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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