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Accounting Study Guide 16-19

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study guide 9-17-2014

Student: _______________________________________________________________________________________

1. Your forecast shows $500,000 annually in sales for each of the next 3 years. If your second and third year predictions have failed to

incorporate 2.5% expected annual inflation, how far off in total dollars is your 3-year forecast?

A. $37,813

B. $50,000

C. $52,550

D. $76,250

2. What is the amount of the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 35%

marginal tax rate?

A. $260,000

B. $325,000

C. $360,000

D. $425,000

3. A project anticipates net cash flows of $10,000 at the end of year 1, with such amount growing at the expected 5% rate of inflation over

the subsequent 4 years. Calculate the real present value of this 5-year cash stream if the firm employs a nominal discount rate of 15%.

A. $33,522

B. $38,377

C. $43,294

D. $55,000

4. What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-tax cash flows from operations, $1,000

from the sale of a fully depreciated machine, $2,000 required in additional working capital, and a 35% tax rate?

A. $8,450

B. $12,600

C. $12,650

D. $14,000

5. For a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense, the depreciation tax shield would

be:

A. $10,500

B. $30,000

C. $35,000

D. $65,000

6. What is the present value at a 10% discount rate of the depreciation tax shield for a firm in the 35% tax bracket that purchases a

$50,000 asset being depreciated straight-line over a 5-year life to a zero salvage value?

A. $10,866

B. $13,268

C. $17,500

D. $37,908

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7. A firm generates sales of $250,000, depreciation expense of $50,000, taxable income of $50,000, and has a 35% tax rate. By how

much does net cash flow deviate from net income?

A. $17,500

B. $50,000

C. $67,500

D. $82,500

8. A new, more efficient machine will last 4 years and allow inventory levels to decrease by $100,000 during its life. At a cost of capital of

13%, how does the net working capital change affect the project's NPV?

A. NPV increases by $38,668.

B. NPV increases by $61,330.

C. NPV increases by $100,000.

D. NPV increases by $138,668.

9. What is the maximum percentage of variable costs in relation to sales that a firm could experience and still break even with $5 million

revenue, $1 million fixed costs, and $500,000 depreciation?

A. 30%

B. 70%

C. 80%

D. 90%

10. If a firm's DOL is 4.0 with a profit of $2,000,000 and depreciation of $500,000, what are its fixed costs?

A. $5,000,000

B. $5,500,000

C. $6,000,000

D. $7,500,000

11. What percentage change in sales occurs if profits increase by 3% when the firm's degree of operating leverage is 4.5?

A. 0.33%

B. 0.67%

C. 1.5%

D. 3.33%

12. Calculate the break-even level of sales, assuming $1.4 million fixed costs, $400,000 depreciation expense, and variable costs-to-sales

ratio of 65%.

A. $2,769,231

B. $2,857,143

C. $4,000,000

D. $5,142,857

13. What is the accounting break-even level of revenues for a firm with $6 million in sales, variable costs of $3.9 million, fixed costs of $1.2

million, and depreciation of $1 million?

A. $3,428,571

B. $6,100,000

C. $6,285,714

D. $6,557,377

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14. A project that has zero EVA:

A. has a positive NPV.

B. has an NPV of zero.

C. has a negative NPV.

D. all of these.

15. What happens to the NPV of a one-year project if fixed costs are increased from $400 to $600, the firm is profitable, has a 35% tax

rate, and employs a 12% cost of capital?

A. NPV decreases by $200.00.

B. NPV decreases by $173.91.

C. NPV decreases by $130.00.

D. NPV decreases by $113.04.

16. If a stock is purchased for $25 per share and held one year, during which time a $1.75 dividend is paid and the price climbs to $29.5,

the nominal rate of return is:

A. 13.00%.

B. 14.00%.

C. 20.00%.

D. 25.00%.

17. What is the percentage return on a stock that was purchased for $40.00, paid no dividend after one year, and was then sold for

$39.00?

A. -2.50%

B. 2.50%

C. 5.00%

D. 7.50%

18. From a historical perspective (1900-2007), what would you expect to be the approximate return on a diversified portfolio of common

stocks in a year that Treasury bills offered 7.5%?

A. 8.3%

B. 12.3%

C. 14.9%

D. 19.3%

19. What is the standard deviation of return of a four-stock portfolio (each stock being equally weighted) that produced returns of 20%,

20%, 25%, and 30%?

A. 2.15%

B. 3.15%

C. 4.15%

D. 5.15%

20. What is the expected return on a portfolio that will decline in value by 13% in a recession, will increase by 16% in normal times, and will

increase by 23% during boom times if each scenario has equal likelihood?

A. 8.67%

B. 13.00%

C. 13.43%

D. 17.33%

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21. What percentage return is achieved by an investor who purchases a stock for $30, receives a $1.50 dividend, and sells the share one

year later for $28.50?

A. -5%

B. 0%

C. 5%

D. 10%

22. What is the beta of a three-stock portfolio including 25% of stock A with a beta of .90, 40% of stock B with a beta of 1.05, and 35%

of stock C with a beta of 1.73?

A. 1.0

B. 1.17

C. 1.22

D. 1.25

23. What should be the beta of a replacement stock if an investor wishes to achieve a portfolio beta of 1.0 by replacing stock C in the

following equally weighted portfolio: stock A = .9 beta; stock B = 1.1 beta; stock C = 1.35 beta?

A. .93 beta

B. 1.00 beta

C. 1.08 beta

D. 1.15 beta

24. Calculate the risk premium on stock C given the following information: risk-free rate = 5%, market return = 13%, stock C beta = 1.3.

A. 8.0%

B. 10.4%

C. 15.4%

D. 16.9%

25. What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is expected to yield 14% and Treasury

bills offer 6%?

A. 9.2%

B. 11.2%

C. 12.4%

D. 12.8%

26. What return would be expected by an investor whose portfolio was 25% market portfolio and 75% Treasury bills if the risk-free rate

was 7% and the market risk premium was 8%?

A. 8.00%

B. 9.00%

C. 10.75%

D. 13.00%

27. What is the standard deviation of the market portfolio if the standard deviation of a fully diversified portfolio with a beta of 1.25 equals

20%?

A. 16.00%

B. 18.75%

C. 25.00%

D. 32.50%

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28. The capital structure for the CR Corporation includes: bonds $5,500 and common stock $11,000. If CR has an after-tax cost of debt

of 6%, and a 16% cost of common stock, what is its WACC?

