FINA 210 Midterm, Spring 2004

MULTIPLE CHOICE QUESTIONS Agency Answer: d Diff: M 1. Which of the following statements is most correct? a. One of the ways in which firms can mitigate or reduce agency problems between bondholders and stockholders is by increasing the amount of debt in the capital structure. b. The threat of takeover is one way in which the agency problem between stockholders and managers can be alleviated. c. Managerial compensation can be structured to reduce agency problems between stockholders and managers. d. Statements b and c are correct. e. All of the statements above are correct Firm organization Answer: a Diff: E N 2. Until this year, Cheers Inc. was organized as a partnership. This year, the partners have decided to organize the business as a corporation. As a result of this change in organizational form, which of the following statements is most correct? a. Cheers’ shareholders (the ex-partners) will now have limited liability. b. Cheers will now be subject to fewer regulations. c. Cheers will now pay less in taxes. d. Cheers’ investors will now find it more difficult to transfer ownership. e. Cheers will now find it more difficult to raise additional capital. Net cash flow, free cash flow, and cash Answer: c Diff: E N 3. Last year, Owen Technologies reported negative net cash flow and negative free cash flow. However, its cash on the balance sheet increased. Which of the following could explain these changes in its cash position? a. The company had a sharp increase in its depreciation and amortization expenses. b. The company had a sharp increase in its inventories. c. The company issued new common stock. d. Statements a and b are correct. e. Statements a and c are correct. Income statement Answer: b Diff: E N 4. Cox Corporation recently reported an EBITDA of $22.5 million and $5.4 million of net income. The company has $6 million interest expense and the corporate tax rate is 35 percent. What was the company’s depreciation and amortization expense? a. $ 4,333,650 1 b. $ 8,192,308 c. $ 9,427,973 d. $11,567,981 e. $14,307,692 Financial statement analysis Answer: e Diff: E 5. Company A and Company B have the same total assets, return on assets (ROA), and profit margin. However, Company A has a higher debt ratio and interest expense than Company B. Which of the following statements is most correct? a. Company A has a higher ROE (return on equity) than Company B. b. Company A has a higher total assets turnover than Company B. c. Company A has a higher operating income (EBIT) than Company B. d. Statements a and b are correct. e. Statements a and c are correct. Du Pont equation Answer: a Diff: E 6. The Wilson Corporation has the following relationships: Sales/Total assets 2.0´ Return on assets (ROA) 4.0% Return on equity (ROE) 6.0% What is Wilson’s profit margin and debt ratio? a. 2%; 0.33 b. 4%; 0.33 c. 4%; 0.67 d. 2%; 0.67 e. 4%; 0.50 Liquidity ratios Answer: a Diff: M 7. Oliver Incorporated has a current ratio equal to 1.6 and a quick ratio equal to 1.2. The company has $2 million in sales and its current liabilities are $1 million. What is the company’s inventory turnover ratio? a. 5.0 b. 5.2 c. 5.5 d. 6.0 e. 6.3 CAPM Answer: b Diff: E N 8. The risk-free rate is 6 percent. Stock A has a beta of 1.0, while Stock B has a beta of 2.0. The market risk premium (kM – kRF) is positive. Which of the following statements is most correct? 