is paid on either the 15th day or the net
day. The cost of credit is:

A. 24.69% lower if the credit is paid on the net day.


B. 48.92% lower if the credit is paid on the net day.
C. 24.21% higher if the credit is paid on 15th day.

Answer: B

54. An analyst gathered the following financial information from


Daniel Inc.

2013 Expected
2014
Units Sold 1300 1400
Revenue ($) 130,000 140,000
Operating income 38,000 52,000
($)
Interest cost ($) 12,000 12,000
Other financing cost 8,000 8,000
($)
Tax ($) 6300 11,200
Net Income ($) 11,700 20,800

The degree of operating leverage of Daniel Inc. from 2013 to


expected 2014 is closest to:

A. 2.11.
B. 3.68.
C. 4.79.

Answer: C
55. Which of the following is considered to be best practice from
shareowners’ perspective?

A. Acquiring entity is required to deal directly with management


and board.
B. Board and management should be able to use cash or available
credit lines to pay hostile bidders to forgo takeover.
C. Under change-in-control provisions, executives should not be
granted severance packages to leave the company.

Answer: C

Option C is correct. Best practice from shareowner’s


perspective suggests that under change-in-control provisions
company’s executives should not be granted severance
packages and other payments to leave the company.

Option A is incorrect. It is not considered best practice if an


acquiring company is forced to deal directly with management
and the board.

Option B is incorrect. The board and management should not


be able to use the company’s cash and available credit lines to
pay a hostile bidder to forgo a takeover.

56. As compared to firms with high degree of financial leverage,


firms with high degree of operating leverage:

A. can easily emerge as a going concern by using bankruptcy laws


and protection.
B. are less flexible in making changes and bankruptcy protection
help little to reduce operating costs.
C. do not lead to major dislocations in the rights and privileges of
owners, lenders and management.

Answer: B

Option B is correct. Companies with high degree of operating


leverage have less flexibility in making changes and bankruptcy
protection does little help to reduce operating costs.

Option A is incorrect. Companies with high degree of financial


leverage use bankruptcy laws and protection to change their
capital structure and after restructuring can emerge as ongoing
concerns.

Option C is incorrect. The difference between a company that


reorganizes and one that liquidates is the difference between
operating and financial leverage. Both types of bankruptcies
lead to major dislocations in the rights and privileges of owners,
lenders and management.

57. The following information is available for a firm:

The firm’s unleveraged beta is closest to:

A. 0.75.
B. 1.20.
C. 1.05.

Answer A
A is correct. Find the comparable firm’s beta: (10.4% –
2.0%)/7.0% = 1.20. Unlever the comparable firm’s beta:
βL,comparable/[1 + (1 – Tax rate) × Debt-to-equity ratio] : 1.20/[1
+ (1 – 40%) × 1.0] = 0.75.

58. The acceptance of which of the following capital budgeting


projects is most likely to expose a company to the highest level of
uncertainty?

A. Replacement of worn out equipment


B. Expansion projects
C. Newly launched product or services

Answer C

2C is correct. Investments related to new products or services


expose the company to even more uncertainties than expansion
projects. These decisions are more complex and will involve more
people in the decision-making process.

59. The optimal capital budget for a firm is best described as


occurring when the company’s marginal cost of capital is:

A. equal to the investment opportunity schedule.


B. less than the investment opportunity schedule.
C. greater than the investment opportunity schedule.

Answer A

A is correct. The optimal capital budget occurs when the marginal


cost of capital (MCC) intersects with (is equal to) the investment
opportunity schedule (IOS).

60. Financial risk is least likely affected by:


A. debentures.
B. dividends.
C. long-term leases.

Answer B

B is correct. By taking on fixed obligations, such as debt (including


debentures) and long- term leases, a company increases its
financial risk. Dividends will not increase financial risk.

61. Which of the following is the least appropriate method for an


external analyst to use to estimate a company’s target capital
structure for determining the weighted average cost of capital
(WACC)?

A. Using the company’s current capital structure at book value


weights
B. Using averages of comparable companies’ capital structure
C. Using statements made by the company’s management
regarding capital structure policy

Answer A

A is correct. An external analyst does not know a company’s actual


target capital structure. Consequently, the analyst should rely on
market value (not book value) weights for the components of the
company’s current capital structure.

62. Which is most likely considered a secondary source of


liquidity?

A. Centralized cash management system


B. Trade credit
C. Liquidating long-term assets
Answer C

C is correct. Liquidating long-term assets is a secondary source of


liquidity.
A is incorrect. Centralized cash management system is considered
as a primary source of liquidity.

63. Under the stakeholder theory, corporate governance is most


consistent with a system of:

A. internal controls and procedures by which individual companies


are managed.
B. defined roles for management and the majority shareowner(s).
C. checks and balances to minimize the conflicting interests among
shareowners.

Answer A

A is correct. Corporate governance is the system of internal


controls and procedures by which individual companies are
managed.

64. Two mutually exclusive projects have the following cash flows
(€) and internal rates of return (IRR):

Assuming a discount rate of 8% annually for both projects, the


best decision for the firm to make is to accept:

A. both projects.
B. Project B only.
C. Project A only.
Answer C

C is correct.
The NPV of project A is €1,780.59.
The NPV of Project B is €1,765.36.

Because Project A has a higher NPV and the projects are mutually
exclusive, only Project A should be accepted.

65. An investment strategy that focuses on climate change is most


likely following which approach to environmental, social, and
governance (ESG) investing?

A. Thematic
B. Best in class
C. Impact

Answer A

A is correct. A strategy that considers a single factor, such as


climate change, is a thematic investment strategy.

66. An investment policy statement’s risk objective states that over


a 12-month period, with a probability of 95%, the client’s portfolio
must not lose more than 5% of its value. This statement is most
likely a(n):

A. total risk objective.


B. relative risk objective.
C. absolute risk objective.

Answer C

C is correct. The statement is an absolute risk objective because it


expresses a maximum loss in value with an associated probability
of loss.

67. The top level of a risk management system most likely is:

A. risk governance.
B. strategic analysis or integration.
C. defined policies or procedures.

Answer A

A is correct. Normally a role of the board of directors of a company,


risk governance is where goals and responsibilities are defined
and top-level decisions (such as determining the company’s risk
tolerance) are made.

68. An investor’s transactions in a mutual fund and the fund’s


returns over a four-year period are provided in the following table:

Based on this data, the money-weighted return (or internal rate of


return) for the investor is closest to:

A. 2.15%.
B. 7.50%.
C. 3.96%.

Answer C
The money-weighted return is calculated by solving for i in the
following equation:
2,500 = -(1,500)/(1+i)-500/(1+i)2-500/(1+i)3+4,626.88/(1+i)4

CF0 = –2,500
CF1 = –1,500 (new investment beginning of Year 2)
CF2 = –500 (withdrawal of 500, end of Year 2; –1,000 new
investment beginning Year 3)
CF3 = –500 (withdrawal of 500, end of Year 3)
CF4 = 4,626.88 (balance at end of Year 4)
i = 0.0396

69. Which of the following sources of credit would an analyst most


likely associate with a borrower of the lowest credit quality?

A. Committed line of credit.


B. Revolving line of credit.
C. Uncommitted line of credit.

Answer C

70. Which yield measure is the most appropriate for comparing a


company’s investments in short- term securities?
A. Money market yield.
B. Discount basis yield.
C. Bond equivalent yield.

Answer C
71. Which of the following is most accurate regarding the
component costs and component weights in a firm’s weighted
average cost of capital (WACC)?

A. The appropriate pre-tax cost of a firm’s new debt is the


average coupon rate on the firm’s existing debt.
B. The weights in the WACC should be based on the
book values of the individual capital components.
C. Taxes reduce the cost of debt for firms in countries in
which interest payments are tax deductible.

Answer C

72. Financial risk is borne by:

A. common shareholders.
B. Creditors
C. Managers

Answer A

73. Hans Klein, CFA, is responsible for capital projects at Vertex


Corporation. Klein and his assistant, Karl Schwartz, were
discussing various issues about capital budgeting and Schwartz
made a comment that Klein believed to be incorrect. Which of the
following is most likely the incorrect statement made by Schwartz?