A. 9.33%

B. 12.67%

C. 13.33%

D. 14.67%

29. XYZ Company issues common stock that is expected to pay a dividend over the next year of $4 at a price of $25 per share. If its

expected growth rate is 5%, what is XYZ's cost of common equity?

A. 9.0%

B. 11.0%

C. 16.0%

D. 21.0%

30. What return on equity do investors seem to expect for a firm with a $55 share price, an expected dividend of $5.50, a beta of .9, and a

constant growth rate of 5.5%?

A. 9.00%

B. 10.00%

C. 13.95%

D. 15.50%

31. What percentage of value should be allocated to equity in WACC computations for a firm with $50 million in debt selling at 85% of par,

$50 million in book value of equity, and $65 million in market value of equity?

A. 50.0%

B. 54.1%

C. 56.5%

D. 60.5%

32. A project will generate $1 million net cash flow annually in perpetuity. If the project costs $7 million, what is the lowest WACC shown

below that will make the NPV negative?

A. 10%

B. 12%

C. 14%

D. 16%

33. What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if the respective costs for these components are

6% after tax, 12% after tax, and 18% before tax? The firm's tax rate is 35%.

A. 9.48%

B. 11.16%

C. 12.00%

D. 15.60%

34. What is the WACC for a firm with equal amounts of debt and equity financing, a 16% before-tax company cost of capital, a 35% tax

rate, and a 10% coupon rate on its debt that is selling at par value?

A. 10.40%

B. 14.25%

C. 15.13%

D. 16.00%

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35. What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7.0%, the tax rate is 35%, and the

required return on equity is 18%?

A. 54.00%

B. 63.64%

C. 70.26%

D. 77.78%

36. What is the company cost of capital for a firm financed with 30% debt if the debt requires a 10% return and equity requires a 16%

return?

A. 11.8%

B. 13.3%

C. 14.2%

D. 14.8%

37. If a firm has three times as much equity as debt in its capital structure, then the firm has:

A. 25.0% debt.

B. 66.7% equity.

C. 40.0% debt.

D. 33.3% equity.

38. A company's CFO wants to maintain a target debt-to-equity ratio of 1/4. If the WACC is 18.6%, and the pretax cost of debt is 9.4%,

what is the cost of common equity assuming a tax rate of 34%?

A. 19.90%

B. 20.90%

C. 21.70%

D. 22.73%

39. What will be the effect on retained earnings if a firm with 5,000 shares outstanding earns $10 per share and has a 30% plowback ratio?

It will increase by:

A. $15,000.

B. $30,000.

C. $35,000.

D. $50,000.

40. Jay's Jams Inc. was just established with an investment of $5 million in stereo equipment. Jay expects his company to generate

$800,000 a year for the next 10 years, followed by $1 million a year for the following 10 years. If Jay's cost of capital is 15%, find the

market value and book value of his company.

A. market value = $9.0 million; book value = $5.0 million

B. market value = $5.0 million; book value = $5.3 million

C. market value = $5.3 million; book value = $5.0 million

D. market value = $18.0 million; book value = $5.0 million

41. Which of the following statements is correct about a corporation in the 35% tax bracket that can invest either in a bond paying 8%

interest or in the preferred stock of another corporation that pays a 6% dividend?

A. The stock is preferred by approximately .17%.

B. The stock is preferred by approximately .80%.

C. The bond is preferred by approximately 1.30%.

D. The after-tax yields are identical on each.

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42. What is the net value of common equity for a firm with 3 million shares issued, 1 million shares outstanding, $4 million of retained

earnings, $2 million of treasury stock at cost, $1 million in additional paid-in capital, and a $1 par value per share?

A. $4 million

B. $6 million

C. $8 million

D. $10 million

43. Earnings this year for Plasti-tech Inc. were $200,000. It decided to plow back $60,000 and recorded $20,000 of depreciation. Plasti-

tech's internally generated funds are:

A. $40,000.

B. $60,000.

C. $80,000.

D. $140,000.

44. If the Beta company issues $100 million worth of preferred stock, what will happen to its net worth if book value of common equity is

$500 million?

A. It will increase by $400 million.

B. It will decrease by $100 million.

C. It will increase to $600 million.

D. It will decrease to $400 million.

45. A firm has just issued $250 million of equity which caused its stock price to drop by 3%. Calculate the loss in value of the firm's equity

given that its market value of equity was $1 billion before the new issue:

A. $7.5 million

B. $30.0 million

C. $33.3 million

D. $37.5 million

46. What is the market value placed on a firm in which an entrepreneur invests $1 million and a venture capitalist invests $3 million in first-

stage financing for a 50% interest in the firm?

A. $4 million

B. $6 million

C. $7 million

D. $8 million

47. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the

shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the cost of

underpricing?

A. $81 million

B. $91 million

C. $101 million

D. $111 million

48. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the

shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. In percentage terms, how

much market value is absorbed by the total cost (direct expenses plus underpricing cost)?

A. 13.33%

B. 23.33%

C. 33.33%

D. 43.33%

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49. If an investor can earn 20% on underpriced IPOs, but will lose 10% on overpriced IPOs in which he was awarded $2,000 worth of the

overpriced issue, how much of the underpriced issue must he be awarded in order to gain $500?

A. $1,500

B. $2,500

C. $3,500

D. $10,000

50. Plasti-tech Inc. has decided to go public and has sold 2 million of its shares to its underwriter for $20 per share. The underwriter then

sold them to the public for $22 each. Plasti-tech also encountered $0.5 million in administrative fees. Soon after the issue, the stock

price rose to $25. Find Plasti-tech Inc.'s total cost of this issue.

A. $4.5 million

B. $9.5 million

C. $10.5 million

D. $14.5 million

51. An underwriter issues a firm commitment to sell 1 million shares at $20 each, including a $2 spread. How much does the issuing firm

receive if only 500,000 shares are sold?

A. $9 million

B. $10 million

C. $18 million

D. $20 million

52. A rights issue offers the firm's shareholders one new share of stock at $40 for every three shares of stock they currently own. What

should be the stock price after the rights issue if the stock sells for $80 per share before the issue?

A. $56.67

B. $60.00

C. $70.00

D. $71.33

53. A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this will generate $12.50

earnings per share. What will happen to EPS if operating income increases to $2.0 million?