2 a. Stock B’s required rate of return is twice that of Stock A. b. If Stock A’s required return is 11 percent, the market risk premium is 5 percent. c. If the risk-free rate increases (but the market risk premium stays unchanged), Stock B’s required return will increase by more than Stock A’s. d. Statements b and c are correct. e. All of the statements above are correct. CAPM and required return Answer: a Diff: M 9. Bradley Hotels has a beta of 1.3, while Douglas Farms has a beta of 0.7. The market return is 12 percent. The risk-free rate of interest is 7 percent. By how much does Bradley’s required return exceed Douglas’ required return? a. 3.0% b. 6.5% c. 5.0% d. 6.0% e. 7.0% Portfolio return Answer: a Diff: E 10. An investor is forming a portfolio by investing $50,000 in stock A that has a beta of 1.50, and $25,000 in stock B that has a beta of 0.90. The return on the market is equal to 6 percent and Treasury bonds have a yield of 4 percent. What is the required rate of return on the investor’s portfolio? a. 6.6% b. 6.8% c. 5.8% d. 7.0% e. 7.5% Portfolio beta Answer: e Diff: M 11. Walter Jasper currently manages a $500,000 portfolio. He is expecting to receive an additional $250,000 from a new client. The existing portfolio has a required return of 10.75 percent. The risk-free rate is 4 percent and the return on the market is 9 percent. If Walter wants the required return on the new portfolio to be 11.5 percent, what should be the average beta for the new stocks added to the portfolio? a. 1.50 b. 2.00 c. 1.67 d. 1.35 e. 1.80 Required return Answer: c Diff: M 12. You are holding a stock that has a beta of 2.0 and is currently in equilibrium. The required return on the stock is 15 percent, and the market return is 10 percent. What would be the percentage change in the return on the stock, if the market return increased by 30 percent while the risk-free rate remained unchanged? 3 a. +20% b. +30% c. +40% d. +50% e. +60% Beta coefficient Answer: b Diff: E 13. Given the following information, determine which beta coefficient for Stock A is consistent with equilibrium: = 11.3%; kRF = 5%; kM = 10% a. 0.86 b. 1.26 c. 1.10 d. 0.80 e. 1.35 Effective annual rate Answer: d Diff: E 14. Which of the following statements is most correct? a. If annual compounding is used, the effective annual rate equals the nominal rate. b. If annual compounding is used, the effective annual rate equals the periodic rate. c. If a loan has a 12 percent nominal rate with semiannual compounding, its effective annual rate is equal to 11.66 percent. d. Statements a and b are correct. e. Statements a and c are correct. PV of an uneven CF stream Answer: b Diff: E 15. A real estate investment has the following expected cash flows: Year Cash Flows 1 $10,000 2 25,000 3 50,000 4 35,000 The discount rate is 8 percent. What is the investment’s present value? a. $103,799 b. $ 96,110 c. $ 95,353 d. $120,000 e. $ 77,592 Time value of money and retirement Answer: b Diff: E N 4 16. Today, Bruce and Brenda each have $150,000 in an investment account. No other contributions will be made to their investment accounts. Both have the same goal: They each want their account to reach $1 million, at which time each will retire. Bruce has his money invested in risk-free securities with an expected annual return of 5 percent. Brenda has her money invested in a stock fund with an expected annual return of 10 percent. How many years after Brenda retires will Bruce retire? a. 12.6 b. 19.0 c. 19.9 d. 29.4 e. 38.9 Answer a 17. A bank recently loaned you $15,000 to buy a car. The loan is for five years (60 months) and is fully amortized. The nominal rate on the loan is 12 percent, and payments are made at the end of each month. What will be the remaining balance on the loan after you make the 30th payment? a. $ 8,611.17 b. $ 8,363.62 c. $14,515.50 d. $ 8,637.38 e. $ 7,599.03 Required annuity payments The following information is needed to answer the next two questions Karen and her twin sister, Kathy, are celebrating their 30th birthday today. Karen has been saving for her retirement ever since their 25th birthday. On their 25th birthday, she made a $5,000 