A. “Net present value (NPV) and internal rate of return


(IRR) result in the same rankings of potential capital
projects.”
B. “The weighted average cost of capital (WACC) should
be based on market values for the firm’s outstanding
securities.”
C. “It is not always appropriate to use the firm’s marginal
cost of capital when determining the net present value
of a capital project.”

Answer A
74. A company director's duty of loyalty is most accurately
described as requiring a director to:

A. perform his or her duties in good faith and with due


diligence.
B. carry out the duties assigned by the managers of the
company.
C. act in the interests of the company and its
shareholders.

Answer C
75. Assume that a company has equal amounts of debt, common
stock, and preferred stock. An increase in the corporate tax rate of
a firm will cause its weighted average cost of capital (WACC) to:

A. rise
B. fall
C. more information is needed

Answer B
76. Which of the following is least likely to be useful to an analyst
when estimating the cost of raising capital through the issuance of
non-callable, nonconvertible preferred stock?

A. The stated par value of the preferred issue.


B. The firm’s corporate tax rate.
C. The preferred stock’s dividend rate.

Answer B
77. Sinclair Construction Company’s Board of Directors is
considering repurchasing $30,000,000 worth of common stock.
Sinclair assumes that the stock can be repurchased at the market
price of $50 per share. After much discussion Sinclair decides to
borrow $30 million that it will use to repurchase shares. Sinclair’s
Chief Executive Officer (CEO) has compiled the following
information regarding the repurchase of the firm’s common stock:
Share price at the time of buyback = $50
Shares outstanding before buyback = 30,600,000
EPS before buyback = $3.33
Earnings yield = $3.33 / $50 = 6.7%
After-tax cost of borrowing = 8.0%
Planned buyback = 600,000 shares
Based on the information above, Sinclair’s earnings per share
(EPS) after the repurchase of its common stock will be closest
to:

A. $3.18
B. $3.32
C. $3.23

Answer B

78. A financial analyst is estimating the effect on the cost of capital


for a company of a decrease in the marginal tax rate. The company
is financed with debt and common equity. A decrease in the firm’s
marginal tax rate would:

A. increase the cost of capital because of a higher after-


tax cost of debt and equity.
B. increase the cost of capital because of a higher after-
tax cost of debt.
C. decrease the cost of capital because of a lower after-
tax cost of debt and equity.
Answer B

79. Nippon Post Corporation (NPC), a Japanese software


development firm, has a capital structure that is comprised of 60%
common equity and 40% debt. In order to finance several capital
projects, NPC will raise USD1.6 million by issuing common equity
and debt in proportion to its current capital structure. The debt will
be issued at par with a 9% coupon and flotation costs on the equity
issue will be 3.5%. NPC’s common stock is currently selling for
USD21.40 per share, and its last dividend was USD1.80 and is
expected to grow at 7% forever. The company’s tax rate is 40%.
NPC’s WACC based on the cost of new capital is closest to:

A. 9.6%
B. 13.1%
C. 9.6%
Answer C
80. The expected annual dividend one year from today is $2.50 for
a share of stock priced at $25. What is the cost of equity if the
constant long-term growth in dividends is projected to be 8%?

A. 19%
B. 18%
C. 15%

Answer B
81. Which of the following statements about independent projects
is least accurate?

A. If the internal rate of return is less than the cost of


capital, reject the project.
B. The internal rate of return and net present value
methods can yield different accept/reject decisions for
independent projects.
C. The net present value indicates how much the value of
the firm will change if the project is accepted.

Answer B

82. The share price of Solar Automotive Industries is $50 per


share. It has a book value of $500 million and 50 million shares
outstanding. What is the book value per share (BVPS) after a
share repurchase of $10 million?

A. $9.84
B. $10.12
C. $10.00

Answer A
83. Which of the following projects would most likely have multiple
internal rates of return (IRRs)? The cost of capital for all projects is
10.0%.

Cash Flows South East West


CF0 -15,000 -12,000 -8,000
CF1 10,000 7,000 4,000
CF2 -1,000 2,000 0
CF3 15,000 2,000 6,000

A. Projects East and West.


B. Project South only.
C. Projects South and West.

Answer B

84. Polington Aircraft Co. just announced a sale of 30 aircraft to


Cuba, a project with a net present value of $10 million. Investors
did not anticipate the sale because government approval to sell to
Cuba had never before been granted. The share price of Polington
should:

A. not necessarily change because new contract


announcements are made all the time.
B. increase by the NPV × (1 – corporate tax rate) divided
by the number of common shares outstanding.
C. increase by the project NPV divided by the number of
common shares outstanding.
Answer C

85. Which of the following is the most appropriate decision rule for
mutually exclusive projects?

A. Accept both projects if their internal rates of return


exceed the firm’s hurdle rate.
B. Accept the project with the highest net present value,
subject to the condition that its net present value is
greater than zero.
C. If the net present value method and the internal rate of
return method give conflicting signals, select the
project with the highest internal rate of return.
Answer B

86. Hatch Corporation's target capital structure is 40% debt, 50%


common stock, and 10% preferred stock. Information regarding the
company's cost of capital can be summarized as follows:

The company's bonds have a nominal yield to maturity of 7%.


The company's preferred stock sells for $40 a share and pays
an annual dividend of $4 a share.
The company's common stock sells for $25 a share and is
expected to pay a dividend of
$2 a share at the end of the year (i.e., D1 = $2.00). The dividend
is expected to grow at a constant rate of 7% a year.
The company has no retained earnings.
The company's tax rate is 40%.

What is the company's weighted average cost of capital (WACC)?

A. 10.59%
B. 10.03%
C. 10.18%
Answer C
87. Tapley Acquisition, Inc., is considering the purchase of Tangent
Company. The acquisition would require an initial investment of
$190,000, but Tapley's after-tax net cash flows would increase by
$30,000 per year and remain at this new level forever. Assume a
cost of capital of 15%. Should Tapley buy Tangent?

A. No, because k > IRR.


B. Yes, because the NPV = $10,000.
C. Yes, because the NPV = $30,000.

Answer B
88. A firm has $3 million in outstanding 10-year bonds, with a fixed
rate of 8% (assume annual payments). The bonds trade at a price
of $92 per $100 par in the open market. The firm’s marginal tax
rate is 35%. What is the after-tax component cost of debt to be
used in the weighted average cost of capital (WACC) calculations?

A. 9.26%
B. 5.40%
C. 6.02%

Answer C

89. Which of the following sources of liquidity is the most reliable?

A. Committed line of credit.


B. Uncommitted line of credit.
C. Revolving line of credit.
Answer C

90. Financial managers utilize stock splits and stock dividends


because they perceive that:

A. investors will double the share price if there is a 20%


stock dividend
B. an optimal trading range exists.
C. brokerage fees paid by shareholders will be reduced.

Answer B
91. Assume that a 30-day commercial paper security has a holding
period yield of 0.80%. The bond equivalent yield of this security is:

A. 9.73%
B. 9.60%
C. 10.12%

Answer A
92. Which of the following statements about leverage is most
accurate?

A. If the company has no debt outstanding, then its


degree of total leverage equals its degree of operating
leverage.
B. An increase in fixed costs (holding sales and variable
costs constant) will reduce the company's degree of
operating leverage.
C. A decrease in interest expense will increase the
company's degree of total leverage.