A. EPS increase to $15.63.

B. EPS increase to $16.67.

C. EPS increase to $17.50.

D. EPS increase to $20.00.

54. A firm issues 100,000 equity shares with a total market value of $5,000,000. The firm's market value of debt is also of equal amount

(i.e., $5,000,000). The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this

will generate $12.50 earnings per share. What will happen to EPS if the firm's borrowing and interest expense increases by 75% and the

number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

A. EPS decrease to $10.00.

B. EPS stay at $12.50.

C. EPS increase to $30.00.

D. EPS increase to $42.50.

55. What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on

debt? Ignore taxes.

A. 54.0%

B. 60.0%

C. 66.7%

D. 75.0%

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56. What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 70% of

assets?

A. 16.14%

B. 17.00%

C. 19.00%

D. 25.67%

57. What happens to an all-equity firm's EPS when $1 million of 20% debt is issued and proceeds used to repurchase two-thirds of the

stock if operating income equals $1.5 million and EPS were $2 when the firm was all-equity-financed? Ignore taxes.

A. EPS increase to $2.60.

B. EPS increase to $3.00.

C. EPS increase to $4.80.

D. EPS increase to $5.20.

58. What is the expected rate of return to equityholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC,

and a 60% debt-asset ratio?

A. 12.50%

B. 21.25%

C. 22.50%

D. 27.75%

59. Stockholders' expected return on a stock priced at $25 per share with zero-growth dividends of $4.00 is:

A. 6.25%.

B. 13.64%.

C. 16.00%.

D. 21.00%.

60. If the value of a levered firm is $4,000,000, then the value of the same firm all-equity-financed is:

A. $3,000,000.

B. $4,500,000.

C. $5,500,000.

D. $6,000,000.

61. What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax

bracket?

A. $126,000

B. $234,000

C. $360,000

D. $1,050,000

62. What is the change in value for a firm with $1 million in equity, $1 million in permanent debt at a 10% interest rate, and a 35% tax rate if

MM I is modified to recognize corporate taxes?

A. Value increases by $35,000.

B. Value increases by $100,000.

C. Value increases by $350,000.

D. Value increases by $700,000.

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63. XYZ Corp. has 1,000 shares outstanding and retained earnings of $25,000. Theoretically, what would you expect to happen to the

price of their stock, currently selling for $30 per share, if a 25% stock dividend is declared?

A. Price should increase to $44.00 per share.

B. Price should increase to $37.50 per share.

C. Price should decrease to $24.00 per share.

D. Nothing; price should remain at $30.00.

64. How much should an investor pay now for a stock expected to sell for $30 one year from now if the stock offers a $2 dividend,

dividends are taxed at 40%, capital gains are taxed at 20%, and a 15% after-tax return is expected on the investment?

A. $25.04

B. $26.53

C. $27.09

D. $27.50

65. Which statement is true concerning the one-year after-tax return on the following stocks, assuming a 40% tax rate on dividends and a

20% tax rate on capital gains: Stock A is purchased for $50, offers a 5% dividend yield, and is sold for $56; stock B is purchased for

$60, offers no dividend yield, but is sold after one year for $70.

A. Stock A's after-tax return is higher by 1.27%.

B. Stock B's after-tax return is higher by .73%.

C. Stock A's after-tax return is higher by .27%.

D. Stock B's after-tax return is higher by .58%.

66. Compare the after-tax returns for a corporation that invests in preferred stock with a 12% dividend versus a common stock with no

dividend but a 16% capital gain. The corporation's tax rate is 35%. The:

A. common stock returns 2.60% more than preferred.

B. preferred stock returns 0.34% more than common.

C. common stock returns 2.32% more than preferred.

D. returns are equal on an after-tax basis.

67. A stock is currently priced at $65 per share and will pay a $4 dividend in one year. What must the stock sell for in one year to meet

investors' expectations of a 15% after-tax yield if dividends are taxed at 28%? Ignore capital gains taxes due to investor timing.

A. $70.75

B. $71.87

C. $73.63

D. $76.00

68. What capital gain must a non-dividend-paying stock attain in order for a corporate investor in the 35% tax bracket to be indifferent to a

stock paying an 8% dividend but having no capital gain?

A. 8.00%

B. 9.29%

C. 11.02%

D. 12.31%

69. The Beta corporation had 1,000 shares outstanding and a market value of $90,000 prior to the declaration of a $5 per share dividend.

To finance a new project they will issue equity and the end result will be that the market value of the firm:

A. drops by $1,000.

B. drops to $85,000.

C. increases by $1,000.

D. increases to $95,000.

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study guide 9-17-2014 KEY

1. Your forecast shows $500,000 annually in sales for each of the next 3 years. If your second and third year predictions have failed to

incorporate 2.5% expected annual inflation, how far off in total dollars is your 3-year forecast?

A. $37,813

B. $50,000

C. $52,550

D. $76,250

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 09 #39

Difficulty: 2 Medium

Learning Objective: 09-01 Identify the cash flows properly attributable to a proposed new project.

Topic: Calculating Cash Flows

2. What is the amount of the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 35%

marginal tax rate?

A. $260,000

B. $325,000

C. $360,000

D. $425,000

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 09 #43

Difficulty: 2 Medium

Learning Objective: 09-01 Identify the cash flows properly attributable to a proposed new project.

Topic: Calculating Cash Flows

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3. A project anticipates net cash flows of $10,000 at the end of year 1, with such amount growing at the expected 5% rate of inflation over

the subsequent 4 years. Calculate the real present value of this 5-year cash stream if the firm employs a nominal discount rate of 15%.

A. $33,522

B. $38,377

C. $43,294

D. $55,000

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 09 #55

Difficulty: 3 Hard

Learning Objective: 09-01 Identify the cash flows properly attributable to a proposed new project.

Topic: Understanding Real and Nominal Rates

4. What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-tax cash flows from operations, $1,000

from the sale of a fully depreciated machine, $2,000 required in additional working capital, and a 35% tax rate?

A. $8,450

B. $12,600

C. $12,650

D. $14,000

Cash flows = after-tax cash flow from operations + recovery of additional working capital + after-tax salvage value

= $10,000 + $2,000 + ($1,000 .65)

= $12,650

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 09 #71

Difficulty: 2 Medium

Learning Objective: 09-02 Calculate the cash flows of a project from standard financial statements.

Topic: Calculating Cash Flows

5. For a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense, the depreciation tax shield would

be:

A. $10,500

B. $30,000

C. $35,000

D. $65,000

Depreciation tax shield = depreciation tax rate

= $100,000 .30

= $30,000

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 09 #73

Difficulty: 2 Medium

Learning Objective: 09-03 Understand how the companys tax bill is affected by depreciation and how this affects project value.