contribution to her retirement account. Every year thereafter on their birthday, she has added another $5,000 to the account. Her plan is to continue contributing $5,000 every year on their birthday. Her 41st, and final, $5,000 contribution will occur on their 65th birthday. So far, Kathy has not saved anything for her retirement but she wants to begin today. Kathy’s plan is to also contribute a fixed amount every year. Her first contribution will occur today, and her 36th, and final, contribution will occur on their 65th birthday. Assume that both investment accounts earn an annual return of 10 percent. Answer c 5 18 Determine how much Karen will have saved by age 65. a. $1,980,661. b. $1,980,666. c. $2,439,259. d. $1,231,664. e. $1,015,330. Answer: b Diff: M N 19 How large does Kathy’s annual contribution have to be for her to have the same amount in her account at age 65, as Karen will have in her account at age 65? a. $9,000.00 b. $8,154.60 c. $7,398.08 d. $8,567.20 e. $7,933.83 Bond concepts Answer: a Diff: E 20. Which of the following statements is most correct? a. All else equal, if a bond’s yield to maturity increases, its price will fall. b. All else equal, if a bond’s yield to maturity increases, its current yield will fall. c. If a bond’s yield to maturity exceeds the coupon rate, the bond will sell at a premium over par. d. All of the statements above are correct. e. None of the statements above is correct. Bond value--semiannual payment Answer: b Diff: E 21. A bond with a $1,000 face value and an 8 percent annual coupon pays interest semiannually. The bond will mature in 15 years. The nominal yield to maturity (Kd) is 11 percent. What is the price of the bond today? a. $ 784.27 b. $ 781.99 c. $1,259.38 d. $1,000.00 e. $ 739.19 YTM and YTC--semiannual bond Answer: e Diff: E 22. A corporate bond matures in 14 years. The bond has an 8 percent semiannual coupon and a par value of $1,000. The bond is callable in five years at a call price of $1,050. The price of 6 the bond today is $1,075. What are the bond’s yield to maturity and yield to call? a. YTM = 14.29%; YTC = 14.09% b. YTM = 3.57%; YTC = 3.52% c. YTM = 7.14%; YTC = 7.34% d. YTM = 6.64%; YTC = 4.78% e. YTM = 7.14%; YTC = 7.05% Bond value--semiannual payment Answer: d Diff: E 23. Assume that you wish to purchase a 20-year bond that has a maturity value of $1,000 and makes semiannual interest payments of $40. If you require a 10 percent nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $619 b. $674 c. $761 d. $828 e. $902 Current yield and yield to maturity Answer: b Diff: E 24. A bond matures in 12 years and pays an 8 percent annual coupon. The bond has a face value of $1,000 and currently sells for $985. What is the bond’s current yield and yield to maturity? a. Current yield = 8.00%; yield to maturity = 7.92% b. Current yield = 8.12%; yield to maturity = 8.20% c. Current yield = 8.20%; yield to maturity = 8.37% d. Current yield = 8.12%; yield to maturity = 8.37% e. Current yield = 8.12%; yield to maturity = 7.92% Bond coupon rate Answer: c Diff: M 25. Cold Boxes Ltd. has 100 bonds outstanding (maturity value = $1,000). The nominal required rate of return on these bonds is currently 10 percent (Kd), and interest is paid semiannually. The bonds mature in 5 years, and their current market value is $768 per bond. What is the annual coupon interest rate? a. 8% b. 6% c. 4% d. 2% e. 0% ANSWERS . Agency Answer: d Diff: M 7 Statement d is most correct. Statement a is incorrect, because increasing the amount of debt can increase agency problems. 2. Firm organization Answer: a Diff: E N Except for statement a, all the other statements are exactly opposite for corporations. 