Answer A

93. Jeffery Marian, an analyst with Arlington Machinery, is


estimating a country risk premium to include in his estimate of the
cost of equity for a project Arlington is starting in India. Marian has
compiled the following information for his analysis:

Indian 10-year government bond yield = 7.20%


10-year U.S. Treasury bond yield = 4.60%
Annualized standard deviation of the Bombay Sensex stock
index = 40%.
Annualized standard deviation of Indian dollar denominated
10-year government bond = 24%
Annualized standard deviation of the S&P 500 Index = 18%.
The estimated country risk premium for India based on Marian’s
research is closest to:

A. 2.60%
B. 4.30%
C. 5.80%

Answer B
94. To judge whether management's incentives are aligned with a
firm's stated goals, an analyst should examine the firm's:

A. remuneration programs.
B. cross-shareholdings.
C. share class structure

Answer A

95. All else equal, a firm's business risk is higher when:

A. the firm has low operating leverage.


B. fixed costs are the highest portion of its expense.
C. variable costs are the highest portion of its expense.
Answer B
96. The quick ratio is considered a more conservative measure of
liquidity than the current ratio because the quick ratio excludes:

A. inventories, which are not necessarily liquid.


B. short-term marketable securities, which may need to
be sold at a significant loss.
C. accounts receivable, which may not be collectible in
the short term.
Answer A
97. When using net present value (NPV) profiles:

A. one should accept all independent projects with


positive NPVs.
B. the NPV profile's intersection with the vertical y-axis
identifies the project's internal rate of return.
C. one should accept all mutually exclusive projects with
positive NPVs
Answer A

98. An example of a secondary source of liquidity is:

A. cash flow management.


B. trade credit and bank lines of credit.
C. negotiating debt contracts.

Answer C
99. Axle Corporation earned £3.00 per share and paid a dividend
of £2.40 on its common stock last year. Its common stock is trading
at £40 per share. Axle is expected to have a return on equity of
15%, an effective tax rate of 34%, and to maintain its historic
payout ratio going forward. In estimating Axle’s after-tax cost of
capital, an analyst’s estimate of Axle’s cost of common equity
would be closest to:

A. 9.20%
B. 8.80%
C. 9.0%

Answer A
100. A banker’s acceptance that is priced at $99,145 and
matures in 72 days at $100,000 has a(n):

A. money market yield greater than its discount yield.


B. discount yield greater than its bond equivalent yield.
C. bond equivalent yield greater than its effective annual
yield.

Answer A

101. Ravencroft Supplies is estimating its weighted average


cost of capital (WACC). Ravencroft’s optimal capital structure
includes 10% preferred stock, 30% debt, and 60% equity. They can
sell additional bonds at a rate of 8%. The cost of issuing new
preferred stock is 12%. The firm can issue new shares of common
stock at a cost of 14.5%. The firm’s marginal tax rate is 35%.
Ravencroft’s WACC is closest to:

A. 13.30%
B. 11.50%
C. 12.30%

Answer B

102. Steven’s Bakery produces snack cakes and bread.


Listed below are the operating costs for the snack cakes division
and the bread division.

Snack Bread
cakes
Price per package $2.00 $2.50
Variable cost per $1.00 $1.30
package
Fixed operating $25,000 $30,000
costs
Fixed financing $10,000 $10,000
costs

Compared to the snack cakes division, the operating breakeven


quantity for the bread division is:

A. less
B. the same
C. greater

Answer B
103. A firm has average days of receivables outstanding of
22 compared to an industry average of 29 days. An analyst would
most likely conclude that the firm:

A. has better credit controls than its peer companies.


B. may have credit policies that are too strict.
C. has a lower cash conversion cycle than its peer
companies.
Answer B

104. Which of the following steps is least likely to be an


administrative step in the capital budgeting process?

A. Arranging financing for capital projects.


B. Conducting a post-audit to identify errors in the
forecasting process.
C. Forecasting cash flows and analyzing project
profitability

Answer A
105. Enamel Manufacturing (EM) is considering investing in a
new vehicle. EM finances new projects using retained earnings and
bank loans. This new vehicle is expected to have the same level of
risk as the typical investment made by EM. Which one of the
following should the firm use in making its decision?

A. Cost of retained earnings.


B. After-tax cost of debt
C. Marginal cost of capital.

Answer C

106. The NPV profile is a graphical representation of the


change in net present value relative to a change in the:

A. prime rate.
B. internal rate of return.
C. Discount rate

Answer C

107. Which of the following statements about the role of the


marginal cost of capital in determining the net present value of a
project is most accurate? The marginal cost of capital should be
used to discount the cash flows:

A. of all projects the firm is considering.


B. for potential projects that have a level of risk near that
of the firm’s average project.
C. if the firm’s capital structure is expected to change
during the project’s life.

Answer B
108. The interests of community groups affected by a
company's operations are most likely to be considered in corporate
governance under:

A. shareholder theory.
B. stakeholder theory.
C. special interest theory.
Answer B

109. Utilitarian Co. is looking to expand its appliances


division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal
tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc.
is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of
3, a marginal tax rate of 40%, and its debt is currently yielding
6.8%. The risk-free rate is currently 5% and the expected return on
the market portfolio is 9%. Using this data, calculate Utilitarian’s
weighted average cost of capital for this potential expansion.

A. 4.20%
B. 7.10%
C. 5.70%

Answer C

110. Which of the following statements about NPV and IRR is


NOT correct?

A. The NPV will be positive if the IRR is less than the cost
of capital.
B. The IRR can be positive even if the NPV is negative.
C. When the IRR is equal to the cost of capital, the NPV
equals zero.

Answer A
111. If two projects are mutually exclusive, a company:

A. must accept both projects or reject both projects.


B. can accept one of the projects, both projects, or neither
project.
C. can accept either project, but not both projects.

Answer C

112. Which of the following statements about business risk


and financial risk is least accurate?

A. Business risk is the riskiness of the company's assets


if it uses no debt.
B. The greater a company's business risk, the higher its
optimal debt ratio.
C. Factors that affect business risk are demand, sales
price, and input price variability.

Answer B
113. Ignoring tax consequences, given a choice between a
cash dividend and a share repurchase of the same amount, a
rational investor would:

A. prefer a cash dividend to a share repurchase.


B. prefer a share repurchase to a cash dividend.
C. be indifferent between a cash dividend and a share
repurchase.

Answer C
114. The effect of a company announcement that they have
begun a project with a current cost of $10 million that will generate
future cash flows with a present value of $20 million is most likely
to:

A. only affect value of the firm’s common shares if the


project was unexpected.
B. increase the value of the firm’s common shares by $20
million.
C. increase value of the firm’s common shares by $10
million.

Answer A

115. Which justification for repurchasing stock is the least


valid?

A. Repurchases offer shareholders more choices than


cash dividends.
B. A cash dividend increase, in response to short-term
excess cash flows, may confuse investors.
C. Shareholders prefer capital gains to cash dividends.
Answer C

116. A firm records the following cash flows on the same day:
$250 million from debt proceeds; $100 million funds transferred to a
subsidiary; $125 million in interest payments; and $30 million in tax
payments. The net daily cash position:

A. improved.
B. remained the same.
C. worsened.

Answer C
117. Which of the following types of capital budgeting
projects are most likely to generate little to no revenue?

A. Replacement projects to maintain the business.


B. Regulatory projects.
C. New product or market development.

Answer B

118. In order to more accurately estimate the cost of equity


for a company situated in a developing market, an analyst should:

A. add a country risk premium to the market risk premium


when using the capital asset pricing model (CAPM).
B. use the yield on the sovereign debt of the developing
country instead of the risk free rate when using the
capital asset pricing model (CAPM).
C. add a country risk premium to the risk-free rate when
using the capital asset pricing model (CAPM).

Answer A
119. Mason Webb makes the following statements to his
boss, Laine DeWalt about the principles of capital budgeting.

Statement 1: Opportunity costs are not true cash outflows and


should not be considered in a capital budgeting analysis.

Statement 2: Cash flows should be analyzed on an after-tax


basis. Should DeWalt agree or disagree with Webb’s
statements?

Statement 1 Statement 2
A. Agree Agree
B. Disagree Disagree
C. Disagree Agree

Answer C
120. In a recent staff meeting, David Hurley, stated that
analysts should understand that financial ratios mean little by
themselves. He advised his colleagues to evaluate financial ratios
carefully. During the discussion he made the following statements:

Statement 1: A company can be compared with others in its


industry by relating its financial ratios to industry norms. However,
care must be taken because many ratios are industry-specific, but
not all ratios are important to all industries.

Statement 2: Comparing a company to the overall economy is


useless because overall business conditions are constantly
changing. Specifically, it is not the case that financial ratios tend to
improve when the economy is strong and weaken during
recessionary times.

Are statements 1 and 2 as made by Hurley regarding financial ratio


analysis
CORRECT?

Statement 1 Statement 2
A. Incorrect Correct
B. Correct Correct
C. Correct Incorrect

Answer C

121. Smith Company's board of directors assigns


responsibilities to three committees. The committee that is most
likely to be responsible for establishing the chief executive officer's
compensation package is Smith's:

A. investment and risk committee.


B. nominations and remuneration committee.
C. audit and governance committee.
Answer B

122. Which of the following is NOT a limitation to financial


ratio analysis?