Topic: Understanding Depreciation

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6. What is the present value at a 10% discount rate of the depreciation tax shield for a firm in the 35% tax bracket that purchases a

$50,000 asset being depreciated straight-line over a 5-year life to a zero salvage value?

A. $10,866

B. $13,268

C. $17,500

D. $37,908

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 09 #77

Difficulty: 2 Medium

Learning Objective: 09-03 Understand how the companys tax bill is affected by depreciation and how this affects project value.

Topic: Understanding Depreciation

7. A firm generates sales of $250,000, depreciation expense of $50,000, taxable income of $50,000, and has a 35% tax rate. By how

much does net cash flow deviate from net income?

A. $17,500

B. $50,000

C. $67,500

D. $82,500

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 09 #81

Difficulty: 2 Medium

Learning Objective: 09-03 Understand how the companys tax bill is affected by depreciation and how this affects project value.

Topic: Calculating Cash Flows

8. A new, more efficient machine will last 4 years and allow inventory levels to decrease by $100,000 during its life. At a cost of capital of

13%, how does the net working capital change affect the project's NPV?

A. NPV increases by $38,668.

B. NPV increases by $61,330.

C. NPV increases by $100,000.

D. NPV increases by $138,668.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 09 #99

Difficulty: 2 Medium

Learning Objective: 09-04 Understand how changes in working capital affect project cash flows.

Topic: Changes in Working Capital

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9. What is the maximum percentage of variable costs in relation to sales that a firm could experience and still break even with $5 million

revenue, $1 million fixed costs, and $500,000 depreciation?

A. 30%

B. 70%

C. 80%

D. 90%

Therefore, variable costs cannot exceed $3.5 million, or 70% of sales.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 10 #35

Difficulty: 3 Hard

Learning Objective: 10-01 Appreciate the practical problems of capital budgeting in large corporations.

Topic: Break-Even Analysis

10. If a firm's DOL is 4.0 with a profit of $2,000,000 and depreciation of $500,000, what are its fixed costs?

A. $5,000,000

B. $5,500,000

C. $6,000,000

D. $7,500,000

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 10 #99

Difficulty: 2 Medium

Learning Objective: 10-03 Understand why an overestimate of sales is more serious for projects with high operating leverage.

Topic: Understanding Leverage

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11. What percentage change in sales occurs if profits increase by 3% when the firm's degree of operating leverage is 4.5?

A. 0.33%

B. 0.67%

C. 1.5%

D. 3.33%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 10 #93

Difficulty: 2 Medium

Learning Objective: 10-03 Understand why an overestimate of sales is more serious for projects with high operating leverage.

Topic: Understanding Leverage

12. Calculate the break-even level of sales, assuming $1.4 million fixed costs, $400,000 depreciation expense, and variable costs-to-sales

ratio of 65%.

A. $2,769,231

B. $2,857,143

C. $4,000,000

D. $5,142,857

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 10 #71

Difficulty: 2 Medium

Learning Objective: 10-02 Use sensitivity; scenario; and break-even analyses to see how project profitability would be affected by an error in your forecasts.

Topic: Break-Even Analysis

13. What is the accounting break-even level of revenues for a firm with $6 million in sales, variable costs of $3.9 million, fixed costs of $1.2

million, and depreciation of $1 million?

A. $3,428,571

B. $6,100,000

C. $6,285,714

D. $6,557,377

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 10 #67

Difficulty: 2 Medium

Learning Objective: 10-02 Use sensitivity; scenario; and break-even analyses to see how project profitability would be affected by an error in your forecasts.

Topic: Break-Even Analysis

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14. A project that has zero EVA:

A. has a positive NPV.

B. has an NPV of zero.

C. has a negative NPV.

D. all of these.

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 10 #37

Difficulty: 2 Medium

Learning Objective: 10-01 Appreciate the practical problems of capital budgeting in large corporations.

Topic: Break-Even Analysis

15. What happens to the NPV of a one-year project if fixed costs are increased from $400 to $600, the firm is profitable, has a 35% tax

rate, and employs a 12% cost of capital?

A. NPV decreases by $200.00.

B. NPV decreases by $173.91.

C. NPV decreases by $130.00.

D. NPV decreases by $113.04.

Change in cash flow = (200) + 70 = (130),

which discounts to $113.04

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 10 #31

Difficulty: 2 Medium

Learning Objective: 10-01 Appreciate the practical problems of capital budgeting in large corporations.

Topic: Project Analysis

16. If a stock is purchased for $25 per share and held one year, during which time a $1.75 dividend is paid and the price climbs to $29.5,

the nominal rate of return is:

A. 13.00%.

B. 14.00%.

C. 20.00%.

D. 25.00%.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 11 #21

Difficulty: 2 Medium

Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio.

Topic: Rates of Return

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17. What is the percentage return on a stock that was purchased for $40.00, paid no dividend after one year, and was then sold for

$39.00?

A. -2.50%

B. 2.50%

C. 5.00%

D. 7.50%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 11 #23

Difficulty: 2 Medium

Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio.

Topic: Rates of Return

18. From a historical perspective (1900-2007), what would you expect to be the approximate return on a diversified portfolio of common

stocks in a year that Treasury bills offered 7.5%?

A. 8.3%

B. 12.3%

C. 14.9%

D. 19.3%

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 11 #39

Difficulty: 2 Medium

Learning Objective: 11-03 Understand why diversification reduces risk.

Topic: Rates of Return

19. What is the standard deviation of return of a four-stock portfolio (each stock being equally weighted) that produced returns of 20%,

20%, 25%, and 30%?

A. 2.15%

B. 3.15%

C. 4.15%

D. 5.15%

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Analyze

Brealey - Chapter 11 #45

Difficulty: 3 Hard

Learning Objective: 11-03 Understand why diversification reduces risk.

Topic: Rates of Return

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20. What is the expected return on a portfolio that will decline in value by 13% in a recession, will increase by 16% in normal times, and will

increase by 23% during boom times if each scenario has equal likelihood?

A. 8.67%

B. 13.00%

C. 13.43%

D. 17.33%

AACSB: Reflective Thinking

Blooms: Understand

Brealey - Chapter 11 #55

Difficulty: 1 Easy

Learning Objective: 11-03 Understand why diversification reduces risk.

Topic: Rates of Return

21. What percentage return is achieved by an investor who purchases a stock for $30, receives a $1.50 dividend, and sells the share one

year later for $28.50?