3. Net cash flow, free cash flow, and cash Answer: c Diff: E N The correct answer is statement c. Recall Net cash flow = NI + DEP and AMORT. Free cash flow = EBIT(1 - T) + Depreciation and amortization – Capital expenditures – ΔNOWC. An increase in depreciation and amortization expenses increases both NCF and FCF, and may reduce taxes. This does not explain why NCF and FCF are negative with an increase in cash flow. So, statement a is not correct. An increase in inventories is paid either in cash or accounts payable. This suggests cash either decreases or remains the same. So, statement b is incorrect. By issuing new stock, cash does increase. And this has no impact on either NCF or FCF, so statement c is the correct response. 4. Income statement Answer: b Diff: E N 5. Financial statement analysis Answer: e Diff: E From the first sentence, both firms have the same net income, sales, and assets. Since A has more debt, it must have less equity. Thus, its ROE (calculated as Net income/Equity) is higher than B’s. So statement a is correct. Since the two firms have the same total assets and sales, their total assets turnover ratios must be the same. So statement b is false. If A has higher interest expense than B but the same net income, this means that A must have higher operating income (EBIT) than B. Therefore statement c is correct. Since statements a and c are correct, the correct choice is statement e. 6. Du Pont equation Answer: a Diff: E 8 First, calculate the profit margin, which equals NI/Sales: ROA = NI/TA = 0.04. Sales/Total assets = S/TA = 2. PM = (NI/TA)(TA/S) = 0.04(0.5) = 0.02. [TA/S = 1/2 = 0.5.] Next, find the debt ratio by finding the equity ratio: E/TA = (E/NI)(NI/TA). [ROE = NI/E and ROA = NI/TA.] E/TA = (1/ROE)(ROA) = (1/0.06)(0.04) = 0.667, or 66.7% equity. Therefore, D/TA must be 0.333 = 33.3%. 7. Liquidity ratios Answer: a Diff: M QR = (Current assets - Inventory)/Current liabilities 1.2 = (CA - I)/$1,000,000 CA - I = $1,200,000. CR = (Current assets - Inventory + Inventory)/Current liabilities 1.6 = ($1,200,000 + Inventory)/$1,000,000 $1,600,000 = $1,200,000 + Inventory Inventory = $400,000. Inventory turnover = Sales/Inventory = $2,000,000/$400,000 = 5.0´. 8. CAPM Answer: b Diff: E N The CAPM is written as: ks = kRF + (kM – kRF)b. Statement a is false based on the CAPM equation. Statement b is correct on the basis of the CAPM equation. Statement c is false; the required returns will increase by the same amount. 9. CAPM and required return Answer: a Diff: M An index fund will have a beta of 1.0. If kM is 12 percent (given in the problem) and the risk-free rate is 7 percent, you can calculate the market risk premium (RPM). ks = kRF + (RPM)b 12%= 7% + (RPM)1.0 5% = RPM. Now, you can use the RPM, the kRF, and the two stock’s betas to calculate their required returns. Bradley: ks = kRF + (RPM)b = 7% + (5%)1.3 9 = 7% + 6.5% = 13.5%. Douglas: ks = kRF + (RPM)b = 7% + (5%)0.7 = 7% + 3.5% = 10.5%. The difference in their required returns is: 13.5% - 10.5% = 3.0%. 10. Portfolio return Answer: a Diff: E The portfolio’s beta is a weighted average of the individual security betas as follows: ($50,000/$75,000)1.5 + ($25,000/$75,000)0.9 = 1.3. The required rate of return is then simply: 4% + (6% - 4%)1.3 = 6.6%. 1. Portfolio beta Answer: e Diff: M Find the beta of the original portfolio (bOld) as 10.75% = 4% + (9% - 4%)bOld or bOld = 1.35. To achieve an expected return of 11.5%, the new portfolio must have a beta (bNew) of 11.5% = 4% + (9% - 4%) or = 1.5. To construct a portfolio with a bNew = 1.5, the added stocks must have an average beta (bAvg) such that: 1.5 = ($250,000/$750,000)bAvg + ($500,000/$750,000)1.35 1.5 = 0.333bAvg + 0.90 0.6 = 0.333bAvg bAvg = 1.8. 