A. The need to use judgment.


B. A firm that operates in only one industry.
C. Differences in international accounting practices.

Answer B

123. For a project with cash outflows during its life, the least
preferred capital budgeting tool would be:

A. net present value.


B. internal rate of return.
C. profitability index.

Answer B

124. Agora Systems Inc. has the following capital structure


and cost of new capital:

Book Value Market Value Cost of


Issuing
Debt $50 million $58 million 5.3%
Preferred stock $25 million $28 million 7.2%
Common stock $200 million $525 million 8.0%
Total capital $275 million $611 million
What is Agora’s weighted-average cost of capital if its marginal
tax rate is 40%?

A. 6.23%
B. 7.50%
C. 8.02%

Answer B
125. Compared to the prior period, a firm has greater days of
receivables. The effect on the firm’s cash conversion cycle and
operating cycle are most likely a(n):

Cash conversion Operating cycle


A. Increase Increase
B. Increase Decrease
C. Decrease Increase

Answer A

126. Which of the following best describes a firm with low


operating leverage? A large change in:

A. earnings before interest and taxes result in a small


change in net income.
B. sales result in a small change in net income.
C. the number of units a firm produces and sells result in
a similar change in the firm’s earnings before interest
and taxes.

Answer C

127. The stakeholder theory of corporate governance is


primarily focused on:

A. the interests of various stakeholders rather than the


interests of shareholders.
B. resolving the competing interests of those who manage
companies and other groups affected by a company's
actions.
C. increasing the value, a company.

Answer B
128. Stock splits:

A. are less common than stock dividends.


B. increase firm value.
C. do not in and of themselves affect firm value.

Answer C

129. Which of the following statements concerning the


principles underlying the capital budgeting process is most
accurate?

A. Cash flows should be based on opportunity costs.


B. Financing costs should be reflected in a project's
incremental cash flows.
C. The net income for a project is essential for making a
correct capital budgeting decision.

Answer A

Cash flows are based on opportunity costs. Financing costs are


recognized in the project's required rate of return. Accounting net
income, which includes non-cash expenses, is irrelevant;
incremental cash flows are essential for making correct capital
budgeting decisions.

130. Which of the following statements about the payback


period method is Least accurate? The payback period:

A. provides a rough measure of a project's liquidity.


B. considers all cash flows throughout the entire life of a
project.
C. is the number of years it takes to recover the original
cost of the investment.

Answer B

The payback period ignores cash flows that go beyond the payback
period.

131. Which of the following statements about NPV and IRR is


Least accurate?

A. The IRR is the discount rate that equates the present


value of the cash inflows with the present value of
outflows.
B. For mutually exclusive projects, if the NPV method and
the IRR method give conflicting rankings, the analyst
should use the IRRs to select the project.
C. The NPV method assumes that cash flows will be
reinvested at the cost of capital, while IRR rankings
implicitly assume that cash flows are reinvested at the
IRR.

Answer B

NPV should always be used if NPV and IRR give conflicting decisions.

132. Which of the following statements is Least accurate?


The discounted payback period:

A. frequently ignores terminal values.


B. is generally shorter than the regular payback.
C. is the time it takes for the present value of the project's
cash inflows to equal the initial cost of the investment.

Answer B
The discounted payback is longer than the regular payback
because cash flows are discounted to their present value.

133. Which of the following statements about NPV and IRR is


Least accurate?

A. The IRR can be positive even if the NPV is negative.


B. When the IRR is equal to the cost of capital, the NPV
will be zero.
C. The NPV will be positive if the IRR is less than the cost
of capital.

Answer C

If IRR is less than the cost of capital, the result will be a negative NPV.

Use the following data to answer Questions 134 through 138


A company is considering the purchase of a copier that costs
$5,000. Assume a required rate of return of 10% and the following
cash flow schedule: •

134. What is the project's payback period?

A. 1.5 years.
B. 2.0 years.
C. 2.5 years.

Answer B
Cash flow (CF) after year 2 = -5,000 + 3,000 + 2,000 = 0. Cost of
copier is paid back in the first two years.

135. The project's discounted payback period is closest to:

A. 1.4 years.
B. 2.0 years.
C. 2.4 years.

Answer C

Year 1 discounted cash flow = 3,000 I 1.10 = 2,727; year 2 DCF =


2,000 I 1.102 = 1 ,653; year 3 DCF = 2,000 I 1 .103 = 1 ,503. CF
required after year 2 = -5,000 + 2,727 +1,653 = -$620, 620 I year 3
DCF = 620 I 1,503 = 0.41, for a discounted payback of 2.4 years.

Using a financial calculator:


Year 1: I= 10%; FV = 3,000; N = 1; PMT = 0; CPT -> PV = -2,727
Year 2: N = 2; FV = 2,000; CPT -> PV = -1,653
Year 3: N = 3; CPT -> PV = -1,503
5,000 - (2,727 + 1,653) = 620, 620 /1 ,503 = 0.413, so discounted
payback = 2 + 0.4 = 2.4.

136. What is the project's NPV?

A. -$309.
B. +$883.
C. +$1 ,523.

Answer B
NPV = CF0 + (discounted cash flows years 0 to 3 calculated in
Question 7) = -5,000 + (2,727 + 1,653 + 1,503) = -5,000 + 5,833 =
$883.

137. The project's IRR is closest to:

A. 1 0%.
B. 1 5%.
C. 20%.

Answer C

From the information given, you know the NPV is positive, so the
IRR must be greater than 10%. You only have two choices, 15%
and 20%. Pick one and solve the NPV; if it's not close to zero, you
guessed wrong-pick the other one. Alternatively, you can solve
directly for the IRR as CF0 = -5,000, CF 1 = 3,000, CF2 = 2,000,
CF3 = 2,000. IRR = 20.64%.

138. What is the project's profitability index (PI)?

A. 0.72.
B. 1.18.
C. 1.72.

Answer B

PI = PV of future cash flows / CF0 (discounted cash flows years 0


to 3 calculated in Question 7). PI = (2,727 + 1,653 + 1 ,503) / 5,000
= 1.177.
139. An analyst has gathered the following information about
a project:
• Cost $10,000
• Annual cash inflow $4,000
• Life 4 years
• Cost of capital 12%
Which of the following statements about the project is least
accurate?

A. The discounted payback period is 3.5 years.


B. The IRR of the project is 21.9%; accept the project.
C. The NPV of the project is +$2, 1 49; accept the project.

Answer A

Use the following data for Questions 140 and 141


An analyst has gathered the following data about two projects,
each with a 12% required rate of return.
140. If the projects are independent, the company should:

A. accept Project A and reject Project


B. B. reject Project A and accept Project B.
C. accept both projects.

Answer C

Independent projects accept all with positive NPVs or IRRs greater


than cost of capital. NPV computation is easy-treat cash flows as
an annuity.
Project A: N = 5; I= 12; PMT = 5,000; FV = 0; CPT -> PV =
-18,024 NPVA = 18,024 - 15,000 = $3,024
Project B: N = 4; I = 12; PMT = 7,500; FV = 0; CPT -> PV =
-22,780 NPV 8 = 22,780 - 20,000 = $2,780

141. If the projects are mutually exclusive, the company


should:

A. reject both projects.


B. accept Project A and reject Project B.
C. reject Project A and accept Project B.
Answer B

Accept the project with the highest NPV.

142. The NPV profiles of two projects will intersect:

A. at their internal rates of return.


B. if they have different discount rates.
C. at the discount rate that makes their net present values
equal.

Answer C

The crossover rate for the NPV profiles of two projects occurs at
the discount rate that results in both projects having equal NPVs

143. The post-audit is used to:

A. improve cash flow forecasts and stimulate


management to improve operations and bring results into
line with forecasts.
B. improve cash flow forecasts and eliminate potentially
profitable but risky projects.
C. stimulate management to improve operations, bring
results into line with forecasts, and eliminate potentially
profitable but risky projects.

Answer A

A post-audit identifies what went right and what went wrong. It is


used to improve forecasting and operations.