A. -5%

B. 0%

C. 5%

D. 10%

Percentage return = capital gain + dividend/initial price

0% = (-1.50 + 1.50)/30

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 11 #89

Difficulty: 2 Medium

Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot.

Topic: Rates of Return

22. What is the beta of a three-stock portfolio including 25% of stock A with a beta of .90, 40% of stock B with a beta of 1.05, and 35%

of stock C with a beta of 1.73?

A. 1.0

B. 1.17

C. 1.22

D. 1.25

Portfolio beta = (.25 0.9) + (.4 1.05) + (.35 1.73)

= .225 + .42 + .606 = 1.25

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 12 #47

Difficulty: 2 Medium

Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.

Topic: Measuring Market Risk

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23. What should be the beta of a replacement stock if an investor wishes to achieve a portfolio beta of 1.0 by replacing stock C in the

following equally weighted portfolio: stock A = .9 beta; stock B = 1.1 beta; stock C = 1.35 beta?

A. .93 beta

B. 1.00 beta

C. 1.08 beta

D. 1.15 beta

New portfolio beta = (.333 .9) + (.333 1.1) + (.333 Beta C)

1.0 = .3 + .366 +.333 beta C

.334 = .333 beta C

1.00 = beta C

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 12 #49

Difficulty: 3 Hard

Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.

Topic: Measuring Market Risk

24. Calculate the risk premium on stock C given the following information: risk-free rate = 5%, market return = 13%, stock C beta = 1.3.

A. 8.0%

B. 10.4%

C. 15.4%

D. 16.9%

Stock C risk premium = beta market risk premium

= 1.3 (13% - 5%) = 10.4%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 12 #59

Difficulty: 2 Medium

Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.

Topic: Capital Asset Pricing Model

25. What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is expected to yield 14% and Treasury

bills offer 6%?

A. 9.2%

B. 11.2%

C. 12.4%

D. 12.8%

r = r

f

+ (r

m

- r

f

) = 6% + .8(14% - 6%) = 6% + 6.4% = 12.4%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 12 #63

Difficulty: 2 Medium

Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.

Topic: Capital Asset Pricing Model

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26. What return would be expected by an investor whose portfolio was 25% market portfolio and 75% Treasury bills if the risk-free rate

was 7% and the market risk premium was 8%?

A. 8.00%

B. 9.00%

C. 10.75%

D. 13.00%

Expected return on market = r

f

+ market risk premium = 15.00%

Expected return on portfolio = (.75 7%) + (.25 15%) = 5.25% + 3.75% = 9.00%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 12 #67

Difficulty: 2 Medium

Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.

Topic: Measuring Market Risk

27. What is the standard deviation of the market portfolio if the standard deviation of a fully diversified portfolio with a beta of 1.25 equals

20%?

A. 16.00%

B. 18.75%

C. 25.00%

D. 32.50%

Portfolio = beta market portfolio

20% = 1.25

m

16% =

m

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 12 #103

Difficulty: 2 Medium

Learning Objective: 12-03 Calculate the opportunity cost of capital for a project.

Topic: Measuring Market Risk

28. The capital structure for the CR Corporation includes: bonds $5,500 and common stock $11,000. If CR has an after-tax cost of debt

of 6%, and a 16% cost of common stock, what is its WACC?

A. 9.33%

B. 12.67%

C. 13.33%

D. 14.67%

WACC = [($5,500/$16,500) (0.06)] + [($11,000/$16,500) (0.16)]

= .02 + .10667

= 12.67%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #91

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Weighted-Average Cost of Capital

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29. XYZ Company issues common stock that is expected to pay a dividend over the next year of $4 at a price of $25 per share. If its

expected growth rate is 5%, what is XYZ's cost of common equity?

A. 9.0%

B. 11.0%

C. 16.0%

D. 21.0%

r

e

= 4/25 + 0.05 = 21.00%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #89

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Company Cost of Capital

30. What return on equity do investors seem to expect for a firm with a $55 share price, an expected dividend of $5.50, a beta of .9, and a

constant growth rate of 5.5%?

A. 9.00%

B. 10.00%

C. 13.95%

D. 15.50%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #87

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Rates of Return

31. What percentage of value should be allocated to equity in WACC computations for a firm with $50 million in debt selling at 85% of par,

$50 million in book value of equity, and $65 million in market value of equity?

A. 50.0%

B. 54.1%

C. 56.5%

D. 60.5%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #85

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Weighted-Average Cost of Capital

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32. A project will generate $1 million net cash flow annually in perpetuity. If the project costs $7 million, what is the lowest WACC shown

below that will make the NPV negative?

A. 10%

B. 12%

C. 14%

D. 16%

$1 million/.16 = $6.25 million < $7 million

Therefore, NPV < $0

At 14%, the NPV is still positive by $142,857.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #79

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Weighted-Average Cost of Capital

33. What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if the respective costs for these components are

6% after tax, 12% after tax, and 18% before tax? The firm's tax rate is 35%.

A. 9.48%

B. 11.16%

C. 12.00%

D. 15.60%

WACC = (.4 .06) + (.2 .12) + (.4 .18)

= .024 + .024 + .072

= 12.0%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #77

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Weighted-Average Cost of Capital

34. What is the WACC for a firm with equal amounts of debt and equity financing, a 16% before-tax company cost of capital, a 35% tax

rate, and a 10% coupon rate on its debt that is selling at par value?

A. 10.40%

B. 14.25%

C. 15.13%

D. 16.00%

WACC = company cost of capital - adjustment for tax shield on debt

WACC = 16% - 1.75%

= 14.25%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #73

Difficulty: 3 Hard

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Weighted-Average Cost of Capital

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35. What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7.0%, the tax rate is 35%, and the

required return on equity is 18%?

A. 54.00%

B. 63.64%

C. 70.26%

D. 77.78%

14% = (1 - x)(7%) + (x)18%

14% = 7% - (x)7% + (x)18%

7% = (x)11%

63.64% = x

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #71

Difficulty: 3 Hard

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Weighted-Average Cost of Capital

36. What is the company cost of capital for a firm financed with 30% debt if the debt requires a 10% return and equity requires a 16%

return?