2. Required return Answer: c Diff: M Step 1: Solve for risk-free rate 15% = kRF + (10% - kRF)2.0 15% = kRF + 20% - 2kRF kRF = 5%. Step 2: Calculate new market return kM increases by 30%, so kM = 1.3(10%) = 13%. Step 3: Calculate new required return on stock ks = 5% + (13% - 5%)2 = 21%. Step 4: Calculate percentage change in return on stock = 40%. 3. Beta coefficient Answer: b Diff: E In equilibrium 10 kA = = 11.3%. kA = kRF + (kM - kRF)b 11.3% = 5% + (10% - 5%)b b = 1.26. 4. Effective annual rate Answer: d Diff: E Statement d is correct. The equation for EAR is as follows: EAR = . If annual compounding is used, m = 1 and the equation above reduces to EAR = kNom. The equation for the periodic rate is: . If annual compounding is used then m = 1 and kPER = kNom, and since EAR = kNom then kPER = EAR. 5. PV of an uneven CF stream Answer: b Diff: E NPV = $10,000/1.08 + $25,000/(1.08)2 + $50,000/(1.08)3 + $35,000/(1.08)4 = $9,259.26 + $21,433.47 + $39,691.61 + $25,726.04 = $96,110.38  $96,110. Financial calculator solution: Using cash flows Inputs: CF0 = 0; CF1 = 10000; CF2 = 25000; CF3 = 50000; CF4 = 35000; I = 8. Output: NPV = $96,110.39  $96,110. 6. Time value of money and retirement Answer: b Diff: E N Step 1: Find the number of years it will take for each $150,000 investment to grow to $1,000,000. BRUCE: I/YR = 5; PV = -150,000; PMT = 0; FV = 1,000,000; and then solve for N = 38.88. BRENDA: I/YR = 10; PV = -150,000; PMT = 0; FV = 1,000,000; and then solve for N = 19.90. Step 2: Calculate the difference in the length of time for the accounts to reach $1 million: Bruce will be able to retire in 38.88 years, or 38.88 – 19.90 = 19.0 years after Brenda does. 11 17. Remaining loan balance Answer: a Diff: E N Step 1: Solve for the monthly payment: Enter the following input data in the calculator: N = 60; I = 12/12 = 1; PV = -15,000; FV = 0; and then solve for PMT = $333.6667. Step 2: Determine the loan balance remaining after the 30th payment: 1 INPUT 30 n AMORT = displays Int: $3,621.1746 = displays Prin: $6,388.8264 = displays Bal: $8,611.1736. Therefore, the balance will be $8,611.17. 18 Work out how much Karen will have saved by age 65: Enter the following inputs in the calculator: N = 41; I = 10; PV = 0; PMT = 5,000; and then solve for FV = $2,439,259. Required annuity paymentsAnswer: b Diff: M N 19: Figure the payments Kathy will need to make to have the same amount saved as Karen: Enter the following inputs in the calculator: N = 36; I = 10; PV = 0; FV = 2,439,259; and then solve for PMT = $8,154.60. 20. Bond concepts Answer: a Diff: E Statement a is correct; the other statements are false. A bond’s price and YTM are negatively related. If a bond’s YTM is greater than its coupon rate, it will sell at a discount. 2. Bond value--semiannual payment Answer: b Diff: E N = 15 ´ 2 = 30; I/YR = 11/2 = 5.5; PMT = 1,000 ´ 0.08/2 = 40; FV = 1000; and then solve for PV = -$781.99. VB = $781.99. 22. YTM and YTC--semiannual bond Answer: e Diff: E To calculate YTM: N = 28; PV = -1075; PMT = 40; FV = 1000; and then solve for I/YR = 3.57% ´ 2 = 7.14%. To calculate YTC: N = 10; PV = -1075; PMT = 40; FV = 1050; and then solve for I/YR = 3.52% ´ 2 = 7.05%. 12 23. Bond value--semiannual payment Answer: d Diff: E Financial calculator solution: Inputs: N = 40; I = 5; PMT = 40; FV = 1000. Output: PV = -$828.41; VB  $828. 24. Current yield and yield to maturity Answer: b Diff: E Current yield is calculated as: $80/$985 = 8.12%. N = 12; PV = -985; PMT = 80; FV = 1000; and then solve for I/YR (YTM) = 8.20%. 25. Bond coupon rate Answer: c Diff: M Tabular solution: $768 = (PMT/2)(PVIFA5%,10) + $1,000(PVIF5%,10) = (PMT/2)(7.7217) + $1,000(0.6139) 154.10 = (PMT/2)(7.7217) PMT/2 = $19.96  $20 PMT  $40 and coupon rate  4%. Financial calculator solution: Inputs: N = 10; I = 5; PV = -768; FV = 1,000. Output: PMT = $19.955 (semiannual PMT). Annual coupon rate = (PMT ´ 2)/M = ($19.955 ´ 2)/$1,000 = 3.99%  4%. 13