144. Based on surveys of comparable firms, which of the


following firms would be most likely to use NPV as its preferred
method for evaluating capital projects?

A. A small public industrial company located in France.


B. A private company located in the United States.
C. A large public company located in the United States.

Answer C

According to survey results, large companies, public companies,


U.S. companies, and companies managed by a corporate manager
with an advanced degree are more likely to use discounted cash
flow techniques like NPV to evaluate capital projects.

145. Fullen Machinery is investing $400 million in new


industrial equipment. The present value of the future after-tax cash
flows resulting from the equipment is $700 million. Fullen currently
has 200 million shares of common stock outstanding, with a current
market price of $36 per share. Assuming that this project is new
information and is independent of other expectations about the
company, what is the theoretical effect of the new equipment on
Fullen's stock price? The stock price will:

A. decrease to $33.50.
B. increase to $37.50.
C. increase to $39.50.

Answer B

The NPV of the new equipment is $700 million - $400 million =


$300 million. The value of this project is added to Fullen's current
market value. On a per-share basis, the addition is worth $300
million I 200 million shares, for a net addition to the share price of
$1 .50. $36.00 + $ 1.50 = $37.50.

146. A company has $5 million in debt outstanding with a


coupon rate of 12%. Currently, the yield to maturity (YTM) on these
bonds is 14%. If the firm's tax rate is 40%, what is the company's
after-tax cost of debt?
A. 5.6%.
B. 8.4%.
C. 14.0%.

Answer B

kd(1 - t) = (0.14)(1 - 0.4) = 8.4%

147. The cost of preferred stock is equal to:

A. the preferred stock dividend divided by its par value.


B. [(1 - tax rate) times the preferred stock dividend] divided by
price.
C. the preferred stock dividend divided by its market price.

Answer C

Cost of preferred stock = kps = Dps /P

148. A company's $100, 8% preferred is currently selling for


$85. What is the company's cost of preferred equity?

A. 8.0%.
B. 9.4%.
C. 10.8%.

Answer B

kps= Dps/Pps , Dps = $ 100 X 8%= $8, kps = 8/85 = 9.4%


149. The expected dividend is $2.50 for a share of stock
priced at $25. What is the cost of equity if the long-term growth in
dividends is projected to be 8%?

A. 15%.
B. 16%.
C. 18%.

Answer C

Using the dividend yield plus growth rate approach: kce = (D1/P0) +
g = (2.50/25.00) + 8% = 18%

150. An analyst gathered the following data about a


company:

Capital structure Required rate of return


30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the
company earn on its investments?

A. 13.0%.
B. 14.2%.
C. 18.0%.

Answer A

WACC = (wd)(kd)(l - t) + (wps )(kps ) + (wce)(kce) = (0.3)(0.1)(1 - 0.4) +


(0.2)(0.11) + (0.5)(0.18) = 13%
151. A company is planning a $50 million expansion. The
expansion is to be financed by selling $20 million in new debt and
$30 million in new common stock. The before-tax required return
on debt is 9% and 14% for equity. If the company is in the 40% tax
bracket, the company's marginal cost of capital is closest to:

A. 7.2%.
B. 10.6%.
C. 12.0%.

Answer B

wd = 20 /(20 + 30) = 0.4, wce = 30/(20 + 30) = 0.6


WACC = (wd)(kd)(l - t) + (wce)(kce) = (0.4)(9)(1 - 0.4) + (0.6)(14) =
10.56% = MCC

Use the following data to answer Questions 152 through 155


• The company has a target capital structure of 40% debt and 60%
equity.
• Bonds with face value of $ 1,000 pay a 10% coupon
(semiannual), mature in 20 years, and sell for $849.54 with a yield
to maturity of 12%.
• The company stock beta is 1.2.
• Risk-free rate is 10%, and market risk premium is 5%.
• The company is a constant-growth firm that just paid a dividend of
$2, sells for $27 per share, and has a growth rate of 8%.
• The company's marginal tax rate is 40%.

152. The company's after-tax cost of debt is:

A. 7.2%.
B. 8.0%.
C. 9.1 %.
Answer A

kd(1- t) = 12(1 - 0.4) = 7.2%

153. The company's cost of equity using the capital asset


pricing model (CAPM) approach is:

A. 16.0%.
B. 16.6%.
C. 16.9%.

Answer A

Using the CAPM formula, kce = RFR + B [ E(Rmkt) - RFR] = 10 + 1


.2(5) = 16%

154. The company's cost of equity using the dividend


discount model is:

A. 15.4%.
B. 16.0%.
C. 16.6%.

Answer B
D1 = D0 (1 + g) = 2(1.08) = 2.16; kce = (D1/P0) + g = (2.16/27) +
0.08 = 16%

155. The company's weighted average cost of capital (using


the cost of equity from CAPM) is closest to:

A. 12.5%.
B. 13.0%.
C. 13.5%.
Answer A

WACC = (wd)(kd)(l - t) + (wce)(kce) = (0.4)(7.2) + (0.6)(16) = 12.48%

156. What happens to a company's weighted average cost of


capital (WACC) if the firm's corporate tax rate increases and if the
Federal Reserve causes an increase in the risk-free rate,
respectively? (Consider the events independently and assume a
beta of less than one.)

Tax rate increase Increase in risk-free rate


A. Decrease WACC Increase WACC
B. Decrease WACC Decrease WACC
C. Increase WACC Increase WACC

Answer A

An increase in the corporate tax rate will reduce the after-tax cost
of debt, causing the WACC to fall. More specifically, because the
after-tax cost of debt = (kd)(l - t), the term (1 - t) decreases,
decreasing the after-tax cost of debt. If the risk-free rate were to
increase, the costs of debt and equity would both increase, thus
causing the firm's cost of capital to increase.

Answer A

157. Given the following information on a company's capital


structure, what is the company's weighted average cost of capital?
The marginal tax rate is 40%.
Answer B

WACC = (wd)(kd)(l - t) + (wps )(kps ) + (wce)(kce) = (0.4)(7.5)(1 - 0.4) +


(0.05)(1 1) + (0.55)(15) = 10.6%

158. Derek Ramsey is an analyst with Bullseye Corporation,


a major U.S.-based discount retailer. Bullseye is considering
opening new stores in Brazil and wants to estimate its cost of
equity capital for this investment. Ramsey has found that:

• The yield on a Brazilian government 10-year U.S. dollar-


denominated bond is 7.2%.
• A 10-year U.S. Treasury bond has a yield of 4.9%.
• The annualized standard deviation of the Sao Paulo Bovespa
stock index in the most recent year is 24%.
• The annualized standard deviation of Brazil's U.S. dollar-
denominated 1 0-year government bond over the last year was
18%.
• The appropriate beta to use for the project is 1 .3.
• The market risk premium is 6o/o. • The risk-free interest rate is
4.5%.
Which of the following choices is closest to the appropriate country
risk premium for Brazil and the cost of equity that Ramsey should
use in his analysis?

Country risk premium for Brazil Cost of equity for project


A. 2.5% 15.60%
B. 2.5% 16.30%
C. 3.1% 16.30%

159. Manigault Industries currently has assets on its balance


sheet of $200 million that are financed with 70% equity and 30%
debt. The executive management team at Manigault is considering
a major expansion that would require raising additional capital.
Rosannna Stallworth, the CPO of Manigault, has put together the
following schedule for the costs of debt and equity:

In a presentation to Manigault's Board of Directors, Stallworth


makes the following statements:

Statement 1: If we maintain our target capital structure of 70%


equity and 30% debt, the break point at which our cost of equity
will increase to 8.0% is $ 1 85 million in new capital.
Statement 2: If we want to finance total assets of $450 million, our
marginal cost of capital will increase to 7.56%. Are Stallworth's
Statements 1 and 2 most Likely correct or incorrect?
Statement 1 Statement 2
A. Correct Correct
B. Incorrect Correct
C. Incorrect Incorrect

Answer C

Statement 1 is incorrect. The break point at which the cost of


equity changes to 8.0% is:

Statement 2 is also incorrect. If Manigault wants to finance $450


million of total assets, that means that the firm will need to raise
$450 - $200 = $250 million in additional capital. Using the target
capital structure of 70% equity, 30% debt, the firm will need to raise
0.70 x $250 = $ 175 million in new equity and 0.30 x $250 = $75 in
new debt. Looking at rhe capital schedule, the cost associated with
$75 million in new debt is 4.2%, and the cost associated with $ 175
million in new equity is 8.0%. The marginal cost of capital at that
point will be (0.3 x 4.2%) + (0.7 x 8.0%) = 6.86%.
160. Black Pearl Yachts is considering a project that requires
a $1 80,000 cash outlay and is expected to produce cash flows of
$50,000 per year for the next five years. Black Pearl's tax rate is
25%, and the before-tax cost of debt is 8%. The current share price
for Black Pearl's stock is $56 and the expected dividend next year
is $2.80 per share. Black Pearl's expected growth rate is 5%.
Assume that Black Pearl finances the project with 60% equity and
40% debt, and the flotation cost for equity is 4.0%. The appropriate
discount rate is the weighted average cost of capital (WACC).
Which of the following choices is closest to the dollar amount of the
flotation costs and the NPV for the project, assuming that flotation
costs are accounted for properly?
Dollar amount of flotation costs NPV of project
A. $4,320 $ 17,548
B. $4,320 $ 13,228
C. $7,200 $ 17,548

Answer B

Because the project is financed with 60% equity, the amount of


equity capital raised is 0.60 X $ 1 80,000 = $108,000.
Flotation costs are 4.0%, which equates to a dollar cost of $
108,000 x 0.04 = $4,320.
After-tax cost of debt = 8.0% (1 - 0.25) = 6.0%

161. Jay Company has a debt-to-equity ratio of 2.0. Jay is


evaluating the cost of equity for a project in the same line of
business as Cass Company and will use the pure-play method with
Cass as the comparable firm. Cass has a beta of 1 .2 and a debt-
to-equity ratio of 1.6. The project beta most Likely:

A. will be less than Jay Company's beta.


B. will be greater than Jay Company's beta.
C. could be greater than or less than Jay Company's beta.

Answer C

The project beta calculated using the pure-play method is nor


necessarily related in a predictable way to the beta of the firm that
is performing the project.
162. Business risk is the combination of:

A. operating risk and financial risk.


B. sales risk and financial risk.
C. operating risk and sales risk.

Answer C

Business risk refers to the risk associated with a firm's operating


income and is the result of uncertainty about a firm's revenues and
the expenditures necessary to produce those revenues. Business
risk is the combination of sales risk (the uncertainty associated with
the price and quantity of goods and services sold) and operating
risk (the leverage created by the use of fixed costs in the firm's
operations).

163. Which of the following is a key determinant of operating


leverage?

A. Level and cost of debt.


B. The competitive nature of the business.
C. The trade-off between fixed and variable costs.

Answer C

The extent to which costs are fixed determines operating leverage.

164. Which of the following statements about capital


structure and leverage is most accurate?

A. Financial leverage is directly related to operating leverage.


B. Increasing the corporate tax rate will not affect capital structure
decisions.
C. A firm with low operating leverage has a small proportion of its
total costs in fixed costs.

Answer C

If fixed costs are a small percentage of total costs, operating


leverage is low. Operating leverage is separate from financial
leverage, which depends on the amount of debt in the capital
structure. Increasing the tax rate would make the after-tax cost of
debt cheaper.

165. Jayco, Inc., sells blue ink for $4 a bottle. The ink's
variable cost per bottle is $2. Ink has fixed operating costs of
$4,000 and fixed financing costs of $6,000. What is Jayco's
breakeven quantity of sales, in units?

A. 2,000.
B. 3,000.
C. 5,000.
Answer C

166. Jayco, Inc., sells blue ink for $4 a bottle. The ink's
variable cost per bottle is $2. Ink has fixed operating costs of
$4,000 and fixed financing costs of $6,000. What is Jayco's
operating breakeven quantity of sales, in units?

A. 2,000.
B. 3,000.
C. 5,000.
Answer A

167. If Jayco's sales increase by 10%, Jayco's EBIT


increases by 15%. If]ayco's EBIT increases by 10%, Jayco's EPS
increases by 12%. Jayco's degree of operating leverage (DOL) and
degree of total leverage (DTL) are closest to:

A. 1.2 DOL and 1.5 DTL.


B. 1.2 DOL and 2.7 DTL.
C. 1.5 DOL and 1.8 DTL.

Answer C

Use the following data to answer Questions 168 and 169


Jayco, Inc., sells 10,000 units at a price of $5 per unit. Jayco's
fixed costs are $8,000, interest expense is $2,000, variable costs
are $3 per unit, and EBIT is $12,000.

168. Jayco's degree of operating leverage (DOL) and degree


of financial leverage (DFL) are closest to:

A. 2.50 DOL and 1 .00 DFL.


B. 1.67 DOL and 2.00 DFL.
C. 1.67 DOL and 1.20 DFL.

Answer C

169. Jayco's degree of total leverage (DTL) is closest to:

A. 2.00.
B. 1.75.
C. 1.50.

Answer A

170. Vischer Concrete has $1.2 million in assets that are


currently financed with 100% equity. Vischer's EBIT is $300,000,
and its tax rate is 30%. IfVischer changes its capital structure
(recapitalizes) to include 40% debt, what is Vischer's ROE before
and after the change? Assume that the interest rate on debt is 5%.

ROE at 100% equity ROE at 60% equity


A. 17.5% 26.8%
B. 25.0% 26.8%
C. 25.0% 37.5%
Answer A

With 100% equity:

171. Which of the following is most likely to increase


shareholders' wealth?

A. A stock dividend.
B. A stock split.
C. A special dividend.
Answer C

"Special" dividends (also known as "extra" or "irregular" dividends)


are likely to be associated with increased shareholder wealth
because they are usually used to distribute excess profits to
shareholders after a period of unusually high earnings. Stock
dividends and stock splits create more shares; however, there is a
proportionate drop in the price per share, so there is no effect on
shareholder wealth

172. Which of the following is most accurate? The purchaser


of a stock will not receive the dividend if the stock was purchased
on or after the:

A. declaration date.
B. ex-dividend date.
C. holder-of-record date.

Answer B

The chronology of a dividend payout is declaration date, ex-


dividend date, holder-of-record date, and payment date. The ex-
dividend date is the cutoff date for receiving the dividend: stocks
purchased on or after the ex-dividend date will not receive the
dividend.

173. A share repurchase that begins with a company


communicating to shareholders a specific number of shares and a
range of acceptable prices is most likely to be a(n):

A. open market repurchase.


B. fixed price tender offer.
C. Dutch auction.

Answer C

Dutch auctions begin with the company communicating to


shareholders a specific number of shares and a range of
acceptable prices. When companies repurchase shares in the
open market, they buy at market prices and in quantities as
conditions warrant. In a fixed price tender offer, the company
announces a fixed number of shares to be repurchased and a fixed
price.

174. If a company's after-tax borrowing rate is greater than


the company's earning yield when the company repurchases stock
with borrowed money, going forward, the earnings per share is
most likely to:

A. Increase.
B. decrease.
C. remain unchanged.

Answer B

Earnings per share is expected to decrease after a share


repurchase if the company's after-tax borrowing rate is greater than
the company's earning yield.

175. After a share repurchase, book value per share is most


likely to increase if, pre-purchase, BVPS was:

A. greater than the market price per share.


B. less than the market price per share.
C. negative.
Answer A

Book value per share will increase after a share repurchase if book
value per share was greater than market price per share. BVPS
will decrease after a share repurchase if BVPS was less than
market price.

176. A company is considering either an open market share


repurchase or a cash dividend of an equal amount. Compared to
the open market share repurchase, the cash dividend is most likely
to:

A. increase a shareholder's wealth by a greater amount.


B. increase a shareholder's wealth by a lesser amount.
C. have a relative impact that depends on the tax treatment of the
two alternatives.

Answer C

A share repurchase is economically equivalent to a cash dividend


of an equal amount, assuming the tax treatment of the two
alternatives is the same.

177. Studdard Controls recently declared a quarterly


dividend of $ 1.25 payable on Thursday, April 25, to holders of
record on Friday, April 12. What is the last day an investor could
purchase Studdard stock and still receive the quarterly dividend?
A. April 9.
B. April 10.
C. April 12.