A. 11.8%

B. 13.3%

C. 14.2%

D. 14.8%

r

assets

= (.3 .10) + (.7 .16)

= .03 + .112

= 14.2%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #65

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Company Cost of Capital

37. If a firm has three times as much equity as debt in its capital structure, then the firm has:

A. 25.0% debt.

B. 66.7% equity.

C. 40.0% debt.

D. 33.3% equity.

Let x = % of debt

Then 3x = % of equity

And 4x = 100% x = 25.0%

Equity = 75.0%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #61

Difficulty: 2 Medium

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Understanding Capital Structure

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38. A company's CFO wants to maintain a target debt-to-equity ratio of 1/4. If the WACC is 18.6%, and the pretax cost of debt is 9.4%,

what is the cost of common equity assuming a tax rate of 34%?

A. 19.90%

B. 20.90%

C. 21.70%

D. 22.73%

Therefore, D/V = 1/5 and E/V = 4/5

0.186 = 1/5(0.094)(1 -0.34) + 4/5(r

e

)

0.186 = .0124 + 4/5(r

e

)

r

e

= 21.70%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 13 #57

Difficulty: 3 Hard

Learning Objective: 13-03 Calculate the weighted-average cost of capital.

Topic: Weighted-Average Cost of Capital

39. What will be the effect on retained earnings if a firm with 5,000 shares outstanding earns $10 per share and has a 30% plowback ratio?

It will increase by:

A. $15,000.

B. $30,000.

C. $35,000.

D. $50,000.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 14 #57

Difficulty: 2 Medium

Learning Objective: 14-04 Describe voting procedures for the election of a firms board of directors and other matters.

Topic: Corporate Financing

40. Jay's Jams Inc. was just established with an investment of $5 million in stereo equipment. Jay expects his company to generate

$800,000 a year for the next 10 years, followed by $1 million a year for the following 10 years. If Jay's cost of capital is 15%, find the

market value and book value of his company.

A. market value = $9.0 million; book value = $5.0 million

B. market value = $5.0 million; book value = $5.3 million

C. market value = $5.3 million; book value = $5.0 million

D. market value = $18.0 million; book value = $5.0 million

Book value = $5 million

Market value = $800,000(10-year annuity factor) + (1/1.15

10

) $1 million(10-year annuity factor)

= $800,000(5.02) + (1/1.15

10

) $1 million(5.02)

= $4,016,000 + $5,020,00/4.05

= $5.3 million

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 14 #73

Difficulty: 3 Hard

Learning Objective: 14-04 Describe voting procedures for the election of a firms board of directors and other matters.

Topic: Corporate Financing

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41. Which of the following statements is correct about a corporation in the 35% tax bracket that can invest either in a bond paying 8%

interest or in the preferred stock of another corporation that pays a 6% dividend?

A. The stock is preferred by approximately .17%.

B. The stock is preferred by approximately .80%.

C. The bond is preferred by approximately 1.30%.

D. The after-tax yields are identical on each.

After-tax yield (bond) = 8%(1 - tax rate)

= 8% (1 - .35)

= 8% .65

= 5.2%

After-tax yield (stock) = 6% - (6% taxable portion tax rate)

= 6% - (6% .3 .35)

= 5.37%

The bond is preferred by .17%.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 14 #83

Difficulty: 2 Medium

Learning Objective: 14-04 Describe voting procedures for the election of a firms board of directors and other matters.

Topic: Corporate Financing

42. What is the net value of common equity for a firm with 3 million shares issued, 1 million shares outstanding, $4 million of retained

earnings, $2 million of treasury stock at cost, $1 million in additional paid-in capital, and a $1 par value per share?

A. $4 million

B. $6 million

C. $8 million

D. $10 million

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 14 #101

Difficulty: 2 Medium

Learning Objective: 14-05 Describe the major classes of securities sold by the firm.

Topic: Corporate Financing

43. Earnings this year for Plasti-tech Inc. were $200,000. It decided to plow back $60,000 and recorded $20,000 of depreciation. Plasti-

tech's internally generated funds are:

A. $40,000.

B. $60,000.

C. $80,000.

D. $140,000.

Internally generated funds:

= $20,000 + $60,000 = $80,000

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 14 #111

Difficulty: 2 Medium

Learning Objective: 14-05 Describe the major classes of securities sold by the firm.

Topic: Corporate Financing

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44. If the Beta company issues $100 million worth of preferred stock, what will happen to its net worth if book value of common equity is

$500 million?

A. It will increase by $400 million.

B. It will decrease by $100 million.

C. It will increase to $600 million.

D. It will decrease to $400 million.

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 14 #109

Difficulty: 2 Medium

Learning Objective: 14-05 Describe the major classes of securities sold by the firm.

Topic: Equity

45. A firm has just issued $250 million of equity which caused its stock price to drop by 3%. Calculate the loss in value of the firm's equity

given that its market value of equity was $1 billion before the new issue:

A. $7.5 million

B. $30.0 million

C. $33.3 million

D. $37.5 million

Loss in value = .03 $1 billion = $30 billion

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 15 #45

Difficulty: 2 Medium

Learning Objective: 15-01 Understand how venture capital firms design successful deals.

Topic: General Security Offers

46. What is the market value placed on a firm in which an entrepreneur invests $1 million and a venture capitalist invests $3 million in first-

stage financing for a 50% interest in the firm?

A. $4 million

B. $6 million

C. $7 million

D. $8 million

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Analyze

Brealey - Chapter 15 #49

Difficulty: 2 Medium

Learning Objective: 15-01 Understand how venture capital firms design successful deals.

Topic: Venture Capital

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47. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the

shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the cost of

underpricing?

A. $81 million

B. $91 million

C. $101 million

D. $111 million

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 15 #67

Difficulty: 2 Medium

Learning Objective: 15-02 Understand how firms make initial public offerings and the costs of such offerings.

Topic: Initial Public Offerings

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48. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the

shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. In percentage terms, how

much market value is absorbed by the total cost (direct expenses plus underpricing cost)?

A. 13.33%

B. 23.33%

C. 33.33%

D. 43.33%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 15 #69

Difficulty: 2 Medium

Learning Objective: 15-02 Understand how firms make initial public offerings and the costs of such offerings.

Topic: Initial Public Offerings

49. If an investor can earn 20% on underpriced IPOs, but will lose 10% on overpriced IPOs in which he was awarded $2,000 worth of the

overpriced issue, how much of the underpriced issue must he be awarded in order to gain $500?

A. $1,500

B. $2,500

C. $3,500

D. $10,000

$500 = (0.20 value of shares) - (0.10 $2,000)

Value of shares = $3,500

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Analyze

Brealey - Chapter 15 #71

Difficulty: 3 Hard

Learning Objective: 15-02 Understand how firms make initial public offerings and the costs of such offerings.