Answer A

If an investor purchases shares of stock on or after the ex-dividend


date, she will NOT receive the dividend. Therefore, to receive the
dividend, the investor must purchase stock the day before the ex-
dividend date. The ex-dividend day is always two business days
before the holder-of-record date. Two days before April 12 is April
10; therefore, the last day the investor can purchase shares and
still receive the dividend is April 9.

178. Arizona Seafood, Inc., plans $45 million in new


borrowing to repurchase 3,600,000 shares at their market price of
$ 12.50. The yield on the new debt will be 12%. The company has
36 million shares outstanding and EPS of $0.60 before the
repurchase. The company's tax rate is 40%. The company's EPS
after the share repurchase will be closest to:
A. $0.50.
B. $0.57.
C. $0.67.

Answer B

179. Northern Financial Co. has a BVPS of $5. The company


has announced a $15 million share buyback. The share price is
$60 and the company has 40 million shares outstanding. After the
share repurchase, the company's BVPS will be closest to:
A. $4.65.
B. $4.90.
C. $5.03.
Answer A

Shares to be repurchased are $15 million I $60 = 250,000 shares.


Remaining shares after the repurchase will be 40,000,000 -
250,000 = 39,750,000 shares. Book value before the repurchase is
40,000,000 x $5.00 = $200,000,000. Book value after the
repurchase will be $200,000,000 - $15,000,000 = $ 1 85,000,000.
BVPS = $185,000,000 I 39,750,000 = $4.654 per share.

180. Firm A and Firm B have the same quick ratio, but Firm
A has a greater current ratio than Firm B. Compared to Firm B, it is
most Likely that Firm A has:
A. greater inventory.
B. greater payables.
C. a higher receivables turnover ratio.

Answer A

Inventory is in the numerator of the current ratio but not in the quick
ratio. Greater inventory for Firm A is consistent with a greater
current ratio for Firm A.

181. An increase in Rowley Corp's cash conversion cycle


and a decrease in Rowley's operating cycle could result from:

Cash conversion cycle (+) Operating cycle (-)


A. Decreased receivables turnover Increased payables turnover
B. Decreased receivables turnover Decrease in days of
inventory
C. Increased inventory turnover Increased payables turnover

Answer B
A decrease in receivables turnover would increase days of
receivables and increase the cash conversion cycle. A decrease in
days of inventory would decrease the operating cycle.

182. An example of a primary source of liquidity is:


A. liquidating assets.
B. negotiating debt contracts.
C. short-term investment portfolios.

Answer C

Primary sources of liquidity include ready cash balances, short-


term funds (e.g., short-term investment portfolios), and cash flow
management. Secondary sources of liquidity include negotiating
debt contracts, liquidating assets, and filing for bankruptcy
protection and reorganization.

183. Which of the following statements most accurately


describes a key aspect of managing a firm's net daily cash
position?

A. Analyze cash inflows and outflows to forecast future needs for


cash.
B. Maximize the firm's cash inflows and minimize its cash outflows.
C. Minimize uninvested cash balances because they earn a return
of zero.

Answer A

The goal of managing the net daily cash position is to ensure that
adequate cash is available to prevent the firm from having to
arrange financing on short notice (and thus at high cost), while
earning a return on cash balances when they are temporarily high
by investing in short-term securities. A firm can meet this goal by
forecasting its cash inflows and outflows to identify periods when
its cash balance is expected to be lower or higher than needed.
"Minimizing uninvested cash balances" is inaccurate because a
firm should maintain some target amount of available cash.

184. Boyle, Inc., just purchased a banker's acceptance for


$25,400. It will mature in 80 days for $26,500. The discount-basis
yield and the bond equivalent yield for this security are closest to:

Discount-basis Bond equivalent


A. 18.7% 18.7%
B. 18.7% 19.8%
C. 4.2% 19.8%

Answer B

The actual discount on the acceptance is (26,500 - 25,400)/26,500


= 4.151 %. The annualized discount, or discount-basis yield, is
4.151 (360/80) = 18.68%. The holding period yield is (26,500 -
25,400)/25,400 = 4.331%. The bond equivalent yield is
4.331(365/80) = 19.76%.

185. Blodnick Corp. has found that its weighted average


collection period has increased from 50 days last year to 55 days
this year, and its average days of receivables this year is 48
compared to 52 last year. It is most Likely that:

A. Blodnick has relaxed its credit standards this year.


B. Blodnick's credit customers are paying more slowly this year.
C. credit sales are a greater part of Blodnick's business this year.

Answer B
Outstanding accounts are paying more slowly because the
average collection period is up. Relaxed credit standards or a
greater reliance on credit sales would tend to increase average
days of receivables. The decrease in days of receivables suggests
neither of these is likely.

186. Chapmin Corp. is a large domestic services firm with a


good credit rating. The source of short-term financing it would most
Likely use is:

A. factoring of receivables.
B. issuing commercial paper.
C. issuing bankers' acceptances.

Answer B

Large firms with good credit have access to the commercial paper
market and can get lower financing costs with commercial paper
than they can with bank borrowing. Bankers' acceptances are used
by companies involved in international trade. Factoring of
receivables is a higher-cost source of funds and is used more by
smaller firms that do not have particularly strong credit.

187. Which of the following board characteristics would least


likely be an indication of high-quality corporate governance?

A. Board members have staggered terms.


B. The board can hire independent consultants.
C. The board has a separate committee to set executive pay.
Answer A

Staggered terms make it more difficult for shareholders to change


the board of directors. Annual elections of all members make the
board more responsive to shareholder wishes.
188. Which of the following board members would most likely
be considered well chosen based on the principles of good
corporate governance?

A. A board member of Company B who is also the CEO of


Company B.
B. A board member of Company B who is a partner in an
accounting firm that competes with the firm's auditor.
C. A board member of Company A who is president of Company B,
when the CFO of Company A sits on Company B's board.

Answer B

A board member who is a partner in an unrelated accounting firm


would be considered independent, has no particular relation to firm
management, and could be a valuable addition to the board

189. Which of the following is least likely to enable a


corporate board to exercise its duty by acting in the long-term
interest of shareholders?
A. The board meets regularly outside the presence of
management.
B. A majority of the board members are independent of firm
management. C. The board has representatives from key suppliers
and important customers.

Answer C

Board members should not be closely aligned with a firm's


suppliers or customers because they may act in the interest of
suppliers and customers rather than in the interest of shareholders.
190. Which of the following would most likely be considered
a negative factor in assessing the suitability of a board member?
The board member:
A. has served for ten years.
B. has served on other boards.
C. is a former CEO of another firm.

Answer A

While experience may be a good thing, a board member with long


tenure may be too closely aligned with management to be
considered an independent member.

191. Which of the following would least likely be an indication


of poor corporate governance?

A. A board member leases office space to the company in a


building he owns. B. There are board members who do not have
previous experience in the industry in which the firm operates.
C. A board member has a consulting contract with the firm to
provide strategic vision for the technology research and
development effort.

Answer B

Lack of previous experience in the firm's industry is not necessarily


a negative and can be consistent with an independent board
member who acts in shareholders' long-term interests. Examples
might be board members with specialized knowledge of finance,
marketing, management, accounting, or auditing. The other
answers indicate possible conflicts of interest

192. Which of the following would most likely be considered


a poor corporate practice in terms of promoting shareholder
interests?
A. The firm can use "share blocking."
B. The firm uses a third party to tabulate shareholder votes.
C. Voting for board members does not allow cumulative voting by
shareholders of all votes allotted to their shares.

Answer A

Share blocking prevents shareholders from trading their shares


over a period prior to the annual meeting and is considered a
restriction on the ability of shareholders to express their opinions
and act in their own interests. Cumulative voting can allow a
minority group, such as a founding family, to serve its own
interests. Third party tabulation of shareowner votes is considered
a good corporate governance practice.

193. Two analysts are discussing shareholder defenses


against hostile takeovers. Alice states, "It is positive for
shareholders that the board has shown a willingness to buy back
shares from holders who may be in a position to effect a hostile
takeover of the firm at less than its long-term value to
shareholders." Bradley states, "Firms that are likely takeover
targets should offer valuable exit packages in the event of a hostile
takeover because they are necessary to recruit highly talented top
executives, such as the CEO." From the perspective of good
corporate governance, are these statements correct?