Topic: Initial Public Offerings

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50. Plasti-tech Inc. has decided to go public and has sold 2 million of its shares to its underwriter for $20 per share. The underwriter then

sold them to the public for $22 each. Plasti-tech also encountered $0.5 million in administrative fees. Soon after the issue, the stock

price rose to $25. Find Plasti-tech Inc.'s total cost of this issue.

A. $4.5 million

B. $9.5 million

C. $10.5 million

D. $14.5 million

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Analyze

Brealey - Chapter 15 #73

Difficulty: 3 Hard

Learning Objective: 15-02 Understand how firms make initial public offerings and the costs of such offerings.

Topic: Initial Public Offerings

51. An underwriter issues a firm commitment to sell 1 million shares at $20 each, including a $2 spread. How much does the issuing firm

receive if only 500,000 shares are sold?

A. $9 million

B. $10 million

C. $18 million

D. $20 million

Proceeds to firm = (price to public - underwriting spread) number of shares committed

= ($20 - $2) 1 million

= $18 million

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Analyze

Brealey - Chapter 15 #91

Difficulty: 3 Hard

Learning Objective: 15-04 Explain the role of the underwriter in an issue of securities.

Topic: Initial Public Offerings

52. A rights issue offers the firm's shareholders one new share of stock at $40 for every three shares of stock they currently own. What

should be the stock price after the rights issue if the stock sells for $80 per share before the issue?

A. $56.67

B. $60.00

C. $70.00

D. $71.33

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 15 #101

Difficulty: 2 Medium

Learning Objective: 15-05 Describe the terms of a rights issue.

Topic: General Security Offers

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53. A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this will generate $12.50

earnings per share. What will happen to EPS if operating income increases to $2.0 million?

A. EPS increase to $15.63.

B. EPS increase to $16.67.

C. EPS increase to $17.50.

D. EPS increase to $20.00.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #31

Difficulty: 2 Medium

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

54. A firm issues 100,000 equity shares with a total market value of $5,000,000. The firm's market value of debt is also of equal amount

(i.e., $5,000,000). The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this

will generate $12.50 earnings per share. What will happen to EPS if the firm's borrowing and interest expense increases by 75% and the

number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

A. EPS decrease to $10.00.

B. EPS stay at $12.50.

C. EPS increase to $30.00.

D. EPS increase to $42.50.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #33

Difficulty: 2 Medium

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

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55. What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on

debt? Ignore taxes.

A. 54.0%

B. 60.0%

C. 66.7%

D. 75.0%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #39

Difficulty: 2 Medium

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

56. What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 70% of

assets?

A. 16.14%

B. 17.00%

C. 19.00%

D. 25.67%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #41

Difficulty: 3 Hard

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

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57. What happens to an all-equity firm's EPS when $1 million of 20% debt is issued and proceeds used to repurchase two-thirds of the

stock if operating income equals $1.5 million and EPS were $2 when the firm was all-equity-financed? Ignore taxes.

A. EPS increase to $2.60.

B. EPS increase to $3.00.

C. EPS increase to $4.80.

D. EPS increase to $5.20.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #53

Difficulty: 3 Hard

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

58. What is the expected rate of return to equityholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC,

and a 60% debt-asset ratio?

A. 12.50%

B. 21.25%

C. 22.50%

D. 27.75%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #69

Difficulty: 2 Medium

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

59. Stockholders' expected return on a stock priced at $25 per share with zero-growth dividends of $4.00 is:

A. 6.25%.

B. 13.64%.

C. 16.00%.

D. 21.00%.

Expected return = ($4/$25) = 16%

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 16 #71

Difficulty: 2 Medium

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

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60. If the value of a levered firm is $4,000,000, then the value of the same firm all-equity-financed is:

A. $3,000,000.

B. $4,500,000.

C. $5,500,000.

D. $6,000,000.

No calculations are necessary because the value of a levered firm will always be greater than the value of the same firm with all-equity

financing.

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Apply

Brealey - Chapter 16 #83

Difficulty: 3 Hard

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: Capital Structure and Corporate Taxes

61. What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax

bracket?

A. $126,000

B. $234,000

C. $360,000

D. $1,050,000

Interest tax shield = interest expense tax rate

= $360,000 .35

= $126,000

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #89

Difficulty: 2 Medium

Learning Objective: 16-02 Show why the tax system encourages debt finance and calculate the value of interest tax shields.

Topic: Capital Structure and Corporate Taxes

62. What is the change in value for a firm with $1 million in equity, $1 million in permanent debt at a 10% interest rate, and a 35% tax rate if

MM I is modified to recognize corporate taxes?

A. Value increases by $35,000.

B. Value increases by $100,000.

C. Value increases by $350,000.

D. Value increases by $700,000.

PV of interest tax shield = (T

c

r

debt

D)/r

debt

= T

c

D

= .35 $1,000,000 = $350,000

Note that the risk of the tax shields can be reasonably assumed to be the same as that of the interest payments generating them. Hence we

use r

debt

for discounting purposes.

Value of levered firm = value if all-equity-financed + present value of tax shield

= $1,000,000 + $350,000 = $1,350,000

Which is an increase of $350,000

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 16 #91

Difficulty: 2 Medium

Learning Objective: 16-02 Show why the tax system encourages debt finance and calculate the value of interest tax shields.

Topic: Understanding MM

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63. XYZ Corp. has 1,000 shares outstanding and retained earnings of $25,000. Theoretically, what would you expect to happen to the

price of their stock, currently selling for $30 per share, if a 25% stock dividend is declared?

A. Price should increase to $44.00 per share.

B. Price should increase to $37.50 per share.

C. Price should decrease to $24.00 per share.

D. Nothing; price should remain at $30.00.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 17 #31

Difficulty: 2 Medium

Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay.

Topic: Dividend Policy

64. How much should an investor pay now for a stock expected to sell for $30 one year from now if the stock offers a $2 dividend,

dividends are taxed at 40%, capital gains are taxed at 20%, and a 15% after-tax return is expected on the investment?

A. $25.04

B. $26.53

C. $27.09

D. $27.50

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 17 #43

Difficulty: 3 Hard

Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay.

Topic: The Effect of Taxes

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65. Which statement is true concerning the one-year after-tax return on the following stocks, assuming a 40% tax rate on dividends and a

20% tax rate on capital gains: Stock A is purchased for $50, offers a 5% dividend yield, and is sold for $56; stock B is purchased for

$60, offers no dividend yield, but is sold after one year for $70.