A. Both statements are correct.


B. Neither statement is correct.
C. Only one of the statements is correct.

Answer B

Defenses against hostile takeovers such as greenmail (Alice) or


golden parachutes (Bradley) tend to protect entrenched or poorly
performing managements and typically decrease share values.
Shareholders as a group always have the choice not to sell when a
takeover offer is not in their long-term interests.

194. An analyst calculates the following leverage ratios for


Burkhardt Company and Dutchin Company

If both companies' sales increase by 5%, what are the most likely
effects on the companies' earnings before interest and taxes
(EBIT) and earnings per share (EPS)?
A. Both companies' EBIT will increase by the same percentage.
B. Dutchin's EPS will increase by a larger percentage than
Burkhardt's EPS. C. Burkhardt's EBIT will increase by a larger
percentage than Dutchin's EBIT.

Answer C

The DOL is the percent change in operating income (EBIT) that will
result from a 1 o/o change in sales. Because Burkhardt has a
higher DOL than Dutchin, Burkhardt's EBIT will increase by a
larger percentage if both companies' sales increase by the same
percentage. The percentage change in EPS resulting from a
change in sales of 1 o/o is measured by the degree of total
leverage. The DTL for Burkhardt is 1.6 x 3.0 = 4.8, and the DTL for
Durchin is 1.2 x 4.0 = 4.8. If both companies' sales increase by the
same percentage, their EPS will also increase by the same
percentage.

195. Which of the following would most likely lead to an


increase in a typical firm's capital investment for the current
period?
A. A need to increase inventory.
B. An increase in the firm's expected marginal tax rate.
C. A decrease in the market value of the firm's debt.

Answer B

Because a typical firm has both equity and debt financing, an


increase in the firm's tax rare will decrease the after-tax cost of
debt and consequently decrease the firm's WACC, which can
change a project's NPV from negative to positive. A decrease in
the market value of the firm's debt will increase the market yield on
the debt, which will increase the after-tax cost of debt and the firm's
WACC. Increases in inventory increase current assets and working
capital needs, nor capital investment.

196. Which of the following changes in a firm's working


capital management is most likely to result in a shorter operating
cycle?

A. Reducing stock-outs by carrying greater quantities of inventory.


B. Stretching its payables by paying on the last permitted date.
C. Changing its credit terms for customers from 2/10, net 60 to
2/10, net 30.

Answer C

The operating cycle is average days of receivables plus average


days of inventory. Changing its credit terms for customers from "net
60" to "net 30" would likely decrease the firm's average days of
receivables and shorten irs operating cycle. Increasing inventory
quantities would increase average days of inventory and lengthen
the operating cycle. Stretching payables by waiting until their due
date to pay would increase the firm's average days of payables.
This would shorten the firm's cash conversion cycle (days of
receivables + days of inventory - days of payables) but would not
affect its operating cycle.
197. A company's operations analyst is evaluating a plant
expansion project that is likely to be financed in part by issuing new
common equity. Flotation costs are expected to be 4o/o of the
amount of new equity capital raised. The most appropriate way for
the analyst to treat the flotation costs is to:

A. ignore them, because flotation costs for common equity are


likely to be nonmaterial.
B. estimate the cost of equity capital based on a share price 4%
less than the current price.
C. determine the flotation cost attributable to this project and treat it
as part of the project's initial cash outflow.

Answer C

The correct treatment of flotation costs is to treat them as a cash


outflow at the project's initiation. Methods that adjust the cost of
equity capital (and therefore the WACC) for flotation costs are
incorrect because the cost of capital is an ongoing expense,
whereas flotation costs are actually a one-time expense. Flotation
costs for common equity are typically large enough that they must
be considered in computing a project's NPV

198. A board of directors is most likely to act in the long-term


interest of shareholders if:

A. all board members are elected annually.


B. most board members are selected from outside the company's
industry. C. there are board members who represent the
company's key supplier and largest customer

Answer A
Annual elections of all board members (as compared to longer
terms) make a board more likely to represent shareholders' long-
term interests because it is easier for shareholders to nominate
and elect new members. Board members who do not have direct
experience in the company's industry might lack the specific
knowledge they need to give proper oversight to management's
decisions and, therefore, tend to defer to management. Board
members who are aligned with the company's customers and
suppliers might have interests that conflict with shareholders'
interests.

199. The manufacturer of Pow Detergent has developed


New Improved Pow with Dirteaters and is considering adding it to
its product line. New Improved Pow would sell at a premium price
compared to Pow. In order to manufacture New Improved Pow, the
firm will need to build a new facility and purchase new equipment.
Which of the following is least likely included when calculating the
appropriate cash flows for analysis of whether to add New
Improved Pow to its product line?

A. Expected depreciation on the new facility and equipment for tax


purposes. B. Costs of a marketing survey performed last month to
decide whether to introduce New Improved Pow.
C. Reduced sales of Pow that result from the introduction of New
Improved Pow.

Answer B

Costs that are incurred prior to the decision of whether or not to


pursue a project are sunk costs and should not be used in the NPV
calculation. Only cash flows that result from the decision to actually
do the project should be considered in the analysis. Taxes must be
deducted so the project's cash flows can be analyzed on an after-
tax basis. Because depreciation is tax deductible, expected
depreciation will affect annual taxes and after-tax cash flows.
Cannibalization of sales of an existing product is an externality that
should be included in the estimation of incremental project cash
flows

200. Acme Corp. has reported the following financial ratios


for the past two years:

Based only on these results, an analyst would most correctly


conclude that the results in year 20X1 compared to those in year
20X0 indicate that Acme's ROE has:
A. declined, in part due to lower profitability.
B. increased because the company has used more debt financing.
C. increased because of the improvement in asset utilization.

Answer B

ROE was (14%)(1.3)(1.1) = 20% in 20X0 and (13%)(1.8)(0.9) = 21


% in 20X1. Both the decrease in profitability and the decrease in
total asset turnover in 20X1 will rend to decrease ROE. The only
reason ROE increased in 20X1 is that more debt was used in the
capital structure, increasing the financial leverage ratio.

201. The use of secondary sources of liquidity would most


likely be considered:
A. a normal part of daily business for a company.
B. a signal that a company's financial position is deteriorating.
C. a lower-cost source of short-term financing compared to primary
sources of liquidity.

Answer B
Secondary sources of liquidity include negotiating debt contracts,
liquidating assets, and filing for bankruptcy protection and
reorganization. The use of these sources of funds is typically a
signal that a company's financial position is deteriorating. The
liquidity provided by these sources usually comes at a substantially
higher cost than liquidity provided by primary sources.

202. A firm's debt-to-equity ratio is most likely to increase as


a result of a(n):
A. extra dividend.
B. stock dividend.
C. purchase of a machine for cash.

Answer A

An extra dividend is a cash payment to shareholders. This


decreases assets (cash) and shareholders' equity (retained
earnings) but does not affect liabilities. Unchanged debt and lower
equity results in a higher debt-to-equity ratio. Stock splits, reverse
stock splits, and stock dividends change the number of shares
outstanding but do not change the value of shareholders' equity or
require any use of the firm's assets. Purchasing a machine for cash
exchanges one asset for another asset and does not affect debt or
equity.

203. A firm is evaluating two mutually exclusive projects of


the same risk class, Project X and Project Y. Both have the same
initial cash outlay and both have positive NPVs. Which of the
following is a sufficient reason to choose Project X over Project Y?
A. Project Y has a lower profitability index than Project X.
B. Project X has both a shorter payback period and a shorter
discounted payback period compared to Project Y.
C. Project Y has a lower internal rate of return than Project X.

Answer A
A The correct method of choosing between two mutually exclusive
projects is to choose the one with the higher NPV The profitability
index is calculated as the present value of the future cash flows
divided by the initial outlay for the project. Because both projects
have the same initial cash outlay, the one with the higher
profitability index has both higher present value of future cash
flows and the higher NPV Ranking projects on their payback
periods or their internal rates of return can lead to incorrect
ranking.

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