A. Stock A's after-tax return is higher by 1.27%.

B. Stock B's after-tax return is higher by .73%.

C. Stock A's after-tax return is higher by .27%.

D. Stock B's after-tax return is higher by .58%.

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 17 #51

Difficulty: 2 Medium

Learning Objective: 17-05 Show how market imperfections; especially the different tax treatment of dividends and capital gains; can affect payout policy.

Topic: The Effect of Taxes

66. Compare the after-tax returns for a corporation that invests in preferred stock with a 12% dividend versus a common stock with no

dividend but a 16% capital gain. The corporation's tax rate is 35%. The:

A. common stock returns 2.60% more than preferred.

B. preferred stock returns 0.34% more than common.

C. common stock returns 2.32% more than preferred.

D. returns are equal on an after-tax basis.

After-tax returns:

Preferred Stock: 12% -(12% 35% 30%) = 10.74%

Common Stock: 16% -(16% 35%) = 10.40%

The preferred stock's after-tax return is 34 basis points higher, although it returned 400 basis points less on a before-tax basis.

AACSB: Reflective Thinking

Blooms: Understand

Brealey - Chapter 17 #53

Difficulty: 2 Medium

Learning Objective: 17-05 Show how market imperfections; especially the different tax treatment of dividends and capital gains; can affect payout policy.

Topic: The Effect of Taxes

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67. A stock is currently priced at $65 per share and will pay a $4 dividend in one year. What must the stock sell for in one year to meet

investors' expectations of a 15% after-tax yield if dividends are taxed at 28%? Ignore capital gains taxes due to investor timing.

A. $70.75

B. $71.87

C. $73.63

D. $76.00

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 17 #73

Difficulty: 3 Hard

Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay.

Topic: The Effect of Taxes

68. What capital gain must a non-dividend-paying stock attain in order for a corporate investor in the 35% tax bracket to be indifferent to a

stock paying an 8% dividend but having no capital gain?

A. 8.00%

B. 9.29%

C. 11.02%

D. 12.31%

AACSB: Analytic

Blooms: Analyze

Brealey - Chapter 17 #75

Difficulty: 3 Hard

Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay.

Topic: The Effect of Taxes

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69. The Beta corporation had 1,000 shares outstanding and a market value of $90,000 prior to the declaration of a $5 per share dividend.

To finance a new project they will issue equity and the end result will be that the market value of the firm:

A. drops by $1,000.

B. drops to $85,000.

C. increases by $1,000.

D. increases to $95,000.

Share price prior to declaration:

= ($90,000/1,000) = $90

Share price after declaration:

= $90 - $5 = $85

Market value of firm = $85 (1,000) = $85,000

AACSB: Ethics

AACSB: Reflective Thinking

Blooms: Analyze

Brealey - Chapter 17 #91

Difficulty: 2 Medium

Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay.

Topic: Payout Policy

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study guide 9-17-2014 Summary

Category # of Questions

AACSB: Analytic 52

AACSB: Ethics 14

AACSB: Reflective Thinking 17

Blooms: Analyze 58

Blooms: Apply 9

Blooms: Understand 2

Brealey - Chapter 09 8

Brealey - Chapter 10 7

Brealey - Chapter 11 6

Brealey - Chapter 12 6

Brealey - Chapter 13 11

Brealey - Chapter 14 6

Brealey - Chapter 15 8

Brealey - Chapter 16 10

Brealey - Chapter 17 7

Difficulty: 1 Easy 1

Difficulty: 2 Medium 51

Difficulty: 3 Hard 17

Learning Objective: 09-01 Identify the cash flows properly attributable to a proposed new project. 3

Learning Objective: 09-02 Calculate the cash flows of a project from standard financial statements. 1

Learning Objective: 09-03 Understand how the companys tax bill is affected by depreciation and how this affects project value. 1

Learning Objective: 09-03 Understand how the companys tax bill is affected by depreciation and how this affects project value. 2

Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. 1

Learning Objective: 10-01 Appreciate the practical problems of capital budgeting in large corporations. 3

Learning Objective: 10-02 Use sensitivity; scenario; and break-

even analyses to see how project profitability would be affected by an error in your forecasts.

2

Learning Objective: 10-03 Understand why an overestimate of sales is more serious for projects with high operating leverage. 2

Learning Objective: 11-

02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio.

2

Learning Objective: 11-03 Understand why diversification reduces risk. 3

Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. 1

Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. 5

Learning Objective: 12-03 Calculate the opportunity cost of capital for a project. 1

Learning Objective: 13-03 Calculate the weighted-average cost of capital. 11

Learning Objective: 14-04 Describe voting procedures for the election of a firms board of directors and other matters. 1

Learning Objective: 14-04 Describe voting procedures for the election of a firms board of directors and other matters. 1

Learning Objective: 14-04 Describe voting procedures for the election of a firms board of directors and other matters. 1

Learning Objective: 14-05 Describe the major classes of securities sold by the firm. 3

Learning Objective: 15-01 Understand how venture capital firms design successful deals. 2

Learning Objective: 15-02 Understand how firms make initial public offerings and the costs of such offerings. 4

Learning Objective: 15-04 Explain the role of the underwriter in an issue of securities. 1

Learning Objective: 15-05 Describe the terms of a rights issue. 1

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. 8

Learning Objective: 16-02 Show why the tax system encourages debt finance and calculate the value of interest tax shields. 2

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Learning Objective: 17-01 Describe how dividends are paid and how corporations decide how much to pay. 5

Learning Objective: 17-

05 Show how market imperfections; especially the different tax treatment of dividends and capital gains; can affect payout policy.

2

Topic: Break-Even Analysis 4

Topic: Calculating Cash Flows 4

Topic: Capital Asset Pricing Model 2

Topic: Capital Structure and Corporate Taxes 9

Topic: Changes in Working Capital 1

Topic: Company Cost of Capital 2

Topic: Corporate Financing 5

Topic: Dividend Policy 1

Topic: Equity 1

Topic: General Security Offers 2

Topic: Initial Public Offerings 5

Topic: Measuring Market Risk 4

Topic: Payout Policy 1

Topic: Project Analysis 1

Topic: Rates of Return 7

Topic: The Effect of Taxes 5

Topic: Understanding Capital Structure 1

Topic: Understanding Depreciation 2

Topic: Understanding Leverage 2

Topic: Understanding MM 1

Topic: Understanding Real and Nominal Rates 1

Topic: Venture Capital 1

Topic: Weighted-Average Cost of Capital 7

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